10-K/A 1 w00317a1e10vkza.htm NATIONAL RURAL UTILITIES COOPERATIVE FINANCE CORP e10vkza
 



UNITED STATES

SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549


FORM 10-K/A

 
x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT of 1934

For the fiscal year ended May 31, 2004

or

 
o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT of 1934

For the transition period from           to                     

Commission file number 1-7102


NATIONAL RURAL UTILITIES COOPERATIVE

FINANCE CORPORATION
(Exact name of registrant as specified in its charter)

DISTRICT OF COLUMBIA


(State or other jurisdiction of incorporation or organization)

52-0891669

(I.R.S. Employer Identification Number)

2201 COOPERATIVE WAY, HERNDON, VA 20171

(Address of principal executive offices)

(Registrant’s telecommunications number, including area code, is 703-709-6700)


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

         
Name of each
exchange on
Title of each class which listed


6.375% Collateral Trust Bonds, due 2004
    NYSE  
5.50% Collateral Trust Bonds, due 2005
    NYSE  
6.125% Collateral Trust Bonds, due 2005
    NYSE  
6.65% Collateral Trust Bonds, due 2005
    NYSE  
7.30% Collateral Trust Bonds, due 2006
    NYSE  
6.20% Collateral Trust Bonds, due 2008
    NYSE  
5.75% Collateral Trust Bonds, due 2008
    NYSE  
5.70% Collateral Trust Bonds, due 2010
    NYSE  
7.20% Collateral Trust Bonds, due 2015
    NYSE  
6.55% Collateral Trust Bonds, due 2018
    NYSE  
7.35% Collateral Trust Bonds, due 2026
    NYSE  
6.75% Subordinated Notes, due 2043
    NYSE  
6.10% Subordinated Notes, due 2044
    NYSE  
7.625% Quarterly Income Capital Securities, due 2050
    NYSE  
7.40% Quarterly Income Capital Securities, due 2050
    NYSE  

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 o.

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained to the best of the registrant’s knowledge in definitive proxy or information statements incorporated by reference in Part IV of this Form 10-K or any amendment to this Form 10-K.    x

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act).    Yes o    No x.

The Registrant has no stock.

EXPLANATORY NOTE

This Form 10-K/A is being filed in order to correct certain typographical errors. This form 10-K/A amends and restates our Form 10-K for the year ended May 31, 2004, as filed with the Securities and Exchange Commission on August 20, 2004.




 

TABLE OF CONTENTS

                         
Part No. Item No. Page



  I.       1.     Business     1  
                     General     1  
                     Members     2  
                     Distribution Systems     3  
                     Power Supply Systems     4  
                     Service Organizations and Associate Systems     4  
                     Telecommunications Systems     4  
                Loan Programs     5  
                     Interest Rates on Loans     7  
                     Electric Loan Programs     7  
                     Telecommunications Loan Programs     7  
                     RUS Guaranteed Loans for Rural Electric Systems     8  
                     Conversion of Loans     9  
                     Prepayment of Loans     9  
                Guarantee Programs     9  
                     Guarantees of Long-Term Tax-Exempt Bonds     9  
                     Guarantees of Lease Transactions     10  
                     Guarantees of Tax Benefit Transfers     10  
                     Letters of Credit     10  
                     Other Guarantees     10  
                Disaster Recovery     11  
                Tax Status     11  
                Investment Policy     11  
                Employees     12  
                CFC Lending Competition     12  
                Member Regulation and Competition     13  
                The RUS Program     16  
                Member Financial Data     16  
          2.     Properties     25  
          3.     Legal Proceedings     25  
          4.     Submission of Matters to a Vote of Security Holders     25  
  II.       5.     Market for the Registrant’s Common Equity and Related Stockholder Matters     26  
          6.     Selected Financial Data     26  
          7.     Management’s Discussion and Analysis of Financial Condition and Results of Operations     28  
                     Overview     30  
                     Critical Accounting Policies     32  
                     Margin Analysis     37  
                     Liquidity and Capital Resources     47  
                     Asset/Liability Management     63  
                     Financial and Industry Outlook     70  
                     Non-GAAP Financial Measures     72  
          7A.     Quantitative and Qualitative Disclosures About Market Risk     77  
          8.     Financial Statements and Supplementary Data     77  
          9.     Changes in and Disagreements with Accountants on Accounting and Financial Disclosure     77  
          9A.     Controls and Procedures     77  
  III.       10.     Directors and Executive Officers of the Registrant     79  
          11.     Executive Compensation     85  
          12.     Security Ownership of Certain Beneficial Owners and Management     88  
          13.     Certain Relationships and Related Transactions     88  
          14.     Principal Accountant Fees and Services     88  
  IV.       15.     Exhibits, Financial Statement Schedules, and Reports on Form 8-K     89  
                Signatures     91  


 

PART I

 
Item 1. Business.

General

National Rural Utilities Cooperative Finance Corporation (“CFC”) was incorporated as a private, not-for-profit cooperative association under the laws of the District of Columbia in April 1969. The principal purpose of CFC is to provide its members with a dependable source of low cost capital and financial products and services. CFC provides its members with a source of financing to supplement the loan programs of the Rural Utilities Service (“RUS”) of the United States Department of Agriculture. CFC will also lend up to 100% of the loan requirements for those members electing not to borrow from RUS consistent with CFC’s credit policies. CFC is owned by and makes loans primarily to its rural utility system members (“utility members”) to enable them to acquire, construct and operate electric distribution, generation, transmission and related facilities. CFC also provides its members with credit enhancements in the form of letters of credit and guarantees of debt obligations. CFC is exempt from payment of federal income taxes under the provisions of Internal Revenue Code Section 501(c)(4). CFC’s internet address is www.nrucfc.coop, where under “Investors,” you can find copies of this annual report on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K, all of which CFC makes available as soon as reasonably practicable after the report is filed with the Securities
and Exchange Commission. Other than as set forth herein, information posted on CFC’s website is not incorporated by reference into this Form 10-K.

Rural Telephone Finance Cooperative (“RTFC”) was incorporated as a private cooperative association in the state of South Dakota in September 1987 and was created for the purpose of providing and/or arranging financing for its rural telecommunications members and their affiliates. Effective June 1, 2003, RTFC’s results of operations and financial condition have been consolidated with those of CFC in the accompanying financial statements. RTFC operates under a management agreement with CFC. RTFC is headquartered with CFC in Herndon, Virginia. RTFC is a taxable entity and takes tax deductions for allocations of net margins as allowed by law under Subchapter T of the Internal Revenue Code. RTFC pays income tax based on its net margins, excluding net margins allocated to its patrons. Prior to June 1, 2003, RTFC’s results of operations and financial condition were combined with CFC’s.

National Cooperative Services Corporation (“NCSC”) was incorporated in 1981 in the District of Columbia as a private cooperative association. NCSC provides lease financing related to its members and general financing to for-profit or non-profit entities that are owned, operated or controlled by or provide substantial benefit to members of CFC. NCSC also markets, through its cooperative members, a consumer loan program for home improvements and an affinity credit card program. Both programs are currently funded by third parties. Effective June 1, 2003, NCSC’s results of operations and financial condition have been consolidated with those of CFC in the accompanying financial statements. NCSC operates under a management agreement with CFC. It is headquartered with CFC in Herndon, Virginia. NCSC is a taxable corporation. NCSC pays income tax annually based on its net margins for the period.

Unless stated otherwise, references to CFC relate to the consolidation of RTFC, NCSC and certain entities controlled by CFC and created to hold foreclosed assets. CFC established limited liability corporations and partnerships to hold foreclosed assets. CFC has full ownership and control of all such companies and thus consolidates their financial results.

There are three primary segments of CFC’s business, rural electric lending, rural telecommunications lending and other lending. Lending to electric cooperatives is done through CFC, lending to telecommunications organizations is done through RTFC and other lending is done through NCSC. In many cases, the residential and commercial customers of the electric cooperatives are also the customers of the telecommunications organizations, as the service territories of the electric and telecommunications members overlap in many of the rural areas of the United States.

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Members

CFC’s consolidated membership was 1,544 as of May 31, 2004 including 897 utility members, the majority of which are consumer-owned electric cooperatives, 507 telecommunications members, 70 service members and 70 associates in 49 states, the District of Columbia and three U.S. territories. The utility members included 826 distribution systems and 71 generation and transmission (“power supply”) systems. Memberships between CFC, RTFC and NCSC have been eliminated in consolidation.

CFC currently has five classes of electric members:
•  Class A — cooperative or not-for-profit distribution systems;
•  Class B — cooperative or not-for-profit power supply systems;
•  Class C — statewide and regional associations which are wholly-owned or controlled by Class A or Class B members;
•  Class D — national associations of cooperatives; and
•  Class E — associate — not-for-profit groups or entities organized on a cooperative basis which are owned, controlled or operated by Class A, B or C members and which provide non-electric services primarily for the benefit of ultimate consumers. Associates are not entitled to vote at any meeting of the members and are not eligible to be represented on CFC’s board of directors.

Membership in RTFC is limited to commercial (for-profit) or cooperative (not-for-profit) telecommunications systems that are eligible to receive loans or other assistance from RUS, and that are engaged (or plan to be engaged) in providing telecommunication services to ultimate users.

Membership in NCSC is limited to organizations that are class A members of CFC or are eligible to be class A members of CFC.

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Set forth below is a table showing by state or U.S. territory the total number of CFC, RTFC and NCSC members, the percentage of total loans and the percentage of total loans and guarantees outstanding at May 31, 2004.

                         
Number Loan and
of Guarantee
State/Territory Members Loan % %




Alabama
    30       1.82 %     1.82 %
Alaska
    29       1.81 %     1.71 %
American Samoa
    1       0.01 %     0.01 %
Arizona
    23       0.98 %     1.14 %
Arkansas
    29       2.70 %     2.64 %
California
    11       0.14 %     0.13 %
Colorado
    40       4.54 %     4.52 %
Connecticut
    2       0.98 %     0.92 %
Delaware
    1       0.10 %     0.10 %
District of Columbia
    5       0.11 %     0.56 %
Florida
    19       2.99 %     3.34 %
Georgia
    68       7.59 %     7.13 %
Guam
    1       0.00 %     0.00 %
Hawaii
    1       0.20 %     0.19 %
Idaho
    17       0.86 %     0.81 %
Illinois
    52       2.88 %     2.73 %
Indiana
    53       1.73 %     2.12 %
Iowa
    118       5.32 %     5.02 %
Kansas
    50       2.65 %     2.65 %
Kentucky
    33       2.17 %     2.66 %
Louisiana
    17       1.58 %     1.50 %
Maine
    6       0.19 %     0.18 %
Maryland
    2       0.75 %     0.70 %
Massachusetts
    2       0.00 %     0.00 %
Michigan
    26       1.40 %     1.32 %
Minnesota
    77       4.65 %     4.81 %
Mississippi
    26       1.53 %     1.66 %
Missouri
    64       3.08 %     3.41 %
Montana
    39       0.88 %     0.82 %
Nebraska
    40       0.07 %     0.07 %
Nevada
    6       0.72 %     0.68 %
New Hampshire
    5       0.92 %     0.95 %
New Jersey
    1       0.10 %     0.09 %
New Mexico
    26       0.18 %     0.18 %
New York
    13       0.10 %     0.09 %
North Carolina
    44       4.82 %     4.99 %
North Dakota
    35       0.42 %     0.48 %
Ohio
    42       1.99 %     1.87 %
Oklahoma
    50       2.36 %     2.26 %
Oregon
    39       1.52 %     1.53 %
Pennsylvania
    26       1.39 %     1.40 %
South Carolina
    38       2.81 %     2.64 %
South Dakota
    47       0.88 %     0.83 %
Tennessee
    30       0.57 %     0.54 %
Texas
    113       17.31 %     16.92 %
Utah
    11       2.73 %     2.78 %
Vermont
    8       0.41 %     0.39 %
Virgin Islands
    1       2.70 %     2.53 %
Virginia
    27       1.52 %     1.45 %
Washington
    18       0.45 %     0.43 %
West Virginia
    5       0.03 %     0.03 %
Wisconsin
    62       1.63 %     1.54 %
Wyoming
    15       0.73 %     0.73 %
     
     
     
 
Total
    1,544       100.00 %     100.00 %
     
     
     
 
Distribution Systems
Distribution systems are utilities engaged in retail sales of electricity to consumers in their service areas. Most distribution systems have all-requirements power purchase contracts with their power supply systems, which are owned and controlled by the member distribution systems. The wholesale power contracts between the distribution systems and the power supply systems provide for rate adjustments to cover the costs of supplying power, although in certain cases such adjustments must be approved by regulatory agencies. Wholesale power for resale also comes from other sources, including power supply system contracts with government agencies, investor-owned utilities and other entities, and in rare cases, the distribution system’s own generating facilities.

Wholesale power supply contracts ordinarily guarantee neither an uninterrupted supply nor a constant cost of power. Contracts with RUS-financed power supply systems (which generally require the distribution system to purchase all its power requirements from the power supply system) provide for rate increases to pass along increases in sellers’ costs. The wholesale power contracts permit the power supply system, subject to approval by RUS and, in certain circumstances, regulatory agencies, to establish rates to its members so as to produce revenues sufficient, with revenues from all other sources, to meet the costs of operation and maintenance (including replacements, insurance, taxes and administrative and general overhead expenses) of all generating, transmission and related facilities, to pay the cost of any power and energy purchased for resale, to pay the costs of generation and transmission, to make all payments on account of all indebtedness and lease obligations of the power supply system and to provide for the

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establishment and maintenance of reasonable reserves. The board of directors of the power supply system may review the rates under the wholesale power contracts at least annually.

Power contracts with investor-owned utilities and power supply systems which do not borrow from RUS generally have rates subject to regulation by the Federal Energy Regulatory Commission (“FERC”). Contracts with federal agencies generally permit rate changes by the selling agency (subject, in some cases, to federal regulatory approval).

 
Power Supply Systems
Power supply systems are utilities that purchase or generate electric power and provide it on a wholesale basis to distribution systems for delivery to the ultimate retail consumer. Of the 60 operating power supply systems financed in whole or in part by RUS or CFC at December 31, 2002 (the most recent year for which data is available), 59 were cooperatives owned directly or indirectly by groups of distribution systems and one was government owned. Of this number, 37 had generating capacity of at least 100 megawatts, 10 had less than 100 megawatts of generating capacity and 12 had no generating capacity. The systems with no generating capacity generally operated transmission lines to supply certain distribution systems. Certain other power supply systems have been formed but do not yet own generating or transmission facilities.

At December 31, 2002, the 56 power supply systems that provide reports to CFC owned interests in 144 generating plants representing generating capacity of approximately 38,197 megawatts, or approximately 5.2% of the nation’s estimated electric generating capacity for facilities similar to those of CFC’s power supply cooperatives, and served 566 RUS distribution system borrowers. Certain of the power supply systems which lease generating plants from others operate these facilities to produce their power requirements. Of the power supply systems’ total generating capacity in place as of December 31, 2002, steam plants accounted for 78.8% (including nuclear capacity representing approximately 6.3% of such total generating capacity), internal combustion plants accounted for 19.0% and hydroelectric plants accounted for 2.2%.

 
Service Organizations and Associate Systems
Service organizations include the National Rural Electric Cooperative Association (“NRECA”), statewide and regional cooperative associations. NRECA represents cooperatives nationally. The statewide cooperative associations represent the cooperatives within a state.

Associates include organizations that are owned, controlled or operated by Class A, B or C members and that provide non-electric services primarily for the benefit of ultimate consumers.

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

Independent rural telecommunications companies provide service throughout many of the rural areas of the United States. These companies, which number approximately 1,300, are called independent because they are not affiliated with the regional Bell operating companies (“RBOCs”). Included in the total are approximately 250 not-for-profit cooperative telecommunications companies. The majority of these independent rural telecommunications companies are family-owned or privately-held commercial companies. However, approximately 20 of these commercial companies are publicly traded or issue bonds publicly.

Rural telecommunications companies (including all local exchange carriers (“LECs”) other than RBOCs and Sprint) comprise a relatively small sector (less than 15%) of a local exchange telecommunications industry that provides service to nearly 175 million access lines. These rural companies range in size from fewer than 100 customers to more than 1,000,000. Rural telecommunications companies’ annual operating revenues range from less than $100,000 to over $2 billion. In addition to basic local exchange and access telecommunications service, most independents offer other communications services including wireless

4


 

telephone, cable television and internet access. Most rural telecommunications companies’ networks incorporate digital switching, fiber optics and other advanced technologies.

Loan Programs

Set forth below is a table showing loans outstanding to borrowers at May 31, 2004, 2003 and 2002 and the weighted average interest rates thereon and loans committed but unadvanced to borrowers at May 31, 2004.

                                                             
Loans outstanding and weighted average interest rates thereon at May 31, Unadvanced

Commitments at
(Dollar amounts in thousands) 2004(A) 2003(A) 2002 May 31, 2004(B)




Long-term fixed rate secured loans(C) :
                                                       
 
Electric systems
  $ 10,897,008       5.27 %   $ 9,484,490       5.64 %   $ 7,848,861       6.32 %   $  
 
Telecommunications systems
    2,695,205       7.33 %     2,735,220       7.77 %     2,694,945       7.90 %      
 
Other
    46,945       8.45 %                              
     
             
             
             
 
 
Total long-term fixed rate secured loans
    13,639,158       5.69 %     12,219,710       6.12 %     10,543,806       6.72 %      
Long-term variable rate secured loans (D):
                                                       
 
Electric systems
    2,904,399       2.63 %     3,211,434       3.35 %     4,127,019       4.21 %     5,483,912  
 
Telecommunications systems
    1,542,554       4.52 %     1,965,390       5.30 %     2,138,174       5.71 %     292,064  
 
Other
    224,134       3.30 %                             50,252  
     
             
             
             
 
 
Total long-term variable rate secured loans
    4,671,087       3.28 %     5,176,824       4.09 %     6,265,193       4.72 %     5,826,228  
Loans guaranteed by RUS:
                                                       
 
Electric systems
    263,392       4.60 %     266,857       4.71 %     242,574       4.75 %     8,491  
Intermediate-term secured loans:
                                                       
 
Electric systems
    4,616       2.50 %     14,525       3.63 %     31,133       5.48 %     20,226  
 
Other
    399       3.99 %                              
     
             
             
             
 
 
Total intermediate-term secured loans
    5,015       2.62 %     14,525       3.63 %     31,133       5.48 %     20,226  
Intermediate-term unsecured loans:
                                                       
 
Electric systems
    43,326       2.56 %     50,843       3.65 %     177,154       5.19 %     60,621  
 
Telecommunications systems
    7,064       4.75 %     18,642       5.45 %     7,298       5.75 %     1,572  
     
             
             
             
 
 
Total intermediate-term unsecured loans
    50,390       2.87 %     69,485       4.13 %     184,452       5.21 %     62,193  
Line of credit loans(E):
                                                       
 
Electric systems
    792,580       2.50 %     884,146       3.57 %     1,002,459       4.57 %     5,249,793  
 
Telecommunications systems
    57,747       5.05 %     223,388       5.60 %     226,113       6.32 %     300,151  
 
Other
    50,119       3.30 %                             109,456  
     
             
             
             
 
 
Total line of credit loans
    900,446       2.71 %     1,107,534       3.98 %     1,228,572       4.89 %     5,659,400  
Non-performing loans:
                                                       
 
Electric systems
                            1,002,782              
 
Telecommunications systems
    340,438       4.54 %                 8,546              
 
Other
    789                                      
     
             
             
             
 
 
Total non-performing loans
    341,227       4.53 %                 1,011,328              
Restructured loans(F):
                                                       
 
Electric systems
    617,808             629,406             540,051       6.92 %      
     
             
             
             
 
   
Total loans
    20,488,523       4.80 %     19,484,341       5.23 %     20,047,109       5.61 %     11,576,538  
Less: Allowance for loan losses
    (573,939 )             (511,463 )             (478,342 )              
     
             
             
             
 
   
Net loans
  $ 19,914,584             $ 18,972,878             $ 19,568,767             $ 11,576,538  
     
             
             
             
 
Total by member class:
                                                       
 
Distribution
  $ 12,569,228             $ 11,410,592             $ 11,866,442             $ 8,532,978  
 
Power supply
    2,819,224               2,701,094               2,624,039               2,101,439  
 
Statewide and associates
    134,677               430,015               481,552               188,626  
     
             
             
             
 
   
Subtotal electric systems
    15,523,129               14,541,701               14,972,033               10,823,043  
 
Telecommunications systems
    4,643,008               4,942,640               5,075,076               593,787  
 
Other
    322,386                                           159,708  
     
             
             
             
 
   
Total
  $ 20,488,523             $ 19,484,341             $ 20,047,109             $ 11,576,538  
     
             
             
             
 

5


 


(A) The interest rates in effect at August 2, 2004 on loans to electric members were 5.85% for long-term loans with a seven-year fixed rate term, 3.30% on variable rate long-term loans and 3.15% on intermediate-term loans and lines of credit. The rates in effect at August 2, 2004 on loans to telecommunications systems were 6.95% for long-term loans with a seven-year fixed rate term, 4.90% on long-term variable rate loans and 5.40% on lines of credit.
(B) Unadvanced commitments include loans approved by CFC for which loan contracts have been approved and executed, but funds have not been advanced. Since commitments may expire without being fully drawn upon, the total amounts reported as commitments do not necessarily represent future cash requirements. Collateral and security requirements for advances on commitments are identical to those on initial loan approval. As the interest rate on unadvanced commitments is not set, long-term unadvanced commitments have been classified in this chart as variable rate unadvanced commitments. However, once the loan contracts are executed and funds are advanced, the commitments could be at either a fixed or a variable rate.
(C) Generally, under the terms of long-term fixed rate loans, members may select a fixed rate for periods that range from one to 35 years. Upon expiration of the interest rate term, the borrower may select another fixed rate term of one to 35 years (but not beyond maturity of the loan) or a variable rate. The borrower may also repay to CFC the principal then outstanding together with interest due thereon and other sums, if required. Includes $349 million and $522 million of unsecured loans at May 31, 2004 and 2003, respectively.
(D) Includes $257 million and $328 million of unsecured loans and $320 million and $396 million of unsecured unadvanced commitments at May 31, 2004 and 2003, respectively.
(E) Includes $299 million and $331 million of secured loans and $481 million and $306 million of secured unadvanced commitments at May 31, 2004 and 2003, respectively.
(F) The rate on restructured loans represents the rate at which CFC was accruing interest on loans classified as restructured at May 31, 2004, 2003 and 2002.

Total loans outstanding, by state or U.S. territory, are summarized below:

                           
May 31,
(Dollar amounts in thousands)
State/Territory 2004 2003 2002




Alabama
  $ 373,978     $ 293,524     $ 263,670  
Alaska
    370,528       312,080       295,386  
American Samoa
    1,859       2,850        
Arizona
    201,548       149,310       133,465  
Arkansas
    552,971       520,305       517,218  
California
    28,270       23,497       18,042  
Colorado
    929,822       957,814       793,398  
Connecticut
    200,100       200,000       201,896  
Delaware
    21,093       14,812       20,881  
District of Columbia
    22,522       298,272       335,410  
Florida
    612,222       475,802       473,582  
Georgia
    1,555,763       1,538,946       1,683,474  
Hawaii
    41,120             233  
Idaho
    175,827       168,971       157,721  
Illinois
    589,870       613,838       683,718  
Indiana
    354,512       326,827       270,907  
Iowa
    1,090,224       1,117,138       1,167,938  
Kansas
    542,033       303,378       289,806  
Kentucky
    445,341       289,375       226,679  
Louisiana
    323,035       283,669       261,570  
Maine
    39,159       40,047       43,780  
Maryland
    152,872       102,886       130,094  
Massachusetts
    100              
Michigan
    286,345       277,150       298,981  
Minnesota
    952,984       853,159       856,013  
Mississippi
    313,904       474,288       373,537  
Missouri
    631,803       618,590       627,508  
Montana
    179,570       218,378       218,497  
Nebraska
    14,975       13,421       12,363  
Nevada
    147,868       90,817       93,399  
New Hampshire
    188,960       204,835       229,569  
New Jersey
    19,576       19,415       9,293  
New Mexico
    37,476       40,061       38,519  
New York
    20,270       16,640       16,885  
North Carolina
    988,101       927,217       963,335  
North Dakota
    85,749       75,435       52,640  
Ohio
    407,850       380,468       387,433  
Oklahoma
    482,824       476,736       521,388  
Oregon
    310,736       285,024       279,818  
Pennsylvania
    284,644       182,996       159,157  
South Carolina
    576,822       536,437       537,722  
South Dakota
    180,518       156,218       162,881  
Tennessee
    117,857       104,722       108,150  
Texas
    3,545,604       3,461,097       4,081,770  
Utah
    558,692       571,703       583,888  
Vermont
    84,510       63,604       40,851  
Virgin Islands
    552,674       623,037       615,599  
Virginia
    311,534       241,157       264,272  
Washington
    93,258       87,893       87,190  
West Virginia
    5,797       3,959       2,160  
Wisconsin
    334,039       303,562       300,464  
Wyoming
    148,814       142,981       154,959  
     
     
     
 
 
Total
  $ 20,488,523     $ 19,484,341     $ 20,047,109  
     
     
     
 

CFC’s loan portfolio is widely dispersed throughout the United States and its territories, including 49 states, the District of Columbia, American Samoa and the U.S. Virgin Islands. At May 31, 2004, 2003 and 2002, loans outstanding to borrowers located in any one state or territory did not exceed 18%, 18% and 21%, respectively.

6


 

 
Interest Rates on Loans
CFC’s goal as a not-for-profit cooperatively-owned finance company is to set rates at levels that will provide its members with the lowest cost financing while maintaining sound financial results as required to obtain high credit ratings on its debt instruments. CFC sets its interest rates based on the cost of funding plus provisions for general and administrative expenses, the loan loss allowance and a reasonable net margin. Various discounts, which reduce the stated interest rates, are available to borrowers meeting certain criteria related to business type, performance, volume and whether they borrow exclusively from CFC. See Note 2 to the combined financial statements for the weighted average interest rates earned on all loans outstanding during the fiscal years ended May 31, 2004, 2003 and 2002.
 
Electric Loan Programs
Long-Term Loans
Long-term loans are generally for terms of up to 35 years. These loans finance electric plant and equipment which typically have a useful life equal to or in excess of the loan maturity. A borrower can select a fixed interest rate for periods of one to 35 years or a variable rate. Upon the expiration of the selected fixed interest rate term, the borrower must select the variable rate or select another fixed rate term for a period that does not exceed the remaining loan maturity. CFC sets long-term fixed rates daily and the long-term variable rate is set on the first business day of each month. The fixed rate on a loan is determined on the day the loan is advanced based on the rate term selected. A borrower may divide its loan into various tranches. The borrower then has the option of selecting a fixed or variable interest rate for each tranche.

To be eligible for long-term loan advances, distribution systems must maintain an average modified debt service coverage ratio (“MDSC”), as defined in the loan agreement, of 1.35 or greater. The distribution systems must also be in good standing with CFC and their states of incorporation, supply evidence of proper corporate authority, deliver to CFC annual audited financial statements and an annual compliance certificate and be in compliance with all other terms of the loan agreement. Generally, the minimum eligibility requirements for power supply systems are an average times interest earned ratio (“TIER”) and MDSC, as described in the loan agreement, of 1.0 or greater. CFC has in the past and may in the future make long-term loans to distribution and power supply systems that do not meet the minimum lending criteria. During the five years ended May 31, 2004, 5% of the dollar amount of long-term loans approved was to borrowers that did not meet the minimum lending criteria.

 
Line of Credit Loans
Line of credit loans may be advanced only at a variable interest rate. The line of credit variable interest rate is set on the first business day of each month. The principal amount of line of credit loans with maturities of greater than one year generally must be paid down to a zero outstanding principal balance for five consecutive days during each 12-month period.

To be eligible for a line of credit loan, distribution and power supply borrowers must be in good standing with CFC and demonstrate their ability to repay the loan.

 
Telecommunications Loan Programs
CFC’s telecommunications loan portfolio is heavily concentrated in the rural local exchange carrier (“RLEC”) segment of the telecommunications market. The two principal barriers to entry for potential competitors are the low population density of the RLEC service territories and the high quality of service the customers receive from the incumbent RLECs. These services are generally delivered over networks that include fiber optic cable and digital switching.

The businesses to which the remaining telecommunications loans have been made are generally supporting the operations of the RLECs and are owned, operated or controlled by RLECs. Many such loans are supported by payment guarantees from the sponsoring RLECs.

7


 

 
Long-Term Loans
CFC makes long-term loans to rural telecommunications companies and their affiliates for the acquisition of and the construction or upgrade of wireline telecommunications systems, wireless telecommunications systems, fiber optic networks, cable television systems and other corporate purposes. Long-term loans are generally for periods of up to 15 years. Loans may be advanced at a fixed or variable interest rate. Fixed rates are generally available for periods from one year to 15 years. Upon the expiration of the selected fixed interest rate term, the borrower must select another fixed rate term for a period that does not exceed the remaining loan maturity or select the variable rate. CFC sets long-term fixed rates for telecommunications loans daily and the long-term variable rate is set on the first business day of each month. The fixed rate on a loan is determined on the day the loan is advanced or converted to a fixed rate based on the term selected. A borrower may divide its loan into various tranches. The borrower then has the option of selecting a fixed or variable interest rate for each tranche.

To borrow from CFC, a wireline telecommunications system generally must be able to demonstrate the ability to achieve and maintain an annual debt service coverage ratio (“DSC”) and an annual TIER of 1.25 and 1.50, respectively. To borrow from CFC, a cable television system, fiber optic network or wireless telecommunications system generally must be able to demonstrate the ability to achieve and maintain an annual DSC of 1.25. Loans made to start-up ventures using emerging technologies are evaluated based on the quality of the business plan and the level and quality of credit support from established companies. Based on the business plan, specific covenants are developed for each transaction which require performance at levels deemed sufficient to repay the CFC obligations under the approved terms.

 
Intermediate-Term Loans and Line of Credit Loans
CFC provides intermediate-term equipment financing to telecommunications borrowers for periods up to five years. These loans are provided on an unsecured basis and are used to finance the purchase and installation of central office equipment, support assets and other communications equipment. Intermediate-term equipment financing loans are generally made to operating telecommunications companies with an equity level of at least 25% of total assets and which have achieved a DSC ratio for each of the previous two calendar years of at least 1.75.

CFC also provides line of credit loans to telecommunications systems for periods of up to five years. These line of credit loans are typically in the form of a revolving line of credit, which generally requires the borrower to pay off the principal balance for five consecutive business days at least once during each 12-month period. These line of credit loans may be provided on a secured or unsecured basis and are designed primarily to assist borrowers with liquidity and cash management.

Interim financing line of credit loans are also made available to CFC telecommunications members that have an RUS and/or Rural Telephone Bank (“RTB”) loan application pending and have received approval from RUS or RTB to obtain interim financing. These loans are for terms up to 24 months and the borrower must repay the CFC loan with advances from the RUS/ RTB long-term loans.

 
RUS Guaranteed Loans for Rural Electric Systems
The level of authority for RUS loan guarantees for the fiscal year ending September 30, 2004 is $2.1 billion. The expected level for fiscal year 2005 is also $2.1 billion. CFC may participate as an eligible lender in the RUS loan guarantee program under the terms and conditions of a master loan guarantee and servicing agreement between RUS and CFC. Under this agreement, CFC may make long-term secured loans to eligible members for periods of up to 35 years, at fixed or variable rates established by CFC. RUS guarantees the principal and interest payments on the notes evidencing such loans. The guarantees are uncontestable except for fraud or misrepresentation which the holder had actual knowledge of at the time it became a holder. At May 31, 2004, CFC had $222 million of loans outstanding under this program. In addition, at May 31, 2004, CFC was holding certificates totaling $41 million representing interests in trusts holding RUS guaranteed loans.

8


 

 
Conversion of Loans
A borrower may convert a long-term loan from a variable interest rate to a fixed interest rate at any time without a fee. A borrower may convert a fixed rate to another fixed rate or a variable rate at any time, subject to a fee in most instances. Intermediate-term loans and line of credit loans do not offer conversion options. The fee on the conversion of a fixed interest rate to a variable interest rate ranges from 25 to 50 basis points of the outstanding loan amount plus a make-whole premium, if applicable per current loan policies.
 
Prepayment of Loans
Borrowers may prepay long-term loans at any time, subject to the payment of a prepayment fee of 33 to 50 basis points and a make-whole premium, if applicable. Line of credit loans may be repaid at any time without a premium.

Guarantee Programs

CFC uses the same credit policies and monitoring procedures in providing guarantees as it does for loans and commitments. The following chart provides a breakout of guarantees outstanding by type.

                           
May 31,

2004 2003 2002
(Dollar amounts in thousands)


Long-term tax-exempt bonds
  $ 780,940     $ 899,420     $ 940,990  
Debt portions of leveraged lease transactions
    14,838       34,105       41,064  
Indemnifications of tax benefit transfers
    159,745       184,605       208,637  
Letters of credit
    307,518       314,114       310,926  
Other guarantees
    68,258       471,312       554,768  
     
     
     
 
 
Total
  $ 1,331,299     $ 1,903,556     $ 2,056,385  
     
     
     
 
 
Guarantees of Long-Term Tax-Exempt Bonds
CFC has guaranteed debt issued in connection with the construction or acquisition by CFC members of pollution control, solid waste disposal, industrial development and electric distribution facilities. Governmental authorities issue such debt and the interest thereon is exempt from federal taxation. The proceeds of the offering are made available to the member system, which in turn is obligated to pay the governmental authority amounts sufficient to service the debt. The debt, which is guaranteed by CFC, may include short-and long-term obligations.

In the event of a default by a system for non-payment of debt service, CFC is obligated to pay, after available debt service reserve funds have been exhausted, scheduled debt service under its guarantee. The bond issue may not be accelerated so long as CFC performs under its guarantee. The system is required to repay, on demand, any amount advanced by CFC pursuant to its guarantee. This repayment obligation is secured by a common mortgage with RUS on all the system’s assets, but CFC may not exercise remedies thereunder for up to two years following default. However, if the debt is accelerated because of a determination that the interest thereon is not tax-exempt, the system’s obligation to reimburse CFC for any guarantee payments will be treated as a long-term loan. The system is required to pay to CFC initial and/or on-going guarantee fees in connection with these transactions.

Certain guaranteed long-term debt bears interest at variable rates which are adjusted at intervals of one to 270 days, weekly, each five weeks or semi-annually to a level expected to permit their resale or auction at par. At the option of the member on whose behalf it is issued, and provided funding sources are available, rates on such debt may be fixed until maturity. Holders have the right to tender the debt for purchase at par at the time rates are reset when the debt bears interest at a variable rate and CFC has committed to purchase debt so tendered if it cannot otherwise be remarketed. If CFC held the securities, the cooperative would pay interest to CFC at its intermediate-term loan rate. Since the inception of the program in the

9


 

mid-1980s, all bonds have been successfully remarketed and thus, CFC has not been required to purchase any bonds.
 
Guarantees of Lease Transactions
CFC guarantees members’ rent obligations to third parties. Included in CFC’s guarantees of lease transactions for the year ended May 31, 2003 and 2002 were CFC’s guarantees of debt issued by NCSC in connection with leveraged lease transactions. In such transactions, NCSC lends money to an industrial or financial company (a “lessor”) for the purchase of a power plant (or an undivided interest therein) or utility equipment which is then leased to a CFC member (the “lessee”) under a lease requiring the lessee to pay amounts sufficient to permit the lessor to service the loan. NCSC borrows the funds it lends either directly from CFC or from another creditor with a CFC guarantee. Effective June 1, 2003, the guarantees of NCSC debt were eliminated in consolidation.
 
Guarantees of Tax Benefit Transfers
CFC has also guaranteed members’ obligations to indemnify against loss of tax benefits in certain tax benefit transfers that occurred in 1981 and 1982. A member’s obligation to reimburse CFC for any guarantee payments would be treated as a long-term loan, secured on a pari passu basis with RUS by a first lien on substantially all the member’s property to the extent of any cash received by the member at the outset of the transaction. The remainder would be treated as an intermediate-term loan secured by a subordinated mortgage on substantially all of the member’s property. Due to changes in federal tax law, no guarantees of this nature have occurred since 1982.
 
Letters of Credit
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 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, with interest accruing from such date at CFC’s line of credit variable rate of interest.
 
Other Guarantees
CFC may provide other guarantees as requested by its members. Such guarantees may be made on a secured or unsecured basis with guarantee fees set to cover CFC’s general and administrative expenses, a provision for losses and a reasonable margin. Included in other guarantees at May 31, 2003 and 2002 was $284 million and $334 million, respectively, of commercial paper issued by NCSC. Effective June 1, 2003, the guarantee of NCSC commercial paper was eliminated in consolidation.

Members’ interest expense for the year ended May 31, 2004 on debt obligations guaranteed by CFC was approximately $13 million.

The following chart summarizes guarantees outstanding by member class at May 31, 2004, 2003 and 2002.

                                                     
Guarantees by Member Class

(Dollar amounts in thousands) 2004 2003 2002
 


Electric systems:
                                               
 
Distribution
  $ 60,672       5 %   $ 77,725       4 %   $ 66,670       3 %
 
Power supply
    1,130,379       85 %     1,220,795       64 %     1,304,367       64 %
 
Statewide and associate
    111,195       8 %     600,036       32 %     680,011       33 %
     
     
     
     
     
     
 
   
Subtotal electric systems
    1,302,246       98 %     1,898,556       100 %     2,051,048       100 %
Telecommunication systems
                5,000             5,337        
Other
    29,053       2 %                        
     
     
     
     
     
     
 
   
Total
  $ 1,331,299       100 %   $ 1,903,556       100 %   $ 2,056,385       100 %
     
     
     
     
     
     
 

10


 

Total guarantees outstanding by state and territory are summarized as follows:

(Dollar amounts in thousands)

                         
May 31,

2004 2003 2002



Alabama
  $ 22,630     $ 22,795     $ 25,945  
Alaska
    3,320       3,320       3,240  
Arizona
    46,865       47,250       47,425  
Arkansas
    23,537       29,703       35,688  
Colorado
    56,518       57,273       58,007  
District of Columbia
    100,000       590,941       674,435  
Florida
    116,447       128,264       137,944  
Idaho
    850       850       850  
Illinois
    6,218       7,093       7,719  
Indiana
    107,997       109,047       121,264  
Iowa
    4,885       12,572       14,290  
Kansas
    37,200       33,100       34,300  
Kentucky
    135,555       142,785       149,405  
Louisiana
    4,728              
Michigan
    1,148       196       691  
Minnesota
    95,556       103,696       111,863  
Mississippi
    47,299       51,304       54,824  
Missouri
    113,186       126,198       138,755  
New Hampshire
    17,500       31,500       27,500  
New Mexico
    1,000              
North Carolina
    100,350       100,950       100,265  
North Dakota
    20,000             338  
Ohio
          1,000        
Oklahoma
    11,221       16,760       23,154  
Oregon
    23,520       25,810       24,628  
Pennsylvania
    21,900       24,229       23,428  
Tennessee
    295       295       300  
Texas
    147,347       149,217       145,935  
Utah
    48,204       71,749       78,315  
Vermont
    750              
Virginia
    4,065       4,215       4,207  
Wisconsin
    1,403       1,439       1,475  
Wyoming
    9,805       10,005       10,195  
     
     
     
 
Total
  $ 1,331,299     $ 1,903,556     $ 2,056,385  
     
     
     
 

Disaster Recovery

CFC has had in place a disaster recovery and business continuity plan since May 2001. The plan includes a duplication of CFC’s information systems at an off-site facility and a comprehensive business recovery plan. CFC’s production data is replicated in real time to the recovery site. The plan also includes steps for each of CFC’s operating groups to conduct business with a view to minimizing disruption for customers. Recovery exercises are conducted twice annually with different teams to expand recovery experience among the staff. CFC contracts with an external vendor for the facilities to house the backup systems as well as office space and related office equipment.

Tax Status

In 1969, CFC obtained a ruling from the Internal Revenue Service recognizing CFC’s exemption from the payment of federal income taxes under Section 501(c)(4) of the Internal Revenue Code. Such exempt status could be removed as a result of changes in legislation or in administrative policy or as a result of changes in CFC’s business. CFC believes that its operations have not changed materially from those described to the Internal Revenue Service in its exemption filing. RTFC is taxable under Subchapter T of the Internal Revenue Code. As long as RTFC continues to qualify under Subchapter T of the Internal Revenue Code, it is allowed a deduction from taxable income for the amount of net margin allocated to its members. NCSC is a taxable corporation. NCSC pays income tax annually based on its net margins for the period.

Investment Policy

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

11


 

Employees

At May 31, 2004, CFC had 218 employees, including engineering, financial and legal personnel, management specialists, credit analysts, accountants and support staff. CFC believes that its relations with its employees are good.

CFC Lending Competition

CFC competes with other lenders on price and the variety of options and additional services offered as well as its overall approach to, and relationship with, its member/owners. Competitors include a government sponsored entity whose status as such gives it the ability to offer lower variable and short-term fixed interest rates in select situations.

According to annual financial data filed with CFC, the 812 reporting electric cooperative distribution and 56 reporting power supply systems had a total of $42 billion in long-term debt outstanding at December 31, 2003. RUS is the dominant lender to the electric cooperative industry with $24 billion or 56% of the total outstanding debt for the 868 systems reporting 2003 results to CFC. At December 31, 2003, CFC had a total of $15 billion of long-term exposure to its reporting distribution and power supply member systems, including $14 billion of long-term loans and $1 billion of guarantees. CFC’s $15 billion long-term exposure represented 37% of the total long-term debt to these electric systems. The remaining $3 billion or 7% was borrowed from other sources. (Competition data is based on December 31, 2003 financial data filed with CFC by its borrowers).

Under the insured loan program, RUS typically does not lend the full amount of debt requested by the cooperative, requiring the cooperative to seek supplemental lending from private capital sources. During fiscal year 2004, CFC was selected as the lender for 87% of the total supplemental lending requirement (not including amounts lent by the Federal Financing Bank (“FFB”)). The amount of funding proposed for RUS direct lending for fiscal year 2005 is $1.2 billion. The amount approved for the prior year was $2.0 billion. The amount proposed for RUS guaranteed loans for fiscal year 2005 is $2.1 billion. CFC and other lenders are not in competition with RUS, but rather compete for the supplemental lending requirement, as well as for the full lending requirement for those cooperatives that have decided not to borrow from RUS. CFC and other lenders also compete to fund projects in anticipation of long-term funding from RUS. Under the hardship program, RUS lends 100% of the permanent financing required. Under the guarantee program, RUS will guarantee the repayment of all principal and interest by the cooperative for 100% of the permanent financing required.

Legislation enacted in 1992 allows RUS electric borrowers to prepay their loans to RUS at a discount based on the government’s cost of funds at the time of prepayment. If a borrower chooses to prepay its notes, it becomes ineligible for future RUS insured loans for a period of ten years, but remains eligible for RUS loan guarantees. During the past year, as fixed interest rates in the markets dropped below 5%, there was an opportunity for CFC member systems to prepay RUS 5% loans. Approximately 90% of the systems electing to prepay their long-term 5% RUS loans selected CFC as the lender. During the year ended May 31, 2004, CFC was selected as lender for 100% of the total remaining amount lent to distribution systems for the repayment of their RUS debt for borrowers in which CFC previously participated as a lender. As of May 31, 2004, 238 borrowers had either fully prepaid or partially prepaid their RUS notes under these provisions. In total, CFC has lent $3.3 billion to distribution systems for the purpose of prepaying their RUS debt, representing 94% of the total note prepayments.

The competitive market for providing credit to the rural telecommunications industry is difficult to quantify, since many rural telecommunications companies are not RUS borrowers. At December 31, 2003, RUS had a total of approximately $3.5 billion outstanding to telecommunications borrowers. The RTB, an instrumentality of the United States government that provides supplemental financing to RUS borrowers and is managed by RUS, had a total of approximately $800 million outstanding to telecommunications borrowers at December 31, 2003. CFC is not in direct competition with RUS or RTB, but rather competes with other lenders for additional supplemental lending and for the full lending requirement of the rural telecommunications companies that have decided not to borrow from RUS or RTB or for projects

12


 

not eligible for RUS or RTB financing. CFC’s competition includes regional banks, CoBank, ACB (“CoBank”) and insurance companies. At December 31, 2003, CFC had a total of $4.5 billion in long-term loans outstanding to telecommunications borrowers. At December 31, 2003, to CFC’s knowledge, only CoBank (which at December 31, 2003 had a telecom portfolio of approximately $2.6 billion), had a rural telecommunications loan portfolio of similar size to CFC’s and RUS/ RTB’s.

Member Regulation and Competition

 
Electric Systems
In 1992 Congress passed the Energy Policy Act, which effectively provided competition in the generation sector of the wholesale electric power industry. Subsequently in 1996, FERC issued order 888 which provided for competitive wholesale power sales by requiring jurisdictional public utilities that own, control or operate transmission facilities to provide others with transmission service and rates comparable to the service and rates they provide themselves.

Section 211 of the Federal Power Act as amended by the Energy Policy Act of 1992 classifies any utility, including a cooperative, with transmission assets as a “transmitting utility” and gives FERC the authority in response to an application from certain third parties to order such utilities to provide transmission service. Also, under the Federal Power Act, a cooperative that pays off its RUS debt may become regulated by FERC if it provides transmission service in interstate commerce, or provides sales for resale in interstate commerce.

The trend toward retail electric competition has appreciably slowed. At May 31, 2004, 16 states were active in the process of moving toward customer choice. In these states, customer choice was either currently available to all or some customers or will soon be available. Those states are Connecticut, Delaware, Illinois, Maine, Maryland, Massachusetts, Michigan, New Hampshire, New Jersey, New York, Ohio, Oregon, Pennsylvania, Rhode Island, Texas and Virginia. Of the remaining states, 27 states were not actively pursuing restructuring, five states have delayed the restructuring process or the implementation of customer choice, and two states (Arizona and California) have suspended customer choice.

In the 16 states where customer choice is or will soon be available, CFC had a total of 224 electric members (171 distribution, 20 power supply and 33 associate) and $4,806 million of loans to electric systems. In New York, where CFC has five electric members and $13 million of loans to electric systems, cooperatives are not required to file competition plans with the state utility commission. In Michigan, where CFC has 14 electric members and $256 million in loans, the starting date for customer choice has been delayed. CFC continues to believe that the distribution systems, which comprise the majority of CFC’s membership and loan exposure, will not be materially impacted by customer choice. To date, even in those states where customers have a choice of alternative energy suppliers, very few customers have switched from the traditional supplier.

In addition, in five of the 16 states actively operating under customer choice laws, co-ops may decide whether to “opt in” to competition or retain a monopoly position with respect to energy sales. Those states are Illinois, New Jersey, Ohio, Oregon and Texas. As of May 31, 2004, CFC had loans outstanding in the amount of $3,772 million in those states. Furthermore, even if customers choose to purchase energy from an alternative supplier, the distribution systems own the lines to the customer and it would not be feasible for a competitor to build a second line to serve the same customers in almost all situations. Therefore, the distribution systems will still be charging a fee or access tariff for the service of delivering power regardless of who supplies the power.

The impact on power supply systems cannot be determined until final rules have been approved in each state with regard to stranded cost recovery.

While customer choice laws have been passed in the above states, there are many factors that may delay or influence the choices that customers have available to them and the timing of competition for cooperatives. One such factor will be the level of fees that systems will be allowed to charge other utilities

13


 

for use of their transmission and distribution system. Other issues that may further delay competition include, but are not limited to, the following:

•  ability of cooperatives to “opt out” of the provisions of the customer choice laws in some states;
•  utilities in many states may still be regulated regarding rates on non-competitive services, such as distribution;
•  many states will still regulate the securities issued by utilities, including cooperatives;
•  FERC regulation of rates as well as terms and conditions of transmission service;
•  reconciling the differences between state laws, such that out-of-state utilities can compete with in-state utilities; and
•  the fact that few competitors have much interest in serving residential or rural customers.

In addition to customer choice laws, some state agencies regulate electric cooperatives with regard to rates and borrowing. There are 16 states that regulate the rates electric systems charge; of these states, two states have partial oversight authority over the cooperatives’ rates, but not the specific authority to set rates, and nine states allow cooperatives the right to opt in or out of state regulation. There are 19 states that regulate electric systems regarding the issuance of long-term debt and there are two states that regulate both the issuance of short-term and long-term debt. FERC also has jurisdiction to regulate rates, terms and conditions of service and securities by electric systems within its jurisdiction, which presently includes some cooperatives.

 
Telecommunications Systems
CFC member telecommunications systems are regulated at the state and federal levels. Most state regulatory bodies regulate local service rates, intrastate access rates and telecommunications company borrowing. The Federal Communications Commission (“FCC”) regulates interstate access rates and the issuance of licenses required to operate certain types of telecom operations. Some member telecommunications systems have affiliated companies that are not regulated.

The Telecommunications Act of 1996 (the “Telecom Act”) created a framework for competition and deregulation in the local telecommunications market. The Telecom Act had four basic goals: competition, universal service, deregulation and fostering advanced telecommunications and information technologies. The Telecom Act seeks to achieve competition by requiring all carriers to interconnect with all others and by requiring LECs to provide competitors with access to elements of their networks. Congress included provisions in the Telecom Act granting RLECs an exemption from the above unbundled network element requirements, absent a determination that it would be in the public interest.

In cities, telecommunications competition is a fact. A recent FCC study stated that as of June 2003 competitive local exchange carriers provided 14.7% of local telephone lines. Despite the 2001-2002 shakeout in the competitive LEC segment, facility and non-facility based competitors are a growing force in the local exchange telecommunications marketplace and have moved beyond their initial focus on the large business user market. The RBOCs were motivated to cooperate with competitors in order to win approval to enter the long distance market in their service territories. Now, the RBOCs have gained authority to provide long distance service in all of their local markets and are less inclined to cooperate with competitors. AT&T, MCI and others have used the unbundled network element platform (“UNE-P”) to compete with the RBOCs for residential customers, offering packages of local and long distance service. The recent court ruling overturning the FCC’s requirement that the RBOCs continue to provide competitors with UNE-P has created significant uncertainty over the continued viability of CLECs that use UNE-P. In fact, the ruling, coupled with the continuing decrease in long-distance usage by customers, has motivated AT&T and MCI to discontinue seeking new residential customers.

Rural markets have generally not been subject to broad based local telecommunications service competition. Rural telecommunications companies that border metropolitan areas are now experiencing competition for their largest business customers and some are beginning to see competition for residential customers. A recent survey of small rural telecommunications companies found that 77% face at least one competitor in their markets. For the most part, local exchange competition has benefited rural LECs by

14


 

enabling them to enter nearby towns and cities as competitive LECs, leveraging their existing infrastructure.

In addition to competition, the Telecom Act also mandated a new universal telecommunications service support mechanism and required that it be: (1) sufficient to ensure that rural customers receive reasonably comparable rates and services when compared to urban customers; and (2) portable, that is available to all eligible providers. Congress stated its intent that implicit subsidies presently contained in the access charges local telecommunications companies levy on long distance carriers be eliminated and be made explicit in the new universal service support mechanism. Rules adopted by the FCC in 2000 have provided adequate levels of universal service support. This has been essential for rural LECs, as other FCC rulings have reduced access charges which are a key revenue source. Numerous wireless carriers have entered rural markets as competitors to the LEC. By obtaining competitive eligible telecommunications carrier status from state regulators (as provided for in the Telecom Act), these wireless carriers are able to receive universal service funds (“USF”) based on the incumbent LEC’s costs. This has led to great concern for the sustainability of the fund. USF’s current funding base of interstate telecommunications revenues is shrinking as long distance minutes-of-use go down due to wireless and email substitution. Uncontrolled growth of the fund would make the rate assessed on all participants in the nationwide network unsustainably high. All industry segments agree that changes need to be made to USF. However, they are not all in agreement on what those changes should be. A joint federal-state board has recommended to the FCC that only primary lines be supported by USF. This would be extremely harmful to rural LECs, as a decrease in USF support for non-primary lines would have to be made up by increased local rates, which would make the rural LEC more vulnerable to competition. Rural legislators, at the urging of LEC trade associations, have argued to the FCC that adoption of such a proposal would likely trigger strong Congressional opposition.

While uncertainty exists regarding USF, CFC does not anticipate that any potential revenue losses resulting from these changes will result in material losses on loans outstanding to rural telecommunications companies.

Most RLECs are expanding their service offerings to customers. Without cable as a competitor in most rural areas, RLECs are introducing digital video, high-speed data, and local and long distance voice service. Where they can leverage their infrastructure, they are competing with RBOCs and cable companies in neighboring towns. RLECs have generally been very successful competitors in these situations.

Deregulation has not had much effect on LECs thus far. The FCC has promulgated a series of rules to implement the Telecom Act, and eliminated very few existing regulatory requirements. States continue to regulate RLECs extensively.

Another aspect of the Telecom Act dealt with advanced telecommunications and information technologies. In the late 1990s there was the concern that there was a growing “digital divide” between various groups and areas within the country. Legislators sought to provide broadband connectivity to all Americans through programs which provide funding to connect schools and libraries to the internet. RUS has issued rules liberalizing its lending criteria to facilitate provision of advanced telecommunications and information services in rural areas. Congress also created an RUS broadband loan program in 2002 and authorized $1.4 billion in fiscal year 2003 lending authority. For fiscal year 2004, Congress authorized an additional $600 million. The impact of all this activity is open to question. The rural telecommunications trade association study cited above also noted that 99% of respondents were providing advanced services (200 kilobits/second or better in both directions) and that 88% of their customers were in reach of such services.

Thus far RUS has not played a significant role in financing infrastructure to help provide rural Americans with access to advanced services. About $200 million has been lent since fiscal year 2003. Given the increased availability of government financing for rural broadband, it is unlikely that CFC or any other supplemental lender will be participating in this financing to any significant degree.

15


 

The RUS Program

Since the enactment of the Rural Electrification Act in 1936 (the “RE Act”), RUS has financed the construction of electric generating plants, transmission facilities and distribution systems in order to provide electricity to rural areas. Principally through the organization of systems under the RUS loan program in 48 states and U.S. territories, the percentage of farms and residences in rural areas of the United States receiving central station electric service increased from 11% in 1934 to almost 100% currently. Rural electric systems serve 12% of all consumers of electricity in the United States and its territories and account for approximately 8% of total sales of electricity and own about 5% of energy generation and generating capacity.

In 1949, the RE Act was amended to allow RUS to lend for the purpose of furnishing and improving rural telecommunications service. For fiscal year 2004, RUS has $515 million in lending authority for rural telephone systems and an additional $2,306 million for other telecommunications programs, including distance learning, broadband and the RTB.

The RE Act provides for RUS to make insured loans and to provide other forms of financial assistance to borrowers. RUS is authorized to make direct loans, at below market rates, to systems that qualify for the hardship program (5% interest rate) or the municipal rate program (based on a municipal government obligation index). RUS is also authorized to guarantee loans that are used mainly to provide financing for construction of bulk power supply projects. Guaranteed loans bear interest at a rate agreed upon by the borrower and the lender (which generally has been the FFB). RUS also provides financing at the Treasury rate. For telecommunications borrowers, RUS also provides financing through the RTB. The RUS exercises financial and technical supervision over borrowers’ operations. Its loans and guarantees are generally secured by a mortgage on substantially all of the system’s property and revenues.

For the fiscal year ending September 30, 2005, the House Appropriations Committee has approved RUS electric loan levels as follows: municipal rate loans of $100 million, hardship loans of $120 million, treasury rate loans of $1 billion and loan guarantees of $2.1 billion. The Senate Appropriations Committee has not yet acted on RUS electric loan levels for fiscal year 2005, therefore the House approved levels are subject to change. Electric funding levels for fiscal year 2004 were as follows: municipal rate loans of $1 billion, hardship loans of $240 million, treasury rate loans of $750 million, and loan guarantees of $2.1 billion.

Member Financial Data

 
Electric Systems
Distribution and power supply systems with long-term loans outstanding are required to submit to CFC annual financial information on Form 7 and Form 12 or FERC Form 1, respectively. The information presented on the Form 7, Form 12 and FERC Form 1 is more detailed information than is typically available in the audited financial statements. The following pages contain composite statements of revenues, expenses and patronage capital for the years ended December 31, 2003, 2002, 2001, 2000 and 1999 and the composite combined balance sheets at December 31, 2003, 2002, 2001, 2000 and 1999, based on the Form 7’s, Form 12’s and FERC Form 1’s received from its borrowers. As of August 4, 2004, CFC had received financial information from 812 distribution systems and 56 power supply systems.

While CFC had 826 distribution system members at May 31, 2004, two distribution systems filed separate financial results on Form 7, and merged after December 31, 2003, 14 distribution systems were not required to report financial results on Form 7 because they did not have an outstanding balance of long-term loans at December 31, 2003, and one distribution system did not file financial results on Form 7 with CFC.

A total of 56 out of the 71 total power supply systems reported December 31, 2003 financial results on Form 12 or FERC Form 1 to CFC. A total of 12 power supply systems did not report financial results because they did not have an outstanding balance of long-term loans at December 31, 2003. Two power supply systems merged with another and filed combined financial results on Form 12 or FERC Form 1. In addition, one power supply system did not file financial results on Form 12 or FERC Form 1 with CFC.

16


 

 
Telecommunications Systems
On the following pages are tables providing composite statements of revenues and expenses from the telecommunications systems that were borrowers of CFC during the five years ended December 31, 2003. Members with long-term loans outstanding are generally required to submit annual data as of December 31 in the form of audited financial statements. As of August 2, 2004, CFC had received audited financial statements from 186 telecommunications systems.

CFC had 206 telecommunications borrowers at May 31, 2004. A total of 8 telecommunications borrowers have not yet filed audited financial statements with CFC, 10 telecommunications borrowers submitted consolidated audited financial statements and one was excluded due to the size of the company resulting in a significant weighting of the composite results, even though its loans from CFC represented only 4% of the total telecommunications portfolio. In addition, one borrower, representing less than 2% of the total telecommunications portfolio, was excluded due to the substantial gain recognized when the borrower emerged from bankruptcy. CFC was kept current on its loans to this borrower throughout the bankruptcy.

NOTE: The financial information submitted to CFC is subject to audit adjustments by reporting borrowers and does not, with minor exceptions, take into account current data for certain systems that are not active CFC borrowers. CFC takes no responsibility for the accuracy or completeness of the borrower data. CFC’s independent auditors have not examined any information contained in this section, and the number and geographical dispersion of the borrowers have made impractical an independent investigation by CFC of the statistical information.

17


 

NATIONAL RURAL UTILITIES COOPERATIVE FINANCE CORPORATION

COMPOSITE STATEMENTS OF REVENUES, EXPENSES AND PATRONAGE CAPITAL
AS REPORTED TO CFC BY DISTRIBUTION SYSTEM BORROWERS

The following are unaudited figures that are based

upon Form 7 submitted to
CFC by Distribution System Borrowers
                                             
Years Ended December 31,

2003 2002 2001 2000 1999
(Dollar amounts in thousands)




Operating revenues and patronage capital
  $ 24,362,612     $ 22,856,370     $ 21,627,713     $ 20,419,019     $ 18,805,359  
     
     
     
     
     
 
Operating deductions:
                                       
 
Cost of power(1)
    (15,236,791 )     (14,153,297 )     (13,550,239 )     (12,925,630 )     (11,828,572 )
 
Distribution expense (operations)
    (1,082,155 )     (992,617 )     (899,310 )     (856,378 )     (792,249 )
 
Distribution expense (maintenance)
    (1,326,725 )     (1,249,463 )     (1,183,558 )     (1,106,780 )     (1,024,734 )
 
Administrative and general expense(2)
    (2,415,950 )     (2,266,334 )     (2,144,824 )     (1,972,220 )     (1,864,344 )
 
Depreciation and amortization expense
    (1,702,167 )     (1,600,544 )     (1,487,657 )     (1,387,923 )     (1,290,354 )
 
Taxes
    (285,813 )     (269,587 )     (252,592 )     (241,219 )     (230,238 )
     
     
     
     
     
 
   
Total
    (22,049,601 )     (20,531,842 )     (19,518,180 )     (18,490,150 )     (17,030,491 )
     
     
     
     
     
 
Utility operating margin
    2,313,011       2,324,528       2,109,533       1,928,869       1,774,868  
Non-operating margin
    63,023       295,588       104,442       211,957       179,940  
Power supply capital credits(3)
    298,638       321,548       326,215       272,007       259,099  
     
     
     
     
     
 
   
Total
    2,674,672       2,941,664       2,540,190       2,412,833       2,213,907  
     
     
     
     
     
 
Interest on long-term debt(4)
    (1,170,129 )     (1,151,978 )     (1,194,016 )     (1,150,231 )     (1,024,369 )
Other deductions
    (69,020 )     (74,769 )     (74,854 )     (84,049 )     (50,523 )
     
     
     
     
     
 
   
Total
    (1,239,149 )     (1,226,747 )     (1,268,870 )     (1,234,280 )     (1,074,892 )
     
     
     
     
     
 
Net margin and patronage capital
  $ 1,435,523     $ 1,714,917     $ 1,271,320     $ 1,178,553     $ 1,139,015  
     
     
     
     
     
 
TIER(5)
    2.22       2.48       2.05       2.01       2.11  
DSC(6)
    2.15       2.16       1.94       2.08       2.15  
MDSC(7)
    2.10       1.98       1.88       1.99       2.03  
Number of systems included
    812       808       811       812       811  


(1)  Includes cost of purchased power, power production and transmission expense.
(2)  Includes sales expenses, consumer accounts and customer service and informational expense as well as other administrative and general expenses.
(3)  Represents net margin of power supply systems and other associated organizations allocated to their member distribution systems and added in determining net margin and patronage capital of distribution systems under RUS accounting practices. Cash distributions of this credit have rarely been made by the power supply systems and such other organizations to their members.
(4)  Interest on long-term debt is net of interest charged to construction. CFC believes that amounts incurred by distribution systems for interest charged to construction and allowance for funds used during construction are immaterial relative to their total interest on long-term debt and net margin and patronage capital.
(5)  The ratio of (x) interest on long-term debt (in each year including all interest charged to construction) and net margin and patronage capital to (y) interest on long-term debt (in each year including all interest charged to construction).
(6)  The ratio of (x) net margin and patronage capital plus interest on long-term debt (including all interest charged to construction) plus depreciation and amortization to (y) long-term debt service obligations.
(7)  The ratio of (x) operating margin and patronage capital plus interest on long-term debt (including all interest charged to construction) plus depreciation and amortization expense plus non-operating margin, interest plus cash received in respect of generation and transmission and other capital credits to (y) long-term debt service obligations.

18


 

NATIONAL RURAL UTILITIES COOPERATIVE FINANCE CORPORATION

COMPOSITE COMBINED BALANCE SHEETS
AS REPORTED TO CFC BY DISTRIBUTION SYSTEM BORROWERS

The following are unaudited figures that are based

upon Form 7 submitted to
CFC by Distribution System Borrowers
                                             
At December 31,

2003 2002 2001 2000 1999
(Dollar amounts in thousands)




Assets and other debits:
                                       
 
Utility plant:
                                       
   
Utility plant in service
  $ 55,318,370     $ 51,732,230     $ 48,895,933     $ 45,985,367     $ 43,023,535  
   
Construction work in progress
    1,380,558       1,350,707       1,442,108       1,438,002       1,262,537  
     
     
     
     
     
 
   
Total utility plant
    56,698,928       53,082,937       50,338,041       47,423,369       44,286,072  
 
Less: Accumulated provision for depreciation and amortization
    (16,030,531 )     (14,841,818 )     (14,044,637 )     (13,083,103 )     (12,225,421 )
     
     
     
     
     
 
   
Net utility plant
    40,668,397       38,241,119       36,293,404       34,340,266       32,060,651  
 
Investment in associated organizations(1)
    4,649,153       4,442,660       4,225,723       4,002,393       3,790,623  
 
Current and accrued assets
    5,568,221       5,360,318       5,038,616       5,651,652       4,520,592  
 
Other property and investments
    1,250,006       1,240,403       1,076,731       1,019,348       703,585  
 
Deferred debits
    630,517       593,995       613,117       626,903       599,511  
     
     
     
     
     
 
   
Total assets and other debits
  $ 52,766,294     $ 49,878,495     $ 47,247,591     $ 45,640,562     $ 41,674,962  
     
     
     
     
     
 
Liabilities and other credits:
                                       
 
Net worth:
                                       
   
Memberships
  $ 172,242     $ 114,001     $ 111,266     $ 140,663     $ 119,175  
   
Patronage capital and other equities(2)
    21,667,573       20,459,062       19,642,036       18,538,088       17,542,625  
     
     
     
     
     
 
   
Total net worth
    21,839,815       20,573,063       19,753,302       18,678,751       17,661,800  
 
Long-term debt(3)
    24,599,854       23,345,933       21,943,560       21,326,555       19,308,152  
 
Current and accrued liabilities
    4,695,803       4,440,751       4,095,900       4,280,010       433,687  
 
Deferred credits
    1,008,417       974,414       952,642       892,001       3,429,173  
 
Miscellaneous operating services
    622,405       544,334       502,187       463,245       842,150  
     
     
     
     
     
 
   
Total liabilities and other credits
  $ 52,766,294     $ 49,878,495     $ 47,247,591     $ 45,640,562     $ 41,674,962  
     
     
     
     
     
 
Equity percentage(4)
    41.4 %     41.2 %     41.8 %     40.9 %     42.5 %
Number of systems included
    812       808       811       812       811  


(1)  Includes investments in service organizations, power supply capital credits and investments in CFC.
(2)  Includes non-refundable donations or contributions in cash, services or property from states, municipalities, other government agencies, individuals and others for construction purposes.
(3)  Principally debt to RUS and CFC. Includes $11,756,020, $10,501,697, $9,794,118, $9,717,546, and $8,342,631, for the years ended December 31, 2003, 2002, 2001, 2000 and 1999, respectively, due to CFC.
(4)  Determined by dividing total net worth by total assets and other debits.

19


 

NATIONAL RURAL UTILITIES COOPERATIVE FINANCE CORPORATION

COMPOSITE STATEMENTS OF REVENUES, EXPENSES AND PATRONAGE CAPITAL
AS REPORTED TO CFC BY POWER SUPPLY SYSTEM BORROWERS

The following are unaudited figures that are based

upon Form 12 or FERC Form 1 submitted to
CFC by Power Supply System Borrowers
                                             
Years Ended December 31,

2003 2002 2001 2000 1999
(Dollar amounts in thousands)




Operating revenues and patronage capital
  $ 12,027,404     $ 11,555,059     $ 11,941,467     $ 11,431,737     $ 10,758,413  
     
     
     
     
     
 
Operating deductions:
                                       
 
Cost of power(1)
    (9,454,449 )     (8,673,728 )     (9,188,992 )     (8,609,376 )     (7,945,476 )
 
Distribution expense (operations)
    (27,177 )     (22,848 )     (22,319 )     (21,375 )     (23,634 )
 
Distribution expense (maintenance)
    (18,268 )     (15,733 )     (15,907 )     (14,333 )     (14,908 )
 
Administrative and general expense(2)
    (454,715 )     (461,984 )     (439,032 )     (433,616 )     (414,362 )
 
Depreciation and amortization expense
    (848,001 )     (977,930 )     (917,165 )     (936,059 )     (904,826 )
 
Taxes(3)
    (39,872 )     (21,493 )     (26,877 )     (82,297 )     (68,681 )
     
     
     
     
     
 
   
Total
    (10,842,482 )     (10,173,716 )     (10,610,292 )     (10,097,056 )     (9,371,887 )
     
     
     
     
     
 
Utility operating margin
    1,184,922       1,381,343       1,331,175       1,334,681       1,386,526  
Non-operating margin
    146,415       224,104       249,256       303,513       258,186  
Power supply capital credits(4)
    40,259       39,653       44,506       49,077       44,180  
     
     
     
     
     
 
   
Total
    1,371,596       1,645,100       1,624,937       1,687,271       1,688,892  
     
     
     
     
     
 
Interest on long-term debt(5)
    (997,537 )     (1,174,279 )     (1,186,371 )     (1,195,644 )     (1,227,548 )
Other deductions
    (111,563 )     (118,386 )     (117,937 )     (144,850 )     (185,621 )
     
     
     
     
     
 
   
Total
    (1,109,100 )     (1,292,665 )     (1,304,308 )     (1,340,494 )     (1,413,169 )
     
     
     
     
     
 
Net margin and patronage capital
  $ 262,496     $ 352,435     $ 320,629     $ 346,777     $ 275,723  
     
     
     
     
     
 
TIER(6)
    1.25       1.29       1.25       1.28       1.22  
DSC(7)
    0.99       0.97       0.99       1.16       1.15  
Number of systems included
    56       51       53       51       54  


(1)  Includes cost of purchased power, power production and transmission expense.
(2)  Includes sales expenses and consumer accounts expense and consumer service and informational expense as well as other administrative and general expenses.
(3)  The significant decrease in 2001 was due to a $63 million deferred income tax credit caused by the change of one system’s allocation of patronage capital from a historical book basis to a tax basis method.
(4)  Certain power supply systems purchase wholesale power from other power supply systems of which they are members. Power supply capital credits represent net margin of power supply systems allocated to member power supply systems on the books of the selling power supply systems. This item has been added in determining net margin and patronage capital of the purchasing power supply systems under RUS accounting practices. Cash distributions of this credit have rarely been made by the selling power supply systems to their members. This item also includes net margin of associated organizations allocated to power supply members and added in determining net margin and patronage capital of the member systems under RUS accounting practices.

20


 

(5)  Interest on long-term debt is net of interest charged to construction. Allowance for funds used during construction has been included in non-operating margin. According to unpublished information, interest charged to construction and allowance for funds used during construction for CFC power supply members in the years 1999-2003 were as follows:

                         
Interest Charged to Allowance for Funds Used
Construction During Construction Total



2003
  $ 31,525     $ 14,486     $ 46,011  
2002
    25,479       15,009       40,488  
2001
    39,140       21,851       60,991  
2000
    20,245       24,736       44,981  
1999
    10,073       13,604       23,677  

(6)  The ratio of (x) interest on long-term debt (in each year including all interest charged to construction) and net margin and patronage capital to (y) interest on long-term debt (in each year including all interest charged at that time to construction). The TIER calculation for 1999 includes the operating results of five systems, which failed to make debt service payments or are operating under a debt restructure agreement. The TIER calculation for 2000 includes the operating results of one system that did not borrow from CFC at that time. The TIER calculation for 2001 includes the operating results of four systems that did not borrow from CFC at that time. The TIER calculation for 2002 includes the operating results of eleven systems that did not borrow from CFC at that time. The TIER calculation for 2003 includes the operating results of sixteen systems that do not currently borrow from CFC. Without these systems, the composite TIER would have been 1.26, 1.29, 1.22, 1.29, and 1.24 for the years ended December 31, 2003, 2002, 2001, 2000 and 1999, respectively.
(7)  The ratio of (x) net margin and patronage capital plus interest on long-term debt (including all interest charged to construction) plus depreciation and amortization to (y) long-term debt service obligations (including all interest charged to construction). The DSC calculation for 1999 includes the operating results of five systems which failed to make debt service payments or are operating under a debt restructure agreement. The DSC calculation for 2000 includes the operating results of one system that did not borrow from CFC at that time. The DSC calculation for 2001 includes the operating results of four systems that did not borrow from CFC at that time. The DSC calculation for 2002 includes the operating results of eleven systems that did not borrow from CFC at that time. The DSC calculation for 2003 includes the operating results of sixteen systems that do not currently borrow from CFC. Without these systems, the composite DSC would have been 1.11, 1.14, 0.98, 1.19, and 1.23 for the years ended December 31, 2003, 2002, 2001, 2000 and 1999, respectively.

21


 

NATIONAL RURAL UTILITIES COOPERATIVE FINANCE CORPORATION

COMPOSITE COMBINED BALANCE SHEETS
AS REPORTED TO CFC BY POWER SUPPLY SYSTEM BORROWERS

The following are unaudited figures that are based

upon Form 12 or FERC Form 1 submitted to
CFC by Power Supply System Borrowers
                                               
At December 31,

2003 2002 2001 2000 1999
(Dollar amounts in thousands)




Assets and other debits:
                                       
 
Utility plant:
                                       
   
Utility plant in service
  $ 32,228,260     $ 35,116,374     $ 32,687,748     $ 31,970,487     $ 31,140,658  
   
Construction work in progress
    1,397,265       1,962,399       1,813,833       1,571,954       1,151,859  
     
     
     
     
     
 
     
Total utility plant
    33,625,525       37,078,773       34,501,581       33,542,441       32,292,517  
   
Less: Accumulated provision for depreciation and amortization
    (14,571,600 )     (15,929,240 )     (14,208,592 )     (13,867,937 )     (13,230,060 )
     
     
     
     
     
 
     
Net utility plant
    19,053,925       21,149,533       20,292,989       19,674,504       19,062,457  
   
Investments in associated organizations(1)
    1,379,634       1,379,768       1,313,453       1,360,671       1,173,026  
   
Current and accrued assets
    3,336,143       4,214,557       4,120,224       4,067,827       3,904,535  
   
Other property and investments
    1,665,089       1,639,204       1,722,999       1,540,147       1,511,145  
   
Deferred debits
    2,004,442       2,102,269       2,113,357       3,027,612       3,251,458  
     
     
     
     
     
 
     
Total assets and other debits
  $ 27,439,233     $ 30,485,331     $ 29,563,022     $ 29,670,761     $ 28,902,621  
     
     
     
     
     
 
Liabilities and other credits:
                                       
 
Net worth:
                                       
   
Memberships
  $ 49,134     $ 49,133     $ 49,129     $ 49,106     $ 49,131  
   
Patronage capital and other equities
    3,728,443       3,942,442       3,575,050       3,498,360       3,175,374  
     
     
     
     
     
 
     
Total net worth
    3,777,577       3,991,575       3,624,179       3,547,466       3,224,505  
 
Long-term debt(2)
    17,770,812       20,159,824       19,935,286       19,051,276       19,591,883  
 
Current and accrued liabilities
    2,894,949       3,070,276       2,878,459       3,186,042       2,328,504  
 
Deferred credits
    1,079,107       1,556,459       1,509,021       1,565,294       1,338,343  
 
Miscellaneous operating reserves
    1,916,788       1,707,197       1,616,077       2,320,683       2,419,386  
     
     
     
     
     
 
     
Total liabilities and other credits
  $ 27,439,233     $ 30,485,331     $ 29,563,022     $ 29,670,761     $ 28,902,621  
     
     
     
     
     
 
Number of systems included
    56       51       53       51       54  


(1)  Includes investments in service organizations, power supply capital credits and investments in CFC.
(2)  Principally debt to RUS or debt guaranteed by RUS and loaned by FFB and includes $2,520,149, $1,979,107, $2,048,767, and $1,905,614 as of December 31, 2003, 2002, 2001, 2000 and 1999, respectively, due to CFC.

22


 

NATIONAL RURAL UTILITIES COOPERATIVE FINANCE CORPORATION

COMPOSITE STATEMENTS OF REVENUES AND EXPENSES
AS REPORTED TO CFC BY TELECOMMUNICATIONS BORROWERS

The following are unaudited figures that are based

upon financial statements submitted to
CFC by Telecommunications Borrowers
                                         
Years Ended December 31,

2003(4)(6) 2002(4)(5)(6) 2001(4) 2000(3) 1999(3)
(Dollar amounts in thousands)




Operating revenues
  $ 4,968,593     $ 4,765,679     $ 4,503,614     $ 4,879,808     $ 3,908,496  
Operating expenses(1)
    (3,258,670 )     (3,364,102 )     (3,030,570 )     (3,509,779 )     (3,003,530 )
     
     
     
     
     
 
Net income before interest, depreciation and taxes
    1,709,923       1,401,577       1,473,044       1,370,029       904,966  
Interest on long-term debt
    (503,399 )     (477,587 )     (568,829 )     (430,825 )     (221,103 )
     
     
     
     
     
 
Net income before depreciation and taxes
    1,206,524       923,990       904,215       939,204       683,863  
Depreciation and amortization expenses
    (763,526 )     (719,204 )     (797,665 )     (675,757 )     (410,805 )
     
     
     
     
     
 
Net income before taxes
    442,998       204,786       106,550       263,447       273,058  
Taxes
    (69,530 )     (93,797 )     (91,420 )     (140,378 )     (89,030 )
     
     
     
     
     
 
Net income
  $ 373,468     $ 110,989     $ 15,130     $ 123,069     $ 184,028  
     
     
     
     
     
 
DSC(2)
    1.80       1.43       1.59       1.79       2.30  
Number of borrowers included
    186       201       208       226       191  


(1)  Includes sales expenses, consumer accounts and customer service and informational expense as well as other administrative and general expenses.
(2)  Debt service coverage ratio is the ratio of (x) net margin plus interest on long-term debt (including all interest charged to construction) plus depreciation and amortization to (y) long-term debt service obligations. During calendar year 2000, CFC closed two large loans to start-up companies for the purpose of acquiring local exchange properties from GTE (now Verizon). Due to significant expenses related to start-up and the transition of these operations, for the years ending 2002, 2001 and 2000 there were substantial transition related expenses reported by these two companies. These expenses were expected when the transactions were underwritten and are typical of such acquisition companies during their start-up mode. Excluding these two borrowers, the composite DSC was 1.71, 1.80 and 2.06 for the years ended December 31, 2002, 2001 and 2000, respectively.
(3)  For the years ended December 31, 2000 and 1999, some telecommunications members were acquired by Alltel Corporation, and CFC agreed to accept Alltel Corporation’s financial statements rather than those of the acquired operating companies. Given Alltel Corporation’s size, it is not included in the composite statistics.
(4)  During the year ended December 31, 2001, Citizens Communications Company became a telecommunications borrower. The December 31, 2003, 2002 and 2001 financial results for Citizens have been excluded from the information above because CFC believes that their inclusion would unduly skew these statistics. Loans to Citizens represent only 4% of the total telecommunications loan portfolio. Citizens’ long-term debt is currently rated Ba3 by Moody’s Investors Service, BB+ by Standard & Poor’s Corporation and BB by Fitch Ratings. For calendar year 2003, Citizens reported revenues of $2,445 million and net income of $188 million. Had Citizens been included in the composite data above, the composite debt service coverage ratio for the years ended December 31, 2003, 2002 and 2001 would have been 1.43, 0.99 including a one-time, non-cash impairment charge totaling $1,074 million, and 1.45, respectively.
(5)  During the year ended December 31, 2002, two of CFC’s large telecommunications borrowers recorded impairments to goodwill as a result of new accounting standards. These non-cash charges, which total $140.3 million, are reflected in the 2002 composite DSC calculation. Exclusion of these charges would result in a composite DSC of 1.59 for 2002.
(6)  One of CFC’s telecommunications borrowers, representing less than 2% of all telecommunications loans outstanding, has been excluded from the 2002 composite figures due to its Chapter 11 bankruptcy filing. The borrower emerged from bankruptcy during 2003 and recognized a substantial gain due to the reduction in its debt balances. For that reason, the borrower is also excluded from the 2003 composite data. CFC was kept current on its loans to this borrower throughout the bankruptcy. The composite DSC with this borrower included for the years ended December 31, 2003 and 2002 would have been 1.92 and 0.99, respectively.

23


 

NATIONAL RURAL UTILITIES COOPERATIVE FINANCE CORPORATION

COMPOSITE COMBINED BALANCE SHEETS
AS REPORTED TO CFC BY TELECOMMUNICATIONS BORROWERS

The following are unaudited figures that are based

upon financial statements submitted to
CFC by Telecommunications Borrowers
                                             
At December 31,

2003(4)(5) 2002(4)(5) 2001(4) 2000(3) 1999(3)
(Dollar amounts in thousands)




Assets and other debits:
                                       
 
Cash and cash equivalents
  $ 768,782     $ 655,500     $ 653,628     $ 639,882     $ 646,409  
 
Current assets
    912,165       970,994       909,931       1,372,186       1,029,905  
 
Plant, property and equipment
    5,035,982       5,024,619       5,572,227       5,674,846       3,998,038  
 
Other non-current assets
    4,286,173       4,331,119       4,728,130       4,957,209       2,505,597  
     
     
     
     
     
 
   
Total assets and other debits
  $ 11,003,102     $ 10,982,232     $ 11,863,916     $ 12,644,123     $ 8,179,949  
     
     
     
     
     
 
Liabilities and equity:
                                       
 
Current liabilities
  $ 1,021,234     $ 935,367     $ 945,181     $ 1,225,408     $ 898,080  
 
Affiliate debt
    12,102       4,266       7,152       1,135       3,804  
 
Long-term debt(1)
    6,689,871       6,844,587       7,156,808       6,960,293       4,309,996  
 
Other non-current liabilities
    693,667       586,628       464,703       741,921       392,982  
 
Equity
    2,586,228       2,611,384       3,290,072       3,715,366       2,575,087  
     
     
     
     
     
 
   
Total liabilities and equity
  $ 11,003,102     $ 10,982,232     $ 11,863,916     $ 12,644,123     $ 8,179,949  
     
     
     
     
     
 
Equity percentage(2)
    24 %     24 %     28 %     29 %     32 %
Number of borrowers included
    186       201       208       226       191  


(1)  Includes current maturities.
(2)  Determined by dividing total net worth by total assets and other debits. During calendar year 2000, CFC closed two large loans to start-up companies for the purpose of acquiring local exchange properties from GTE (now Verizon). Due to significant expenses related to start-up and the transition of these operations, for the years ending 2001 and 2000 there were substantial operating losses reported by these two companies, which had a negative impact on their reported equity. For the years ended December 31, 2002, 2001, and 2000, the equity percentage would have been, 27%, and 30%, and 32% respectively, if the data for these two borrowers were excluded.
(3)  For the years ended December 31, 2000 and 1999, some telecommunications members were acquired by Alltel Corporation, and CFC agreed to accept Alltel Corporation’s financial statements rather than those of the acquired operating companies. Given Alltel Corporation’s size, it is not included in the composite statistics.
(4)  During the year ended December 31, 2001, Citizens Communications Company became a telecommunications borrower. The December 31, 2003, 2002 and 2001 financial results for Citizens have been excluded from the information above because CFC believes that their inclusion would unduly skew these statistics. Loans to Citizens represent only 4% of the telecommunications loan portfolio. Citizens’ long-term debt is currently rated Ba3 by Moody’s Investors Service, BB+ by Standard & Poor’s Corporation and BB by Fitch Ratings. At December 31, 2003, Citizens had total assets of $7.7 billion and equity of $1.4 billion. Had Citizens been included in the composite combined balance sheet data above, the composite equity percentage at December 31, 2003, 2002 and 2001 would have been 21%, 20% and 23%, respectively.
(5)  One of CFC’s telecommunications borrowers, representing less than 2% of all telecommunications loans outstanding, has been excluded from the 2002 composite figures due to its Chapter 11 bankruptcy filing. The borrower emerged from bankruptcy during 2003 and recognized a substantial gain due to the reduction in its debt balances. For that reason, the borrower is also excluded from the 2003 composite data. CFC was kept current on its loans to this borrower throughout the bankruptcy. The composite equity percentage with this borrower included would have remained at 24% and 19% at December 31, 2003 and 2002, respectively.

24


 

 
Item 2. Properties.

CFC owns and operates a headquarters facility in Fairfax County, Virginia. This facility consists of two six-story office buildings and two separate parking garages situated on ten acres of land. CFC also owns an additional two acres of unimproved land adjacent to its office building.

 
Item 3. Legal Proceedings.

On June 1, 2004, RTFC filed a lawsuit in the Eastern District Court of Virginia against Innovative Communication Corporation (“ICC”) for failure to comply with the terms of ICC’s loan agreement. The complaint was amended by RTFC on July 20, 2004 to allege additional loan agreement defaults and to demand immediate full repayment of approximately $552 million of principal outstanding under loans to ICC plus related interest and fees. On August 3, 2004, ICC filed its amended answer and counterclaims, in which it denies that it is in default of the loan agreement, and asserts a counterclaim seeking the reformation of the loan agreement to conform to a 1989 settlement agreement among the Virgin Islands Public Services Commission, ICC’s predecessor, and RTFC, in a manner that ICC contends would relieve it of some of the defaults alleged in the amended complaint.

 
Item 4. Submission of Matters to a Vote of Security Holders.

None.

25


 

PART II

 
Item 5. Market for Registrant’s Common Equity and Related Stockholder Matters.

Inapplicable.

 
Item 6. Selected Financial Data.

The following is a summary of selected financial data for each of the five years ended May 31, 2004.

                                         
2004 2003 2002 2001 2000
(Dollar amounts in thousands)




For the year ended May 31:
                                       
Operating income
  $ 1,005,520     $ 1,070,875     $ 1,186,533     $ 1,388,295     $ 1,020,998  
Gross margin
    91,292       140,028       300,695       270,456       159,674  
Derivative cash settlements(A)
    110,087       122,825       34,191              
Derivative forward value(A)
    (229,132 )     757,212       41,878              
Foreign currency adjustments(B)
    (65,310 )     (243,220 )     (61,030 )            
Operating (loss) margin
    (194,584 )     651,970       78,873       132,766       115,333  
Cumulative effect of change in accounting principle(A)
    22,369             28,383              
Net margin (loss)
  $ (178,021 )   $ 651,970     $ 107,256     $ 132,766     $ 115,333  
Fixed charge coverage ratio(C)(D)
          1.70       1.09       1.12       1.13  
Adjusted fixed charge coverage ratio(E)
    1.12       1.17       1.12       1.12       1.13  
As of May 31:
                                       
Loans to members
  $ 20,488,523     $ 19,484,341     $ 20,047,109     $ 19,683,950     $ 16,678,045  
Allowance for loan losses
    (573,939 )     (511,463 )     (478,342 )     (317,197 )     (213,292 )
Assets
    21,349,572       21,027,883       20,371,335       20,013,642       17,098,440  
Long-term debt(F)
    16,659,182       16,000,744       14,855,550       11,376,412       10,595,596  
Subordinated deferrable debt
    550,000       650,000       600,000       550,000       400,000  
Members’ subordinated certificates
    1,665,158       1,708,297       1,691,970       1,581,860       1,340,417  
Members’ equity(A)
    483,126       454,376       392,056       393,899       341,217  
Total equity
    695,734       930,836       328,731       393,899       341,217  
Guarantees
  $ 1,331,299     $ 1,903,556     $ 2,056,385     $ 2,217,559     $ 1,945,202  
Leverage ratio(D)
    31.57       23.64       67.23       55.44       54.81  
Adjusted leverage ratio(E)
    7.03       6.65       7.20       7.73       8.11  
Debt to equity ratio(D)
    29.66       21.59       60.97       49.81       49.11  
Adjusted debt to equity ratio(E)
    6.54       5.97       6.43       6.85       7.17  


 
(A) Derivative cash settlements represent the net settlements received/paid on interest rate and cross currency exchange agreements that do not qualify for hedge accounting for the years ended May 31, 2004, 2003 and 2002. In prior years this amount had been included in the cost of funds line on the combined statement of operations. The derivative forward value represents the change in fair value on exchange agreements that do not qualify for hedge accounting, as well as amortization related to the long-term debt valuation allowance and related to the transition adjustment recorded as an other comprehensive loss on June 1, 2001. The cumulative effect of change in accounting principle in 2002 represents the forward value of interest rate and cross currency exchange agreements recorded as a transition adjustment upon adoption of SFAS 133. Members’ equity represents total equity excluding foreign currency adjustments, derivative forward value, cumulative effect of change in accounting principle in 2002 and accumulated other comprehensive income (see “Non-GAAP Financial Measures” in Management’s Discussion and Analysis for further explanation of members’ equity and a reconciliation to total equity).
(B) Foreign currency adjustments represent the change on foreign denominated debt that is not related to a qualifying hedge under SFAS 133 during the period. The foreign denominated debt is revalued at each reporting date based on the current exchange rate. To the extent that the current exchange rate is different than the exchange rate at the time of issuance, there will be a

26


 

change in the value of the foreign denominated debt. CFC enters into foreign currency exchange agreements at the time of each foreign denominated debt issuance to lock in the exchange rate for all principal and interest payments required through maturity.
(C) The fixed charge coverage ratio is the same calculation as CFC’s Times Interest Earned Ratio (“TIER”). For the year ended May 31, 2004, CFC’s earnings were insufficient to cover fixed charges by $200 million.
(D) See “Non-GAAP Financial Measures” in Management’s Discussion and Analysis for the GAAP calculations of these ratios.
(E) Adjusted ratios include non-GAAP adjustments that CFC makes to financial measures in assessing its financial performance. See “Non-GAAP Financial Measures” in Management’s Discussion and Analysis for further explanation of these calculations and a reconciliation of the adjustments.
(F) Includes notes payable reclassified as long-term debt in the amount of $4,650 million, $3,951 million, $3,706 million, $4,638 million, and $5,493 million at May 31, 2004, 2003, 2002, 2001, and 2000, respectively, and excludes $2,365 million, $2,911 million, $2,883 million, $4,388 million, and $3,040 million in long-term debt that comes due, matures and/or will be redeemed during fiscal years 2005, 2004, 2003, 2002, and 2001, respectively (see Note 4 to combined financial statements). Includes the long-term debt valuation allowance of $0 million, $(1) million and $2 million and the foreign currency valuation account of $234 million, $176 million and $(2) million at May 31, 2004, 2003 and 2002, respectively.

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

The following discussion and analysis is designed to provide a better understanding of National Rural Utilities Cooperative Finance Corporation’s (“CFC”) consolidated financial condition and results of operations and as such should be read in conjunction with the consolidated financial statements, including the notes thereto. Effective June 1, 2003, CFC’s financial results include the consolidated accounts of CFC, Rural Telephone Finance Cooperative (“RTFC”), National Cooperative Services Corporation (“NCSC”) and certain entities controlled by CFC that were created to hold foreclosed assets. CFC’s financial results prior to June 1, 2003 were consolidated with certain entities controlled by CFC that were created to hold foreclosed assets and combined with those of RTFC. CFC refers to its financial measures that are not in accordance with generally accepted accounting principles (“GAAP”) as “adjusted” throughout this document. See “Non-GAAP Financial Measures” for further explanation.

This annual report on Form 10-K 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 allowance, net margin growth, leverage and debt to adjusted equity ratios, and borrower financial performance are forward-looking statements.

Forward-looking statements are based on management’s current views and assumptions regarding future events and operating performance that are subject to risks and uncertainties. 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. 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:

•  Liquidity — CFC depends on access to the capital markets to refinance its long and short-term debt, fund new loan advances and if necessary, to fulfill its obligations under its guarantees and repurchase agreements. At May 31, 2004, CFC had $3,625 million of commercial paper, daily liquidity fund and bank bid notes and $2,365 million of medium-term notes, collateral trust bonds and long-term notes payable scheduled to mature during the next twelve months. There can be no assurance that CFC will be able to access the capital markets in the future. Downgrades to CFC’s long-term debt ratings or other events that may deny or limit CFC’s access to the capital markets could negatively impact its operations. CFC has no control over certain items that are considered by the credit rating agencies as part of their analysis for CFC, such as the overall outlook for the electric and telecommunications industries.
 
•  Covenant compliance — CFC must maintain compliance with all covenants related to its revolving credit agreement, including the adjusted times interest earned ratio (“TIER”), adjusted leverage and amount of loans pledged in order to have access to the funds available under the revolving lines of credit. See “Non-GAAP Financial Measures” for further explanation and a reconciliation of adjusted ratios. A restriction on access to its revolving lines of credit would impair CFC’s ability to issue short-term debt, as it is required to maintain backup-liquidity to maintain preferred rating levels on its short-term debt.
 
•  Restructured borrower — Denton County Electric Cooperative, Inc. d/b/a CoServ Electric (“CoServ”) has emerged from bankruptcy and the joint plans of liquidation and reorganization filed by CoServ and CFC are effective. However, the calculated impairment on the restructured loan would increase if CoServ were not able to perform as required by the joint plans of liquidation and reorganization.
 
•  Credit concentration — CFC lends only into the rural electric and telephone industries and is subject to risks associated with those industries. Credit concentration is one of the risk factors considered by the

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rating agencies in the evaluation of CFC’s credit rating. CFC’s credit concentration to its ten largest borrowers could increase from the current 21% of total loans and guarantees outstanding, if:

  •  it were to extend additional loans to the current ten largest borrowers,
 
  •  its total loans outstanding were to decrease, with a disproportionately large share of the decrease to borrowers not in the current ten largest, or
 
  •  it were to advance large new loans to one of the next group of borrowers below the ten largest.

•  Loan loss allowance — Computation of the loan loss allowance is inherently based on subjective estimates. A loan write-off in excess of specific reserves for impaired borrowers or a large net loan write-off to a borrower that is currently performing would have a negative impact on the adequacy of the loan loss allowance and the net margin for the year due to an increased loan loss provision.
 
•  Adjusted leverage and adjusted debt to equity ratios — If CFC were to experience significant loan growth over the next few years, as it did from fiscal year 1998 through fiscal year 2001, the adjusted leverage and adjusted debt to equity ratios would increase. See “Non-GAAP Financial Measures” for further explanation and a reconciliation of adjusted ratios. The equity retention policies are tied to the growth in loans outstanding, as members may be required to purchase subordinated certificates with the advance of loans. However, the required subordinated certificate purchase is not sufficient to allow equity retention in an amount that will continue to lower the adjusted leverage and adjusted debt to equity ratios. The increased loan volume would result in an increased gross margin, which could result in an increased allocation to the members’ equity reserve, but not in an amount required to reduce the adjusted leverage and adjusted debt to equity ratios.
 
•  Tax exemption — Legislation that removes or imposes new conditions on the federal tax exemption for 501(c)(4) social welfare corporations could have a negative impact on CFC’s net margins. CFC’s continued exemption depends on CFC conducting its business in accordance with the exemption granted to it by the Internal Revenue Service.
 
•  Derivative accounting — The required accounting for derivative financial instruments has caused increased volatility in CFC’s reported financial results. In addition, a standard market does not exist for CFC’s derivative instruments, therefore the fair value of derivatives reported in CFC’s financial statements is based on quotes obtained from CFC’s counterparties. The market quotes provided by counterparties do not represent offers to trade at the quoted price.
 
•  Foreign currency — The required accounting for foreign denominated debt has caused increased volatility in CFC’s financial results. CFC is required to adjust the value of the foreign denominated debt on its consolidated and combined balance sheets at each reporting date based on the then current foreign exchange rate.
 
•  Rating triggers — CFC has interest rate, cross currency, and cross currency interest rate exchange agreements that contain a condition that will allow one counterparty to terminate the agreement if the credit rating of the other counterparty drops to a certain level. This condition is commonly called a rating trigger. Under the rating trigger, if the credit rating for either counterparty falls to the level specified in the agreement, the other counterparty may, but is not obligated to, terminate the agreement. If either counterparty terminates the agreement, a net payment may be due from one counterparty to the other based on the fair value of the underlying derivative instrument. CFC’s rating triggers are based on its senior unsecured credit rating from Standard & Poor’s Corporation and Moody’s Investors Service. At May 31, 2004, there are rating triggers associated with $12,061 million notional amount of interest rate, cross currency and cross currency interest rate exchange agreements. If CFC’s rating from Moody’s Investors Service falls to Baa1 or CFC’s rating from Standard & Poor’s Corporation falls to BBB+, the counterparties may terminate agreements with a total notional amount of $1,754 million. If CFC’s rating from Moody’s Investors Service falls below Baa1 or CFC’s rating from Standard & Poor’s Corporation falls below BBB+, the counterparties may terminate the agreements on the remaining total notional amount of $10,307 million. Based on the fair market value of its interest rate, cross currency

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and cross currency interest rate exchange agreements at May 31, 2004, CFC may be required to make a payment of up to $34 million if its senior unsecured ratings declined to Baa1 or BBB+, and up to $64 million if its senior unsecured ratings declined below Baa1 or BBB+. In calculating the required payments, CFC only considered agreements in which it would have been required to make a payment upon termination.
 
•  Calculated impairment — CFC calculates loan impairments per the requirements of Statement of Financial Accounting Standards (“SFAS”) 114, Accounting by Creditors for Impairment of a Loan — an Amendment of SFAS 5 and SFAS 15, as amended. This pronouncement states that the impairment is calculated based on a comparison of the present value of the expected future cash flows discounted at the original interest rate and/or the estimated fair value of the collateral securing the loan to the recorded investment in the loan. The interest rate in the original loan agreements between CFC and its borrowers may be a blend of the CFC long-term fixed rate for various maturity periods, the CFC long-term variable and line of credit interest rate. CFC periodically adjusts the long-term variable and line of credit interest rates to reflect the cost of variable rate and short-term debt. Thus, the original contract rate (weighted average of interest rates on all of the original loans to the borrower), will change as CFC adjusts its long-term variable and line of credit interest rates. CFC’s long-term variable and line of credit interest rates have been at historically low levels over this past year. CFC’s calculated impairment on the non-performing and restructured loans will increase as CFC’s long-term variable and line of credit interest rates increase. Currently, an increase of 25 basis points to CFC’s variable interest rates results in an increase of $14 million to the calculated impairment.
 
•  Deficiency of fixed charges — For the year ended May 31, 2004, CFC’s net loss prior to the cumulative effect of change in accounting principle reported on the consolidated statement of operations as required under GAAP totaled $200 million and was not sufficient to cover fixed charges.

Overview

CFC was formed in 1969 by the rural electric cooperatives to provide them with a source of funds to supplement the financing provided by the Rural Utilities Service (“RUS”). CFC was organized as a cooperative in which each member (other than associates) receives one vote. Under CFC’s bylaws, the board of directors is composed of 23 individuals, 20 of whom must be either general managers or directors of member systems, two of whom are designated by the National Rural Electric Cooperative Association and one at-large position who must satisfy the requirements of an audit committee financial expert as defined by Section 407 of the Sarbanes-Oxley Act of 2002 and must be elected from the general membership. The at-large position is to be filled at the discretion of the board and currently is not filled. CFC was granted tax-exempt status under Section 501(c)(4) of the Internal Revenue Code.

RTFC was incorporated as a private cooperative association in the state of South Dakota in September 1987 and was created for the purpose of providing and/or arranging financing for its rural telecommunications members and affiliates. Effective June 1, 2003, RTFC’s results of operations and financial condition have been consolidated with those of CFC in the accompanying financial statements (see Note 1(b) to the consolidated and combined financial statements). RTFC operates under a management agreement with CFC and is headquartered with CFC in Herndon, Virginia. RTFC is a taxable entity and takes tax deductions for allocations of net margins as allowed by law under Subchapter T of the Internal Revenue Code. RTFC pays income tax based on its net margins, excluding net margins allocated to its members. Prior to June 1, 2003, RTFC’s results of operations and financial condition were combined with CFC’s. At May 31, 2004, CFC had committed to lend RTFC up to $10 billion, of which $5 billion was outstanding.

NCSC was incorporated in 1981 in the District of Columbia as a private cooperative association. NCSC provides lease financing related to its members and general financing to for-profit or non-profit entities that are owned, operated or controlled by or provide substantial benefit to members of CFC. NCSC also markets, through its cooperative members, a consumer loan program for home improvements and an affinity credit card program. Both programs are currently funded by third parties. Effective June 1, 2003,

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NCSC’s results of operations and financial condition have been consolidated with those of CFC in the accompanying financial statements. NCSC’s membership consists of CFC and distribution systems that are members of CFC or are eligible for such membership. NCSC operates under a management agreement with CFC and is headquartered with CFC in Herndon, Virginia. NCSC is a taxable corporation. NCSC pays income tax annually based on its net margins for the period. At May 31, 2004, CFC had committed to provide a total of $2 billion of credit to NCSC. At May 31, 2004, CFC had provided a total of $535 million of credit to NCSC, $180 million of outstanding loans and $355 million of credit enhancements.

Unless stated otherwise, references to CFC relate to the consolidation of RTFC, NCSC and certain entities controlled by CFC and created to hold foreclosed assets. CFC established limited liability corporations and partnerships to hold foreclosed assets. CFC has full ownership and control of all such companies and thus consolidates their financial results.

CFC implemented Financial Accounting Standards Board (“FASB”) Interpretation No. (“FIN”) 46(R), Consolidation of Variable Interest Entities, an interpretation of Accounting Research Bulletin No. 51 effective June 1, 2003, which resulted in the consolidation of two variable interest entities, RTFC and NCSC. CFC is the primary beneficiary of RTFC and NCSC as a result of its exposure to absorbing a majority of the expected losses. Neither company was consolidated with CFC prior to June 1, 2003 and the implementation of FIN 46(R) since CFC has no direct financial ownership interest in either company.

On June 1, 2003, as a result of the consolidation of RTFC and NCSC, total assets increased by $353 million, total liabilities increased by $331 million, minority interest — RTFC and NCSC members’ equity increased by $20 million and CFC total equity increased by $2 million. As a result of the consolidation, NCSC loans were consolidated with CFC’s loans. Additionally, NCSC debt guaranteed by CFC became debt of the consolidated entity, resulting in a reduction to CFC’s guarantee liability. CFC recorded a cumulative effect of change in accounting principle gain of $22 million on the consolidated statement of operations for the year ended May 31, 2004, representing a $3 million increase to the loan loss allowance, a $34 million decrease to the guarantee liability and a $9 million loss representing the amount by which cumulative losses of NCSC exceeded NCSC equity.

CFC’s primary objective as a cooperative is to provide its members with the lowest possible loan and guarantee rates while maintaining sound financial results required to obtain high credit ratings on its debt instruments. Therefore, CFC marks up its funding costs only to the extent necessary to cover its operating expenses, a provision for loan losses and to provide a margin sufficient to preserve interest coverage in light of CFC’s financing objectives.

CFC obtains its funding from the capital markets and its membership. CFC enters the capital markets, based on the combined strength of its members, to borrow the funds required to fulfill the financing requirements of its members. On a regular basis, CFC obtains debt financing in the capital markets by issuing fixed rate or variable rate secured collateral trust bonds, fixed rate subordinated deferrable debt, fixed rate or variable rate unsecured medium-term notes, commercial paper and enters into bank bid note agreements. In addition, CFC obtains debt financing from its membership and other qualified investors through the direct sale of its commercial paper, daily liquidity fund and unsecured medium-term notes.

Rural electric cooperatives that join CFC are generally required to purchase membership subordinated certificates from CFC as a condition of membership. In connection with any long-term loan or guarantee made by CFC on behalf of one of its members, CFC may require that the member make an additional investment in CFC by purchasing loan or guarantee subordinated certificates. The membership subordinated certificates and the loan and guarantee subordinated certificates are unsecured and subordinate to other senior debt of CFC. Membership subordinated certificates typically pay interest at a rate of 5% and have maturities of up to 100 years. Loan and guarantee certificates may or may not earn interest and have maturities tied to the maturity of the related loan or guarantee.

CFC is required by the cooperative laws under which it is incorporated to have a mechanism to allocate its net margin to its members. CFC allocates its net margin before the non-cash effects of SFAS 133 and

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foreign currency adjustments annually to an education fund, a members’ capital reserve and to members based on each member’s patronage of the loan programs during the year. The membership and loan and guarantee subordinated certificates along with the education fund, members’ capital reserve and unretired allocated margins provide CFC’s base capitalization.

CFC’s performance is closely tied to the performance of its member rural electric and telecommunications systems due to the near 100% concentration of its loan and guarantee portfolio in those industries.

Critical Accounting Policies

Allowance for Loan Losses

For all reporting periods presented, management’s estimates of CFC’s exposure to losses within the guarantee portfolio were reclassified from the allowance for loan losses to a guarantee liability on the consolidated and combined balance sheets. On the consolidated and combined statements of operations, the provision for guarantee losses is being shown separately from the provision for loan losses for all reporting periods presented. These reclassifications were made to conform to the fiscal year 2004 presentation.

At May 31, 2004 and 2003, CFC had a loan loss allowance that totaled $574 million and $511 million, representing 2.80% and 2.62% of total loans outstanding, respectively. Generally accepted accounting principles require loans receivable to be reported on the consolidated and combined balance sheets at net realizable value. The net realizable value is the total principal amount of loans outstanding less an estimate of the expected losses inherent in the portfolio. CFC calculates its loss allowance on a quarterly basis. The loan loss analysis segments the portfolio into three categories: impaired, high risk and general portfolio. There are significant subjective assumptions and estimates used in calculating the amount of the loss allowance required by each of the three categories. Different assumptions and estimates could also be reasonable. Changes in these assumptions and estimates could have a material impact on CFC’s financial statements.

Impaired Exposure

CFC calculates impairment on certain loans in accordance with SFAS 114 and SFAS 118. SFAS 114 states that a loan is impaired when a creditor does not expect to collect all principal and interest due under the original terms of the loan. CFC reviews its portfolio to identify impairments on a quarterly basis. Factors considered in determining an impairment include, but are not limited to: the review of the borrower’s audited financial statements and interim financial statements if available, the borrower’s payment history, communication with the borrower, economic conditions in the borrower’s service territory, pending legal action involving the borrower, restructure agreements between the borrower and CFC, and estimates of the value of the borrower’s assets that have been pledged as collateral to secure CFC loans. CFC calculates the impairment by comparing the future estimated cash flow, discounted at the original loan interest rate, against CFC’s current investment in the receivable. If the current investment in the receivable is greater than the net present value of the future payments discounted at the original contractual interest rate, the impairment is equal to that difference. If it is not possible to estimate the future cash flow associated with a loan, then the impairment calculation is based on the value of the collateral pledged as security for the loan. At May 31, 2004 and 2003, CFC had a total of $233 million and $164 million reserved specifically against impaired exposure totaling $959 million and $629 million, respectively, representing 24% and 26% of the total impaired loan exposure. The $233 million and $164 million specific reserves represented 41% and 32% of the total loan loss allowance at May 31, 2004 and 2003, respectively. The calculated impairment at May 31, 2004 was higher than at May 31, 2003 due to the increase in loan exposure classified as impaired related to a telecommunications borrower, offset by payments received and lower interest rates on CFC variable rate loans. The original contract rate on a portion of CFC’s impaired loans at May 31, 2004 will vary with the changes in CFC’s variable interest rates. Based on the current balance of impaired loans at May 31, 2004, a 25 basis point increase or decrease to CFC variable interest rates will result in an increase or decrease, respectively, of approximately $14 million to the calculated impairment.

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In calculating the impairment on a loan, the estimate of the expected future cash flow or collateral value are the key estimates made by management. Changes in the estimated future cash flow or collateral value would impact the amount of the calculated impairment. The change in cash flow required to make the change in the calculated impairment material will be different for each borrower and depend on the period covered, the original contract interest rate and the amount of the loan outstanding. Estimates are not used to determine CFC’s investment in the receivables or the discount rate since, in all cases, they are the loan balance outstanding at the reporting date and the original loan interest rate.

 
High Risk Exposure
Loan exposures considered to be high risk represent exposure in which the borrower has had a history of late payments, the borrower’s financial results do not satisfy loan financial covenants, the borrower has contacted CFC to discuss pending financial difficulties or for some other reason CFC believes that the borrower’s financial results could deteriorate resulting in an elevated potential for loss. CFC’s corporate credit committee is responsible for determining which loans should be classified as high risk and the level of reserve required for each borrower. The committee meets at least quarterly to review all loan facilities with an internal risk rating above a certain level. Once it is determined that exposure to a borrower should be classified as high risk, the committee sets the required reserve level based on the facts and circumstances for each borrower, such as the borrower’s financial condition, payment history, CFC’s estimate of the collateral value, pending litigation, if any, and other factors. This is an objective and subjective exercise in which the committee uses the available information to make its best estimate as to the level of loss allowance required. At any reporting date the reserve required could vary significantly depending on the facts and circumstances, which could include, but are not limited to: changes in collateral value, deterioration in financial condition, the borrower declaring bankruptcy, payment default on CFC’s loans and other factors. The borrowers in the high risk category will generally either move to the impaired category or back to the general portfolio within a period of twelve months. At May 31, 2004 and 2003, CFC had reserved $109 million and $87 million against the $607 million and $870 million of exposure classified as high risk, representing coverage of 18% and 10%, respectively. The $109 million and $87 million reserve for loans in the high risk category represents 19% and 17%, respectively, of the total loan loss allowance at May 31, 2004 and 2003.
 
General Portfolio
In fiscal year 2003, CFC made refinements to the methodology used to determine the required loan loss allowance for the general portfolio. The refinements include the use of the improved internal risk rating system, historical default data on corporate bonds and CFC specific loss recovery data. CFC uses the following factors to determine the level of the loan loss allowance for the general portfolio category:

•  Internal risk ratings — CFC maintains risk ratings for each credit facility outstanding to its borrowers. CFC adopted the risk rating methodology in fiscal year 2002. The ratings are updated at least annually and are based on the following:

  •  General financial condition of the borrower.
  •  CFC’s internal estimated value of the collateral securing its loans.
  •  CFC’s internal evaluation of the borrower’s management.
  •  CFC’s internal evaluation of the borrower’s competitive position within its service territory.
  •  CFC’s estimate of potential impact of proposed regulation and litigation.
  •  Other factors specific to individual borrowers or classes of borrowers.

•  Standard corporate default table — The table provides expected default rates based on rating level and the remaining maturity of the bond. CFC uses the standard default table for all corporate bonds provided by Standard and Poor’s Corporation to assist in estimating its reserve levels.
 
•  Recovery rates — Estimated recovery rates based on historical experience of loan balance at the time of default compared to the total loss on the loan to date.

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CFC aggregates the loans in the general portfolio by borrower type (distribution, generation, telecommunications, associate and other member) and by internal risk rating within borrower type. CFC correlates its internal risk ratings to the ratings used in the standard default table based on a comparison of CFC’s rating on borrowers that have a rating from one or more of the recognized credit rating agencies and based on a standard matching used by banks.

In addition to the general portfolio reserve requirement as calculated above, CFC maintains an additional reserve for borrowers with a total exposure in excess of 1.5% of the total CFC loans and guarantees outstanding. The additional reserve is based on the amount of exposure in excess of 1.5% of the CFC total exposure and the borrower’s internal risk rating. At May 31, 2004 and 2003, respectively, CFC had a reserve of $19 million and $25 million based on the additional risk related to large exposures.

At May 31, 2004 and 2003, CFC had a total of $18,660 million and $17,718 million of loans, respectively, in the general portfolio. This total does not include $263 million and $267 million of loans at May 31, 2004 and 2003, respectively, that have a US Government guarantee of all principal and interest payments. CFC does not maintain a loan loss allowance on loans that are guaranteed by the US Government. CFC reserved a total of $232 million and $260 million (including the $19 million and $25 million described above) for loans in the general portfolio at May 31, 2004 and 2003, respectively, representing coverage of 1.24% and 1.47% of the total loans for the general portfolio.

The methodology used in fiscal year 2002 considered many of the factors listed above, but the process of evaluating those factors was not as formalized as in fiscal year 2003 after the final adoption of the internal risk rating process. Overall, CFC believes the methodology used in fiscal year 2003 to be enhanced and less subjective than the methodology used in fiscal year 2002.

In fiscal years 2004, 2003 and 2002, CFC made provisions to the loan loss reserve totaling $55 million, $43 million and $186 million, respectively. The important factors affecting the provision for each year are listed below:

•  Fiscal year 2004 provision of $55 million resulted primarily from the following factors:
  •  Increase to the calculated impairment of $69 million due to an increase of $330 million to impaired loans outstanding because of the deteriorating financial condition of one borrower which moved from high risk to impaired in fiscal year 2004 offset by repayments from another borrower and the impact of lower interest rates on variable rate loans.
  •  Increase of $22 million to the required high risk reserve due to legal action involving one high risk borrower and to a refinement in process to set a minimum reserve for high risk borrowers.
  •  A decrease of $28 million to the required general reserve due to a 9% reduction in the weighted average risk rating for all loans in the general portfolio and a decrease of $6 million required for large exposures offset by an increase in allowance as a result of a $942 million increase to loans outstanding in the general portfolio.
  •  Net recoveries of $2 million.
•  Fiscal year 2003 provision of $43 million resulted from the following factors:
  •  Impaired exposure decreased by $924 million and calculated impairment decreased by $38 million. Calculated impairment was impacted by decreases to CFC variable interest rates and reductions in total impaired exposure.
  •  High risk exposure decreased by $74 million and the CFC corporate credit committee determined, based on facts and circumstances at that time, that a 10% reserve was required on the high risk exposure compared to a 5% reserve in 2002 which results in a net increase of $40 million to the reserve allocated to the high risk category.
  •  General portfolio exposure increased by $411 million and the refinement of the allowance methodology resulted in an increase to the reserve of $31 million.
  •  Net write-offs of $10 million during fiscal year 2003.

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•  Fiscal year 2002 provision of $186 million resulted from the following factors:
  •  Impaired exposure increased by $88 million and calculated impairments increased by $47 million. One impaired borrower defaulted on its restructure agreement and declared bankruptcy resulting in a higher calculated impairment as compared to fiscal year 2001.
  •  High risk exposure increased by $441 million. At year end it was estimated that a reserve of 5.00% was required on high risk exposure resulting in an increase of $27 million compared to 3.98% for fiscal year 2001.
  •  General portfolio exposure decreased by $226 million, however the reserve requirement based on the methodology in effect at that time required an increase to the general reserve of $87 million due to the downturn in the electric and telecommunications industries.
  •  Net write-offs of $25 million during fiscal year 2002.

Senior management reviews and discusses the estimates and assumptions used in the calculations of the loan loss allowance for impaired loans, high risk loans and loans covered by the general portfolio, including high exposures related to single obligors, on a quarterly basis. Senior management discusses estimates with the board of directors and audit committee and reviews all loan loss related disclosures included in CFC’s Form 10-Qs and Form 10-Ks filed with the SEC.

CFC’s corporate credit committee makes recommendations of loans to be written off to the respective boards of directors. In making its recommendation to write off all or a portion of a loan balance, CFC’s corporate credit committee considers various factors including cash flow analysis and collateral securing the borrower’s loans. Under current policy, the respective boards of directors are required to approve all loan write-offs.

 
Derivative Financial Instruments

In June 1998, the FASB issued SFAS 133. SFAS 133, as amended, establishes accounting and reporting standards requiring that derivative instruments (including certain derivative instruments embedded in other contracts) be recorded in the consolidated and combined balance sheets as either an asset or liability measured at fair value. The statement requires that changes in the derivative instrument’s fair value be recognized currently in earnings unless specific hedge accounting criteria are met. Special accounting for qualifying hedges allows a derivative instrument’s gains and losses to offset related results on the hedged item in the consolidated and combined statements of operations or to be recorded as other comprehensive income, to the extent effective, and requires that a company formally document, designate, and assess the effectiveness of transactions that receive hedge accounting. CFC adopted this statement on June 1, 2001. CFC is neither a dealer nor trader in derivative financial instruments. CFC uses interest rate, cross currency and cross currency interest rate exchange agreements to manage its interest rate and foreign currency risk.

As a result of applying SFAS 133, CFC has recorded derivative assets of $577 million and $1,160 million and derivative liabilities of $130 million and $355 million at May 31, 2004 and 2003, respectively, as well as a long-term debt valuation allowance that decreases long-term debt by $1 million at May 31, 2003. Accumulated other comprehensive losses related to derivatives from inception to date were $12 million and $47 million as of May 31, 2004 and 2003, respectively.

The impact of derivatives on CFC’s consolidated and combined statements of operations for the years ended May 31, 2004 and 2003 was a loss of $128 million and a gain of $872 million, respectively. The change in the fair value of derivatives for the years ended May 31, 2004 and 2003 was a loss of $229 million and a gain of $757 million recorded in CFC’s derivative forward value. At May 31, 2004 and 2003, the derivative forward value also includes amortization totaling $1 million and $(3) million, respectively, related to the long-term debt valuation allowance and $17 million and $22 million, respectively, related to the transition adjustment recorded as an other comprehensive loss on June 1, 2001, the date CFC implemented SFAS 133. In addition, income totaling $101 million and $115 million was recorded for net cash settlements received by CFC during the years ended May 31, 2004 and 2003, respectively, of which $110 and $123 million, respectively, relate to interest rate and cross currency interest

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rate exchange agreements that do not qualify for hedge accounting under SFAS 133 and were recorded in the derivative cash settlements line. The remaining expense of $9 million and $8 million, respectively, relate to interest rate and cross currency interest rate exchange agreements that do qualify for hedge accounting under SFAS 133 and were recorded in the cost of funds line. All cash settlements were recorded in the cost of funds prior to June 1, 2001.

CFC is required to determine the fair value of its derivative instruments. Because there is not an active secondary market for the types of derivative instruments it uses, CFC obtains market quotes from its dealer counterparties. The market quotes are based on the expected future cash flow and estimated yield curves. CFC records the change in the fair value of its derivatives for each reporting period in the derivative forward value line on the consolidated and combined statements of operations for the majority of its derivatives or in the other comprehensive income account on the consolidated and combined balance sheets for the derivatives that qualify for hedge accounting. The counterparties are estimating future interest rates as part of the quotes they provide to CFC. CFC adjusts all derivatives to fair value on a quarterly basis. The fair value recorded by CFC will change as estimates of future interest rates change. To estimate the impact of changes to interest rates on CFC’s forward value of derivatives, CFC would need to estimate all changes to interest rates through the maturity of its outstanding derivatives. CFC has derivatives in the current portfolio that do not mature until 2029. Due to the volatility in expected future interest rates, CFC does not believe that it is a useful exercise to attempt to estimate future interest rates through the maturity of its derivative portfolio. In addition, CFC excludes the changes to the fair value of derivatives from its internal analysis since they represent the net present value of all future estimated cash settlements. Thus, CFC does not estimate the impact of changes in future interest rates to the fair value of its derivatives. CFC does not believe that volatility in the derivative forward value line on the consolidated and combined statements of operations is material as it represents an estimated future value and not a cash impact for the current period.

Cash settlements that CFC pays and receives for derivative instruments that do not qualify for hedge accounting are recorded in the cash settlements line in the consolidated and combined statements of operations. A 25 to 50 basis point increase to the 30-day composite commercial paper index, the three-month LIBOR rate and the six-month LIBOR rate would not have a significant impact on CFC’s total cash settlements due to the composition of the portfolio at May 31, 2004. CFC’s interest rate exchange agreements at May 31, 2004 include $7,435 million notional amount, or 48% of the total interest rate exchange agreements in which CFC synthetically changed the interest rate on the debt securities from variable to fixed. The remaining $8,050 million notional amount, or 52% of the total interest rate exchange agreements at May 31, 2004, synthetically changed the interest rate on CFC’s debt securities from fixed to variable. As a result, the impact of an increase in interest rates for interest rate exchange agreements in which CFC pays a variable rate would be offset by the impact of the increase in interest rates for interest rate exchange agreements in which CFC receives a variable rate.

The majority of CFC’s derivatives do not qualify for hedge accounting. To qualify for hedge accounting, there must be a high correlation between the pay leg of the interest rate exchange agreement and the asset being hedged or between the receive leg of the interest rate exchange agreement and the liability being hedged. A large portion of CFC’s interest rate exchange agreements use a 30-day composite commercial paper index as the receive leg, which would have to be highly correlated to CFC’s own commercial paper rates to qualify for hedge accounting. CFC sells commercial paper to its members as well as investors in the capital markets. CFC sets its commercial paper rates daily based on its cash requirements. The correlation between the CFC commercial paper rates and the 30-day composite commercial paper index has not been consistently high enough to qualify for hedge accounting.

CFC does not plan to adjust its practice of using the 30-day composite commercial paper or a LIBOR index as the receive portion of its interest rate exchange agreements. CFC sets the variable interest rates on its loans based on the cost of its short-term debt, which is comprised of long-term debt due within one year and commercial paper. CFC believes that it is properly hedging its gross margin on loans by using the 30-day composite commercial paper or LIBOR index, which is the rate that is most closely related to the rates it charges on its own commercial paper. During certain periods, the correlation between the LIBOR rates or the

36


 

30-day composite commercial paper rate and the CFC 90-day and 30-day commercial paper rate has been higher than the required 90% to qualify for hedge accounting. However, the correlation is not consistently above the 90% threshold, therefore the interest rate exchange agreements that use the three-month LIBOR rate or 30-day composite commercial paper rate do not qualify for hedge accounting. For the purposes of its own analysis, CFC believes that the correlation is sufficiently high to consider these agreements effective economic hedges.

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 in dollar terms is subject to fluctuation as interest rates change. In addition, as CFC is a not-for-profit member-owned finance cooperative, its objective is not to maximize its net margin dollars, but to offer its members the lowest cost financial services. Management has established a 1.10 adjusted TIER as its minimum operating objective. TIER is a measure of CFC’s ability to cover the interest expense on its debt obligations. TIER is calculated by dividing the cost of funds and the net margin prior to the cumulative effect of change in accounting principle by the cost of funds. CFC’s TIER for the years ended May 31, 2003 and 2002 was 1.70 and 1.09, respectively. For the year ended May 31, 2004, CFC reported a net loss prior to the cumulative effect of change in accounting principle of $200 million, thus the TIER calculation results in a value below 1.00. CFC adjusts TIER to exclude the SFAS 133 derivative forward value and foreign currency adjustments from net margin and include the derivative cash settlements in the cost of funds. Adjusted TIER for May 31, 2004 also adds back minority interest. Adjusted TIER for the years ended May 31, 2004, 2003 and 2002 was 1.12, 1.17 and 1.12, respectively. See “Non-GAAP Financial Measures” for further explanation and a reconciliation of the adjustments CFC makes in its TIER calculation to exclude the non-cash impact of SFAS 133 and foreign currency adjustments.

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Fiscal Year 2004 versus 2003 Results

The following chart presents the results for the year ended May 31, 2004 versus May 31, 2003.

                           
For the year ended
May 31,

Increase/
2004 2003 (Decrease)
(Dollar amounts in millions)


Operating income
  $ 1,005     $ 1,071     $ (66 )
Cost of funds
    (914 )     (931 )     17  
     
     
     
 
 
Gross margin
    91       140       (49 )
Operating expenses:
                       
General and administrative expenses
    (41 )     (38 )     (3 )
Provision for loan losses
    (55 )     (43 )     (12 )
Recovery (provision) for guarantee losses
    1       (25 )     26  
     
     
     
 
 
Total operating expenses
    (95 )     (106 )     11  
 
Results of operations of foreclosed assets
    4       1       3  
Impairment loss on foreclosed assets
    (11 )     (20 )     9  
     
     
     
 
 
Total loss on foreclosed assets
    (7 )     (19 )     12  
 
Derivative cash settlements
    110       123       (13 )
Derivative forward value
    (229 )     757       (986 )
Foreign currency adjustments
    (65 )     (243 )     178  
     
     
     
 
 
Total (loss) gain on derivative and foreign currency adjustments
    (184 )     637       (821 )
     
     
     
 
 
Operating (loss) margin
    (195 )     652       (847 )
Income tax expense
    (3 )           (3 )
Minority interest — RTFC and NCSC net margin
    (2 )           (2 )
Cumulative effect of change in accounting principle
    22             22  
     
     
     
 
 
Net (loss) margin
  $ (178 )   $ 652     $ (830 )
     
     
     
 
TIER(1)
          1.70          
     
     
         
Adjusted TIER(2)
    1.12       1.17          
     
     
         


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

Operating Income

The $66 million or 6% decrease in operating income for the year ended May 31, 2004 compared to the prior year period was due to a $85 million decrease due to the lower yield on average loans outstanding offset by a $19 million increase due to higher average loan volume. The average yield on total loans decreased from 5.40% for the year ended May 31, 2003 to 4.95% for the year ended May 31, 2004 due to reductions to CFC’s long-term variable and line of credit interest rates during the year ended May 31, 2004. The decrease to CFC’s interest rates was based on its decision to lower the gross margin yield it was charging its members. CFC’s average loan volume outstanding increased slightly by $486 million or 2% to $20,332 million for the year ended May 31, 2004 compared to $19,846 million for the year ended May 31, 2003. CFC’s goal as a not-for-profit, member-owned financial cooperative is to provide financial products to its members at the lowest rates possible after covering all expenses and maintaining a reasonable net margin. For the year ended May 31, 2004, CFC exceeded its minimum operating objective of a 1.10 adjusted TIER.

Electric systems operating income is comprised of income from loans to electric members. Electric systems operating income for the year ended May 31, 2004 decreased $45 million compared to the prior year

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period due to a $58 million decrease caused by lower interest rates, partly offset by an increase of $13 million due to an increase in average loan volume. The average yield on electric loans fell from 4.88% for the year ended May 31, 2003 to 4.50% for the year ended May 31, 2004 while average loan volume increased 2%. CFC reduced its long-term variable interest rate for electric loans by 70 basis points and its line of credit interest rate for electric loans by 110 basis points during the year ended May 31, 2004. Telecommunications operating income is comprised of income from loans to telecommunications borrowers. Telecommunications operating income for the year ended May 31, 2004 decreased $37 million compared to the prior year period. The average yield on telecommunications loans fell from 6.93% to 6.37% accounting for $27 million of the decrease while lower average telecommunications loans outstanding of 3% resulted in the remaining $10 million of the decrease. CFC reduced its long-term variable and line of credit interest rates on telecommunications loans by 65 basis points and 70 basis points, respectively, during the year ended May 31, 2004. Other operating income is comprised of loans to electric consumers, loans to the for-profit subsidiaries of members and other items not included in the electric or telecommunications segments. Other operating income increased from zero for the year ended May 31, 2003 to $16 million for the year ended May 31, 2004 due to the consolidation of NCSC beginning June 1, 2003.
 
Cost of Funds
The $17 million, or 2%, decrease in cost of funds for the year ended May 31, 2004 compared to the prior year period was due to a $28 million decrease due to a reduction to interest rates in the markets offset by an increase of $11 million due to an increase in loan volume as compared to the prior year. Cost of funds for the year ended May 31, 2004 and 2003 includes $9 million and $8 million of expense, respectively, for net cash settlements related to exchange agreements that qualify as effective hedges. CFC’s average cost of funding for the year ended May 31, 2004 was 4.50% compared to 4.69% in the prior year period. CFC’s average adjusted cost of funding, which includes derivative cash settlements, for the year ended May 31, 2004 was 3.96% compared to 4.07% for the prior year period. See “Non-GAAP Financial Measures” for further explanation and a reconciliation of these adjustments. Electric cost of funds for the year ended May 31, 2004 increased $9 million compared to the prior year period due to a $12 million increase as a result of higher average loan volume, offset by a $3 million decrease due to lower interest rates. The telecommunications cost of funds decreased $33 million for the year ended May 31, 2004 compared to the prior year period, $25 million of which was due to reductions in the average telecommunication cost from 5.59% to 5.08% period over period. The remaining $8 million decrease was due to the 3% reduction in average telecommunications loan volume. Other cost of funds increased from zero for the year ended May 31, 2003 to $7 million for the year ended May 31, 2004 due to the consolidation of NCSC beginning June 1, 2003.
 
Gross Margin
The gross margin spread earned on loans for the year ended May 31, 2004 was 45 basis points, a decrease of 26 basis points, or 37%, compared to 71 basis points for the year ended May 31, 2003. The adjusted gross margin spread earned on loans for the year ended May 31, 2004, which includes derivative cash settlements, was 99 basis points, a decrease of 34 basis points, or 26%, compared to the adjusted gross margin spread of 133 basis points for the prior year period. See “Non-GAAP Financial Measures” for further explanation of the adjustment CFC makes in its financial analysis to include the derivative cash settlements in its cost of funds, and therefore gross margin. The decrease to CFC’s gross margin spread and adjusted gross margin spread was primarily due to the reductions in CFC’s variable interest rates during the year ended May 31, 2004 without a corresponding decrease to rates in the capital markets. The $49 million decrease to gross margin was due to the $53 million and $5 million decrease to electric and telecommunications gross margin, respectively, partly offset by the $9 million increase to other gross margin. By reducing the gross margin yield, CFC is effectively giving its members an immediate return of patronage capital rather than collecting the higher gross margin yield during the year and returning it at year end and in subsequent years. This is consistent with CFC’s goal as a not-for-profit, member-owned, finance cooperative, to provide its members with the lowest cost financial services.

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Operating Expenses
General and administrative expenses for the year ended May 31, 2004 were $41 million compared to $38 million for the year ended May 31, 2003. General and administrative expenses represented 20 basis points of average loan volume for the year ended May 31, 2004, an increase of one basis point as compared to 19 basis points for the prior year period.

The loan loss provision of $55 million for the year ended May 31, 2004 represented an increase of $12 million from the provision of $43 million for the prior year period. The $55 million provision required for the year ended May 31, 2004 was the result of a $63 million increase to the estimated loan loss allowance at May 31, 2004 versus May 31, 2003, including an increase of $6 million due to the June 1, 2003 consolidation of NCSC that was recorded as a cumulative change in accounting principle offset by a net recovery of $2 million related to amounts written off in prior periods. The $63 million increase to the estimated loan loss allowance for the year ended May 31, 2004 was primarily due to an increase in the amount allocated to impaired loan and high risk exposures. As a result of consolidation, loans outstanding increased due to the addition of NCSC loans and the loan loss allowance increased due to the addition of the NCSC loan loss allowance.

The $55 million provision for the year ended May 31, 2004 includes an electric segment recovery of $99 million from the loan loss allowance due to a decrease in the estimated loan loss for electric loans of $102 million and a net recovery of $2 million of amounts written off in prior periods offset by a cumulative change increase of $5 million as a result of the consolidation of NCSC. The estimated loan loss allowance for electric loans decreased due to an improved aggregate credit risk rating on electric loans and a reduction to calculated impairments as a result of lower variable interest rates and principal repayments. The telecommunications segment provision of $146 million for the year ended May 31, 2004 was due to an increase in the amount of loan loss allowance allocated to impaired and high risk exposures. The other segment loan loss provision of $8 million was due to the consolidation of NCSC.

CFC reported a $1 million recovery in the provision for guarantee losses for the year ended May 31, 2004 representing a decrease of $26 million from the provision of $25 million recorded for the prior year period. The provision of $25 million for the year ended May 31, 2003 was due to a refinement of the process of estimating the guarantee liability to incorporate the improved internal risk rating system, standard corporate bond default tables and CFC’s estimated recovery rates. The total guarantee liability at May 31, 2004 has decreased from May 31, 2003 as a result of the consolidation of NCSC. At May 31, 2003, CFC had a total of $476 million of guarantees of NCSC debt obligations. As a result of the June 1, 2003 consolidation of NCSC, the guaranteed debt became debt of the consolidated company, which eliminated the guarantees. At May 31, 2004 and 2003, 97.8% and 99.7%, respectively, of guarantees were related to the electric segment.

 
Results of Operating Foreclosed Assets
In October and December 2002, CFC received assets as a result of bankruptcy settlements. CFC records the results of operating these assets as the results of operations of foreclosed assets. CFC recorded net margin of $4 million from the operation of foreclosed assets for the year ended May 31, 2004 compared to $1 million for the year ended May 31, 2003. In addition, CFC recognized an impairment loss of $11 million to reflect the decrease in the fair value of certain foreclosed assets during the year ended May 31, 2004 compared to $20 million during the prior year. It is not management’s intent to hold and operate these assets, but to preserve the value for sale at the appropriate time. On October 27, 2003, CFC sold the Denton Telecom Partners d/b/a Advantex (telecommunication assets received as part of the CoServ bankruptcy settlement) for $31 million in cash. This sale terminates CFC’s responsibilities for all future operations of the telecommunications assets acquired in the bankruptcy settlement with CoServ.
 
Derivative Cash Settlements
Derivative cash settlements decreased $13 million during the year ended May 31, 2004 compared to the prior year period. The decrease in the interest rates related to CFC’s derivatives contracts resulted in a $27 million decrease in derivative cash settlements partly offset by a $14 million increase due to the

40


 

increase in the notional amount of CFC’s derivative contracts. The derivative cash settlements for the period represent the net amount that CFC paid or received on its derivative contracts that do not qualify for hedge accounting. CFC is currently collecting more on its derivative contracts than it is paying.
 
Derivative Forward Value
During the year ended May 31, 2004, derivative forward value decreased $986 million compared to the prior year period. The decrease in the derivative forward value is due to changes in the estimate of future interest rates over the remaining life of the derivative contracts. The derivative forward value for the year ended May 31, 2004 and 2003 also includes amortization of $1 million and $(3) million, respectively, related to the long-term debt valuation allowance and $17 million and $22 million, respectively, related to the transition adjustment recorded as an other comprehensive loss on June 1, 2001, the date CFC implemented SFAS 133. These adjustments will be amortized into earnings over the remaining life of the underlying debt and related derivative contracts.

CFC is required to record the fair value of derivatives on its consolidated and combined balance sheets with changes in the fair value of derivatives that do not qualify for hedge accounting recorded in the consolidated and combined statements of operations as a current period gain or loss. This change in fair value is recorded as the derivative forward value on the consolidated and combined statements of operations. The derivative forward value does not represent a current period cash inflow or outflow to CFC, but represents the net present value of the estimated future cash settlements, which are based on the estimate of future interest rates over the remaining life of the derivative contract. The expected future interest rates change often, causing significant changes in the recorded fair value of CFC’s derivatives and volatility in the reported estimated gain or loss on derivatives in the consolidated and combined statements of operations. Recording the forward value of derivatives results in recording only a portion of the impact on CFC’s operations due to future changes in interest rates. Under GAAP, CFC is required to recognize changes in the fair value of its derivatives as a result of changes to interest rates, but there are no provisions for recording changes in the fair value of its loans as a result of changes to interest rates. As a finance company, CFC passes on its cost of funding through interest rates on loans to members. CFC has demonstrated the ability to pass on its cost of funding to its members by consistently earning an adjusted TIER in excess of the minimum 1.10 target. CFC has earned an adjusted TIER in excess of 1.10 in every year since 1981. See “Non-GAAP Financial Measures” for further explanation and a reconciliation of adjusted ratios.

 
Foreign Currency Adjustment
CFC’s foreign currency adjustment increased $178 million for the year ended May 31, 2004 as compared to the year ended May 31, 2003 due to the change in the exchange rates. Changes in the exchange rate between the U.S. dollar and Euro and the U.S. dollar and Australian dollar will cause the value of CFC’s outstanding foreign denominated debt to fluctuate. An increase in the value of the Euro or the Australian dollar versus the value of the U.S. dollar results in an increase in the recorded U.S. dollar value of foreign denominated debt and therefore a charge to expense on the consolidated and combined statements of operations, while a decrease in exchange rates results in a reduction in the recorded U.S. dollar value of foreign denominated debt and income. CFC has entered into foreign currency exchange agreements to cover all of the cash flows associated with its foreign denominated debt. Changes in the value of the foreign currency exchange agreement will be approximately offset by changes in the value of the outstanding foreign denominated debt.
 
Operating (Loss) Margin
Operating loss for the year ended May 31, 2004 was $195 million, compared to operating margin of $652 million for the prior year period. The adjusted operating margin, which excludes derivative forward value and foreign currency adjustments, for the year ended May 31, 2004 was $99 million, compared to $138 million for the prior year period. See “Non-GAAP Financial Measures” for further explanation of the adjustment CFC makes in its financial analysis to exclude the derivative forward value and foreign currency adjustments in its adjusted operating margin. The adjusted operating margin decreased due to the

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$62 million decrease in gross margin adjusted for cash settlements, the $3 million increase to general and administrative expenses and the $12 million increase to the provision for loan losses partially offset by the $26 million decrease to the provision for guarantee losses and the $12 million decrease to the results of operations and impairment loss on foreclosed assets.

Cumulative Effect of Change in Accounting Principle

As a result of the implementation of FIN 46(R) on June 1, 2003, CFC consolidated the financial results of NCSC and RTFC. CFC recorded a cumulative effect of change in accounting principle gain of $22 million on the consolidated statement of operations for the year ended May 31, 2004, representing a $3 million increase to the loan loss allowance, a $34 million decrease to the guarantee liability and a $9 million loss representing the amount by which cumulative losses of NCSC exceeded NCSC equity.

Net (Loss) Margin

Net loss for the year ended May 31, 2004 was $178 million, a decrease of $830 million compared to a net margin of $652 million for the prior year period. The net loss for the year ended May 31, 2004 and the significant decrease from the prior year period are primarily due to the $986 million decrease in the estimated fair value of derivatives and the $49 million decrease to gross margin partly offset by the $178 million and $22 million increase in foreign currency adjustments and cumulative effect of change in accounting principle, respectively. The adjusted net margin, which excludes the impact of the derivative forward value, foreign currency adjustments, cumulative effect of change in accounting principle and adds back minority interest was $96 million, compared to $138 million for the prior year period. See “Non-GAAP Financial Measures” for further explanation of the adjustments CFC makes in its financial analysis to net (loss) margin.

Fiscal Year 2003 versus 2002 Results

The following chart details the results for the year ended May 31, 2003 versus May 31, 2002.
                           
For the year
ended May 31,

Increase/
2003 2002 (Decrease)
(Dollar amounts in millions)


Operating income
  $ 1,071     $ 1,187     $ (116 )
Cost of funds
    (931 )     (886 )     (45 )
     
     
     
 
 
Gross margin
    140       301       (161 )
Operating expenses:
                       
General and administrative expenses
    (38 )     (38 )      
Provision for loan losses
    (43 )     (186 )     143  
Provision for guarantee losses
    (25 )     (13 )     (12 )
     
     
     
 
 
Total operating expenses
    (106 )     (237 )     131  
Results of operations of foreclosed assets
    1             1  
Impairment loss on foreclosed assets
    (20 )           (20 )
     
     
     
 
 
Total loss on foreclosed assets
    (19 )           (19 )
Derivative cash settlements
    123       34       89  
Derivative forward value
    757       42       715  
Foreign currency adjustments
    (243 )     (61 )     (182 )
     
     
     
 
 
Total gain on derivative and foreign currency adjustments
    637       15       622  
     
     
     
 
 
Operating margin
    652       79       573  
Cumulative effect of change in accounting principle
          28       (28 )
     
     
     
 
 
Net margin
  $ 652     $ 107     $ 545  
     
     
     
 
TIER
    1.70       1.09          
     
     
         
Adjusted TIER(1)
    1.17       1.12          
     
     
         


(1)  Adjusted to exclude the impact of the derivative forward value, foreign currency adjustments and minority interest from net margin and include the derivative cash settlements in the cost of funds. See “Non-GAAP Financial Measures” for further explanation and a reconciliation of these adjustments.

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Operating Income
The $116 million or 10% decrease in operating income for the year ended May 31, 2003 compared to the prior year was due to the decrease in the yield on average loans outstanding caused by lower interest rates. CFC’s calculated average yield on its loan portfolio was 5.40% for the year ended May 31, 2003, a decrease of 0.58% from 5.98% for the prior year. CFC reduced its long-term variable interest rates by 85 basis points and reduced its line of credit interest rates by 100 basis points during the year ended May 31, 2003. Average loan volume for the year ended May 31, 2003 was $19,846 million, an increase of $10 million, or less than 1%, over the average loan volume of $19,836 million for the prior year. CFC’s goal as a not-for-profit, member-owned financial cooperative is to provide financial products to its members at the lowest rates possible after covering all expenses and maintaining a reasonable net margin. For the year ended May 31, 2003, CFC exceeded its minimum operating objective of a 1.10 adjusted TIER.

Electric systems operating income is comprised of income from loans to electric members. Electric systems operating income for the year ended May 31, 2003 decreased $87 million compared to the prior year period due to decreases in interest rates. The average yield on electric loans fell from 5.57% for the year ended May 31, 2002 to 4.88% for the year ended May 31, 2003 accounting for $102 million of the decrease offset by the 2% increase in average loan volume which accounted for a $15 million increase. Telecommunications operating income is comprised of income from loans to telecommunications borrowers. Telecommunications operating income for the year ended May 31, 2003 decreased $29 million compared to the prior year period. The average yield on telecommunications loans fell from 7.13% for the year ended May 31, 2002 to 6.93% for the year ended May 31, 2003, accounting for $10 million of the decrease while a decrease of 5% in average loans outstanding resulted in the remaining $19 million of the decrease.

 
Cost of Funds
The total cost of funding for the year ended May 31, 2003 increased $45 million or 5% compared to the prior year. CFC replaced dealer commercial paper with medium-term notes and collateral trust bonds with longer maturities in order to reduce liquidity risk in funding its long-term loans. As a result, CFC’s funding costs for the year ended May 31, 2003 increased compared to the prior year offsetting the impact of decreasing interest rates on short-term funding. CFC’s average cost of funding for the year ended May 31, 2003 was 4.69% compared to 4.46% in the prior year period. CFC’s average adjusted cost of funding, which includes derivative cash settlements, was 4.07% for fiscal year 2003, a decrease from 4.29% for fiscal year 2002. See “Non-GAAP Financial Measures” for further explanation and a reconciliation of these adjustments. The electric cost of funds increased $24 million for the year ended May 31, 2003 compared to the prior year period, $12 million of which was due to increases in the average cost from 4.31% to 4.39% period over period and $12 million due to the 2% increase in average loan volume. The telecommunications cost of funds increased $21 million for the year ended May 31, 2003 compared to the prior year period, $34 million of which was due to increases in the average cost from 4.90% to 5.59% period over period offset by the $13 million decrease due to the 5% reduction in average loan volume.
 
Gross Margin
The gross margin earned on loans for the year ended May 31, 2003 was 71 basis points, a decrease of 81 basis points, or 53%, compared to 152 basis points for the prior year. The adjusted gross margin earned on loans for the year ended May 31, 2003, which includes derivative cash settlements, was 133 basis points, representing a decrease of 36 basis points, or 21%, compared to the adjusted gross margin of 169 basis points for the prior year period. See the “Non-GAAP Financial Measures” section for further explanation of the adjustment CFC makes in its financial analysis to include the derivative cash settlements in its cost of funds, and therefore gross margin. The decrease to CFC’s gross margin and adjusted gross margin for fiscal year 2003 was primarily due to the increased cost associated with replacing dealer commercial paper with medium-term notes and collateral trust bonds offsetting the impact of decreasing interest rates on the gross margin earned on loans. The $161 million decrease to gross margin was due to the $111 million and $50 million decrease to electric and telecommunications gross margin, respectively. CFC’s goal as a not-for-profit, member-owned financial cooperative is to provide financial

43


 

products to its members at the lowest rates possible after covering all expenses and maintaining a reasonable net margin. For the year ended May 31, 2003, CFC exceeded its minimum operating objective of a 1.10 adjusted TIER, therefore CFC did not pass the increase in its cost of funding on to its borrowers.
 
Operating Expenses
General and administrative expenses for fiscal year 2003 were consistent with fiscal year 2002. The general and administrative expenses for fiscal year 2003 represented 0.19% of average loan volume, the same as the prior year.

CFC considers various factors to determine the adequacy of the loan loss allowance in relation to the credit quality of its loan and guarantee portfolio. During the year ended May 31, 2003, CFC determined that a total of $43 million was required as an addition to the loan loss allowance based on the credit quality of CFC’s loan portfolio compared to $186 million for the prior year. The loan loss provision for the prior year was higher due to the default and subsequent impairment on the CoServ loan and to an increase in loans classified as high risk. The provision to the reserve for fiscal year 2003 represented 0.22% of average loan volume, a decrease from 0.94% for the prior year.

The $43 million provision for the year ended May 31, 2003 includes an electric segment provision of $6 million due to net write-offs of $9 million partially offset by a decrease in the estimated loan loss for electric loans of $3 million. The estimated loan loss allowance for electric loans decreased due to a reduction to calculated impairments as a result of lower variable interest rates and due to an improved aggregate credit risk rating on electric loans. The telecommunications segment provision of $37 million for the year ended May 31, 2003 was due to an increase in the estimated loan loss allowance for telecommunications loans of $36 million and write-offs of $1 million.

The provision for guarantee losses for the year ended May 31, 2003 of $25 million represented an increase of $12 million from the provision of $13 million recorded for the prior year period. The provision of $25 million for the year ended May 31, 2003 was due to a refinement of the process of estimating the guarantee liability to incorporate the improved internal risk rating system, standard corporate bond default tables and CFC’s estimated recovery rates. At May 31, 2003, 99.7% of guarantees were related to the electric segment.

 
Results of Operating Foreclosed Assets
During the year ended May 31, 2003, entities controlled by CFC received real estate developer notes receivable, limited partnership interests in certain real estate developments, partnership interests in real estate properties and telecommunications assets from entities related to CoServ as part of the plan for CoServ to emerge from bankruptcy. Another borrower transferred real estate assets to an entity controlled by CFC in satisfaction of the loan as part of a settlement. CFC accounts for these assets on the combined balance sheet as foreclosed assets. The results of operations from foreclosed assets are shown on the combined statement of operations since the dates of foreclosure. For the year ending May 31, 2003, this amount was net margin of $1 million. CFC also recorded a $20 million impairment loss for the write down of certain foreclosed assets to their estimated fair value at May 31, 2003.
 
Derivative Cash Settlements
Derivative cash settlements increased $89 million during the year ended May 31, 2003 compared to the prior year period, $76 million of which was due to an increase in the interest rates related to CFC’s derivative contracts. The remaining $13 million increase was due to an increase in the total notional amount of CFC’s derivative contracts.
 
Derivative Forward Value
The $715 million increase in the derivative forward value during the year ended May 31, 2003 is due to changes in the fair value quotes of the interest rate and cross currency interest rate exchange agreements estimated at May 31, 2003 as compared to the prior year. In most cases, variable interest rates have not

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increased as expected and in a decreasing interest rate environment, a rise in the fair value of fixed to variable exchange agreements usually occurs. CFC pays a variable rate and receives a fixed rate on the majority of its exchange agreements. At May 31, 2003, CFC’s interest rate and cross currency interest rate exchange agreements include $8,484 million notional amount, or 51% of the total exchange agreements, in which CFC synthetically changed the interest rate on the debt securities from fixed to variable and $6,595 million notional amount, or 40% of the total exchange agreements, in which CFC synthetically changed the interest rate on the debt securities from variable to fixed. CFC pays a variable rate of interest and receives a variable rate of interest on the remaining exchange agreements. These types of exchange agreements have very little impact on the derivative forward value. The derivative forward value for the year ended May 31, 2003 and 2002 also includes amortization expense of $(3) million and $0.4 million, respectively, related to the long-term debt valuation allowance and $22 million and $21 million, respectively, related to the transition adjustment recorded as an other comprehensive loss on June 1, 2001, the date CFC implemented SFAS 133. These adjustments will be amortized into earnings over the remaining life of the underlying debt and related derivative contracts.

CFC is required to record the fair value of derivatives on its combined balance sheet with changes in the fair value of derivatives that do not qualify for hedge accounting recorded in the combined statement of operations as a current period gain or loss. This amount is recorded as the derivative forward value. The derivative forward value does not represent a current period cash inflow or outflow to CFC, but represents the net present value of the estimated future cash settlements, which are based on the estimate of future interest rates over the remaining life of the derivative contract. The expected future interest rates change often, causing significant changes in the recorded fair value of CFC’s derivatives and volatility in the reported estimated gain or loss on derivatives in the combined statement of operations. Recording the forward value of derivatives results in recording only a portion of the impact on CFC’s operations due to future changes in interest rates. Under GAAP, CFC is required to recognize changes in the fair value of its derivatives as a result of changes to interest rates, but there are no provisions for recording changes in the fair value of its loans as a result of changes to interest rates. As a finance company, CFC passes on its cost of funding through interest rates on loans to members. CFC has demonstrated the ability to pass on its cost of funding to its members by consistently earning an adjusted TIER in excess of the minimum 1.10 target. CFC has earned an adjusted TIER in excess of 1.10 in every year since 1981. See “Non-GAAP Financial Measures” for further explanation and a reconciliation of adjusted ratios.

 
Foreign Currency Adjustments
For the year ended May 31, 2003, CFC recorded a loss of $243 million related to foreign denominated debt that does not receive hedge treatment under SFAS 133. This was an increase from the loss of $61 million recorded for the prior year. CFC’s foreign currency adjustment increased by $182 million due to the change in exchange rates. Changes in the exchange rate between the U.S. dollar and Euro will cause the value of CFC’s outstanding foreign denominated debt to fluctuate. An increase in the value of the Euro versus the value of the U.S. dollar results in an increase in the recorded U.S. dollar value of foreign denominated debt and therefore a charge to expense on the combined statement of operations, while a decrease in exchange rates results in a reduction in the recorded U.S. dollar value of foreign denominated debt and income. During fiscal year 2003, CFC had outstanding a total 1,350 million Euros. At each reporting date, CFC is required to record the dollar equivalent of foreign denominated debt on its combined balance sheet with any change from the prior period reported on the combined statement of operations. For foreign denominated debt with related cross currency exchange agreements that qualify for hedge treatment under SFAS 133, the change in the value of the debt reported in the combined statement of operations is fully offset by the reclassification of an equal amount of the change in the fair value of the related hedge from accumulated other comprehensive loss, where the change in the fair value of the hedge was originally reported.
 
Operating Margin
Operating margin for the year ended May 31, 2003 was $652 million, compared to operating margin of $79 million for the prior year period. The adjusted operating margin, which excludes derivative forward

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value and foreign currency adjustments, for the year ended May 31, 2003 was $138 million, compared to $98 million for the prior year period. See “Non-GAAP Financial Measures” for further explanation of the adjustment CFC makes in its financial analysis to exclude the derivative forward value and foreign currency adjustments in its adjusted operating margin. The adjusted operating margin increase of $40 million was due to the $143 million decrease to the provision for loan losses partially offset by the $12 million increase to the provision for guarantee losses, $72 million decrease in gross margin adjusted for cash settlements and a $19 million loss on foreclosed assets.
 
Cumulative Effect of Change in Accounting Principle
Related to the adoption of SFAS 133 during the year ended May 31, 2002, CFC recorded a $28 million gain as a cumulative effect of change in accounting principle on June 1, 2001.
 
Net Margin
Net margin for the year ended May 31, 2003 was $652 million, an increase of $545 million compared to a net margin of $107 million for the prior year period. The adjusted net margin, which excludes derivative forward value, foreign currency adjustments and cumulative effect of change in accounting principle, was $138 million, compared to $98 million for the prior year period. See “Non-GAAP Financial Measures” for further explanation of the adjustments CFC makes in its financial analysis to net margin (loss). The net margin for the year ended May 31, 2003 and the significant increase from the prior year period are primarily due to the $715 million increase in the estimated fair value of derivatives and $40 million increase in adjusted net margin partly offset by the $182 million and $28 million decrease in foreign currency adjustments and cumulative effect of change in accounting principle, respectively.

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Operating Results as a Percentage of Average Loans Outstanding
The following is a summary of CFC’s operating results as a percentage of average loans outstanding for the fiscal years ended May 31, 2004, 2003 and 2002.
                             
2004 2003 2002



 
Operating income
    4.95 %     5.40 %     5.98 %
 
Cost of funds
    (4.50 )%     (4.69 )%     (4.46 )%
     
     
     
 
   
Gross margin
    0.45 %     0.71 %     1.52 %
 
Operating expenses:
                       
 
General and administrative
    (0.20 )%     (0.19 )%     (0.19 )%
 
Provision for loan losses
    (0.27 )%     (0.22 )%     (0.94 )%
 
Provision for guarantee losses
          (0.12 )%     (0.06 )%
     
     
     
 
   
Total operating expenses
    (0.47 )%     (0.53 )%     (1.19 )%
 
 
Results of operations of foreclosed assets
    0.02 %            
 
Impairment loss on foreclosed assets
    (0.05 )%     (0.10 )%      
     
     
     
 
   
Total loss on foreclosed assets
    (0.03 )%     (0.10 )%      
 
 
Derivative cash settlements
    0.54 %     0.62 %     0.17 %
 
Derivative forward value
    (1.13 )%     3.81 %     0.21 %
 
Foreign currency adjustments
    (0.32 )%     (1.22 )%     (0.31 )%
     
     
     
 
   
Total (loss) gain on derivative and foreign currency adjustments
    (0.91 )%     3.21 %     0.07 %
     
     
     
 
   
Operating (loss) margin
    (0.96 )%     3.29 %     0.40 %
 
Income tax expense
    (0.02 )%            
 
Minority interest — RTFC and NCSC net margin
    (0.01 )%            
 
Cumulative effect of change in accounting principle
    0.11 %           0.14 %
     
     
     
 
   
Net (loss) margin
    (0.88 )%     3.29 %     0.54 %
     
     
     
 
Adjusted gross margin(1)
    0.99 %     1.33 %     1.69 %
     
     
     
 
Adjusted operating margin(2)
    0.49 %     0.70 %     0.50 %
     
     
     
 

(1)  Adjusted to include derivative cash settlements in the cost of funds. See “Non-GAAP Financial Measures” for further explanation and a reconciliation of these adjustments.
(2)  Adjusted to exclude derivative forward value and foreign currency adjustments from the operating margin (loss). See “Non-GAAP Financial Measures” for further explanation and a reconciliation of these adjustments.
Liquidity and Capital Resources
 
Assets
At May 31, 2004, CFC had $21,350 million in total assets, an increase of $322 million, or 2%, from the balance of $21,028 million at May 31, 2003. Net loans outstanding to members totaled $19,915 million at May 31, 2004, an increase of $942 million compared to a total of $18,973 million at May 31, 2003. Net loans represented 93% and 90% of total assets at May 31, 2004 and May 31, 2003, respectively. The remaining assets, $1,435 million and $2,055 million at May 31, 2004 and May 31, 2003, respectively, consisted of other assets to support CFC’s operations, primarily cash and cash equivalents, derivative assets and foreclosed assets. Included in assets at May 31, 2004 and 2003 is $577 million and $1,160 million, respectively, of derivative assets. Derivative assets decreased by $583 million due to a projected increase to future interest rates. Foreclosed assets of $248 million and $336 million at May 31, 2004 and 2003, respectively, relate to assets received from borrowers as part of bankruptcy and/or loan settlements. Foreclosed assets decreased by $88 million due to the sale of telecommunications assets received as part of the CoServ bankruptcy settlement and principal payments on the real estate note portfolio. Other than excess cash invested overnight, CFC does not generally use funds to invest in debt or equity securities.

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Loans to Members
Net loan balances increased by $942 million, or 5%, from May 31, 2003 to May 31, 2004. Gross loans increased by $1,005 million, and the allowance for loan losses increased by $63 million, compared to the prior year end. As a percentage of the portfolio, long-term loans represented 94% (including secured long-term loans classified as restructured and non-performing) at May 31, 2004 and 2003. The remaining 6% at May 31, 2004 and 2003 consisted of secured and unsecured intermediate-term and line of credit loans.

Long-term fixed rate loans represented 72% and 68% of the total long-term loans at May 31, 2004 and 2003, respectively. Loans converting from a variable rate to a fixed rate for the year ended May 31, 2004 totaled $1,916 million, an increase from the $1,747 million that converted during the year ended May 31, 2003. Offsetting the conversions to the fixed rate were $1,218 million and $533 million of loans that converted from the fixed rate to the variable rate for the years ended May 31, 2004 and 2003, respectively. This resulted in a net conversion of $698 million from the variable rate to a fixed rate for the year ended May 31, 2004 compared to a net conversion of $1,214 million for the year ended May 31, 2003. Approximately 68% or $13,840 million of total loans carried a fixed rate of interest at May 31, 2004 compared to 64% or $12,426 million at May 31, 2003. All other loans, including $6,649 million and $7,058 million in loans at May 31, 2004 and 2003, respectively, are subject to interest rate adjustment monthly or semi-monthly.

The increase in total loans outstanding at May 31, 2004 as compared to May 31, 2003 was due primarily to the refinancing of 5% RUS loans that have a remaining maturity of 10 years or less. The $1,005 million increase in loans includes increases of $914 million in long-term loans and $330 million in non-performing and restructured loans offset by decreases of $29 million in intermediate-term loans, $207 million in short-term loans and $3 million in RUS guaranteed loans. Loans outstanding to electric systems increased by $982 million and CFC added $322 million of other loans related to the consolidation of NCSC, while loans outstanding to telecommunications systems decreased by $299 million. The increase to electric systems includes increases of $1,159 million to distribution systems and $118 million to power supply systems offset by a decrease of $295 million to service members and associates. The increase to distribution system loans outstanding includes the refinancing of 5% RUS loans. The consolidation of NCSC was the reason for the decrease to associate and service loans as the loans from CFC to NCSC are eliminated in consolidation.

 
Loan and Guarantee Portfolio Assessment
Portfolio Diversity
CFC provides credit products (loans, financial guarantees and letters of credit) to its members. The combined memberships include rural electric distribution systems, rural electric power supply systems, telecommunication systems, statewide rural electric and telecommunication organizations and associated affiliates.

The following chart summarizes loans and guarantees outstanding by member class at May 31, 2004, 2003 and 2002.

                                                     
Loans and Guarantees by Member Class

(Dollar amounts in millions) 2004 2003 2002



Electric systems:
                                               
 
Distribution
  $ 12,630       58 %   $ 11,488       54 %   $ 11,933       54 %
 
Power supply
    3,950       18 %     3,922       18 %     3,928       18 %
 
Statewide and associate
    246       1 %     1,030       5 %     1,162       5 %
     
     
     
     
     
     
 
   
Subtotal electric systems
    16,826       77 %     16,440       77 %     17,023       77 %
Telecommunications systems
    4,643       21 %     4,948       23 %     5,080       23 %
Other
    351       2 %                        
     
     
     
     
     
     
 
   
Total
  $ 21,820       100 %   $ 21,388       100 %   $ 22,103       100 %
     
     
     
     
     
     
 

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The following table summarizes CFC’s telecommunications loan and guarantee portfolio as of May 31, 2004, 2003 and 2002.

                                                   
2004 2003 2002



(Dollar amounts in millions)
Rural local exchange carriers
  $ 3,615       78 %   $ 3,831       77 %   $ 3,817       75 %
Wireless providers
    267       6 %     335       7 %     357       7 %
Long distance carriers
    340       7 %     324       7 %     374       8 %
Fiber optic network providers
    168       4 %     191       4 %     211       4 %
Cable television providers
    176       4 %     185       4 %     195       4 %
Competitive local exchange carriers
    62       1 %     64       1 %     105       2 %
Other
    15             18             21        
     
     
     
     
     
     
 
 
Total
  $ 4,643       100 %   $ 4,948       100 %   $ 5,080       100 %
     
     
     
     
     
     
 

CFC’s members are widely dispersed throughout the United States and its territories, including 49 states, the District of Columbia, American Samoa, Guam and the U.S. Virgin Islands. At May 31, 2004, 2003 and 2002, loans and guarantees outstanding to members in any state or territory did not exceed 17%, 17% and 20%, respectively, of total loans and guarantees outstanding.

Credit Concentration

In addition to the geographic diversity of the portfolio, CFC limits its exposure to any one borrower. At May 31, 2004, the total exposure outstanding to any one borrower or controlled group did not exceed 3.0% of total loans and guarantees outstanding compared to 3.4% at May 31, 2003. At May 31, 2004, CFC had $4,415 million in loans outstanding and $240 million in guarantees outstanding to its ten largest borrowers compared to $4,768 million in loans and $610 million in guarantees for the prior year. The amounts outstanding to the ten largest borrowers at May 31, 2004 represented 22% of total loans outstanding and 18% of total guarantees outstanding compared to 24% of total loans outstanding and 32% of total guarantees outstanding for the prior year. Total credit exposure to the ten largest borrowers, including loans and guarantees, was $4,655 million and $5,378 million and represented 21% and 25%, respectively, of total credit exposure at May 31, 2004 and 2003, respectively. At May 31, 2004, the ten largest borrowers included two distribution systems, three power supply systems and five telecommunications systems. At May 31, 2003, the ten largest borrowers included two distribution systems, two power supply systems, one service organization and five telecommunications systems.

Credit Limitation

CFC, RTFC and NCSC each have policies that limit the amount of credit that can be extended to borrowers. All three policies establish an amount of credit that may be extended to each borrower based on an internal risk rating system. The level of credit that may be extended is the same at CFC and RTFC. The amount of credit for each level of risk rating in the NCSC policy is significantly lower due to the difference in the size of NCSC’s balance sheet versus the balance sheets of CFC and RTFC and the types of businesses to which NCSC lends.

For the year ended May 31, 2004, CFC approved new loan and guarantee facilities totaling approximately $599 million to 11 borrowers that had a total or unsecured exposure in excess of the limits set forth in the credit limitation policy. There were no additional credit facilities approved to RTFC and NCSC borrowers in excess of their established credit limits during the year ended May 31, 2004.

Of the $599 million in loans approved during the year ended May 31, 2004, $284 million were refinancings or renewals of existing loans and $57 million were bridge loans that must be paid off once the borrower obtains long-term financing from RUS.

CFC’s credit limitation policy sets the limit on CFC’s total exposure and unsecured exposure to the borrower based on CFC’s assessment of the borrower’s risk profile. The board of directors must approve

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new loan requests from a borrower with a total exposure or unsecured exposure in excess of the limits in the policy.

Total exposure, as defined by the policy, includes the following:
•  loans outstanding, excluding loans guaranteed by RUS,
•  CFC guarantees of the borrower’s obligations,
•  unadvanced loan commitments, and
•  borrower guarantees to CFC of another borrower’s debt.

Security Provisions

Except when providing lines of credit and intermediate-term loans, CFC typically lends to its members on a senior secured basis. At May 31, 2004, a total of $1,439 million of loans were unsecured representing 7% of total loans. CFC’s long-term loans are typically secured on a parity with other secured lenders (primarily RUS), if any, by all assets and revenues of the borrower with exceptions typical in utility mortgages. Short-term loans are generally unsecured lines of credit. At May 31, 2003, a total of $1,696 million of loans were unsecured representing 9% of total loans. At May 31, 2004 and 2003, a total of $122 million and $94 million, respectively, of guarantee reimbursement obligations were unsecured, representing 9% and 5%, respectively, of total guarantees. Guarantee reimbursement obligations are typically secured on a parity with other secured creditors by all assets and revenues of the borrower or by the underlying financed asset. In addition to the collateral received, CFC also requires that its borrowers set rates designed to achieve certain financial ratios. At May 31, 2004 and 2003, CFC had a total of $1,561 million and $1,790 million, respectively, of unsecured loans and guarantees, representing 7% and 8%, respectively, of total loans and guarantees.

Portfolio Quality

Most CFC power supply borrowers sell the majority of their power under all-requirements power contracts to their member distribution systems. These contracts allow, subject to regulatory requirements and competitive constraints, for the recovery of all costs at the power supply level. Due to the contractual connection between the power supply and distribution systems, total combined system equity (power supply equity plus the equity at its affiliated distribution systems) has typically been maintained at the distribution level.

The effectiveness of the all-requirements power contract is dependent on the individual systems’ right and ability (legal as well as economic) to establish rates to cover all costs. The boards of directors of most of CFC’s power supply and distribution members have the authority to establish rates for their consumer members subject to state and federal regulations, as applicable. Some states regulate rate setting and can therefore override the system’s internal rate-setting procedures.

For financial information on CFC’s members, see pages 18 to 24.

Non-performing 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 on the original terms is not anticipated, or
•  for some other reason, management does not expect the timely repayment of principal and interest.

Once a borrower is classified as non-performing, interest on its loans is generally recognized on a cash basis. Alternatively, CFC may choose to apply all cash received to the reduction of principal, thereby foregoing interest income recognition. At May 31, 2004, CFC had non-performing loans in the amount of $341 million outstanding. At May 31, 2003, CFC had no outstanding loans classified as non-performing. Non-performing loans at May 31, 2004 include a total of $340 million to Vartec Telecom (“VarTec”). On May 31, 2004, loans to VarTec were reclassified to non-performing and put on non-accrual status as of June 1, 2004.

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Currently, there is significant competition in both of VarTec’s primary businesses, dial-around long-distance service and as a competitive local exchange carrier (“CLEC”). This competition has resulted in a significant reduction to the cashflow generated by VarTec. In addition, on a prospective basis recent court rulings have given the incumbent local exchange carrier network owners more control of the prices they can charge to companies leasing elements of the network, which will most likely result in an increase to the cost of operating as a CLEC that leases network capacity.

VarTec is engaged in binding arbitration with Teleglobe, Inc. (“Teleglobe”), in connection with VarTec’s acquisition of Teleglobe subsidiaries. The subsidiary acquisition was financed with approximately $227 million of unsecured notes issued by VarTec to Teleglobe. Teleglobe contends that VarTec is in payment default with regard to the notes, while VarTec contends that Teleglobe breached its agreement with VarTec and that VarTec has significant offset and recoupment rights relative to the breach. The arbitration is expected to be completed no sooner than late August 2004. The outcome of the arbitration is unknown.

CFC’s exposure to VarTec is secured under a mortgage on substantially all of its assets. VarTec was current with respect to debt service payments to CFC at May 31, 2004. However, VarTec has informed CFC that it will not be able to meet the principal portion of the debt service payments due on August 31, 2004 and November 30, 2004. Failure to make such payments constitutes an event of default under the credit agreement. CFC believes it is doubtful that VarTec can continue to make regularly scheduled payments of principal as and when due under the existing credit agreement. CFC is currently in negotiations with VarTec regarding future payments on the outstanding debt, as well as other terms and conditions of the lending relationship.

 
Restructured Loans
Loans classified as restructured are loans for which agreements have been executed that changed the original terms of the loan, generally a change to the originally scheduled cash flows. CFC will make a determination on each restructured loan with regard to the accrual of interest income on the loan. The initial decision is based on the terms of the restructure agreement and the anticipated performance of the borrower over the term of the agreement. CFC will periodically review the decision to accrue or not to accrue interest income on restructured loans based on the borrower’s past performance and current financial condition. At May 31, 2004 and 2003, restructured loans totaled $618 million and $629 million, respectively.

At May 31, 2004 and 2003, CFC had a total of $618 million and $628 million, respectively, in loans outstanding to CoServ, all of which were classified as restructured. CFC will maintain the restructured CoServ loans on non-accrual status in the near term. Total loans to CoServ at May 31, 2004 and 2003 represented 2.8% and 2.9%, respectively, of CFC’s total loans and guarantees outstanding.

To date, CoServ has made all required payments under the restructured loan. Under the agreement, CoServ will be required to make quarterly payments to CFC through 2037. Under the agreement, CFC may be obligated to provide up to $200 million of senior secured capital expenditure loans to CoServ for electric distribution infrastructure through 2012. If CoServ requests capital expenditure loans from CFC, these loans will be provided at the standard terms offered to all borrowers and will require debt service payments in addition to the quarterly payments that CoServ will make to CFC under its restructure agreement. As of May 31, 2004, no amounts have been advanced to CoServ under this loan facility. Under the terms of the restructure agreement, CoServ has the option to prepay the restructured loan for $415 million plus an interest payment true up after December 13, 2007 and for $405 million plus an interest payment true up after December 13, 2008.

 
Loan Impairment
On a quarterly basis, CFC reviews all non-performing and restructured borrowers, as well as some additional borrowers, to determine if the loans to the borrower are impaired and/or to update the impairment calculation. CFC calculates an impairment for a borrower based on the expected future cash flow or the fair value of any collateral held by CFC as security for loans to the borrower. In some cases, to

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estimate future cash flow, CFC is required to make certain assumptions regarding, but not limited to, the following:
•  interest rates,
•  court rulings,
•  changes in collateral values,
•  changes in economic conditions in the area in which the cooperative operates, and
•  changes to the industry in which the cooperative operates.

As events related to the borrower take place and economic conditions and CFC’s assumptions change, the impairment calculations will change. CFC adjusts the amount of its loan loss allowance specifically reserved to cover the calculated impairments on a quarterly basis based on the most current information available. At May 31, 2004 and 2003, CFC had impaired loans totaling $959 million and $629 million, respectively. At May 31, 2004 and 2003, CFC had specifically reserved a total of $233 million and $164 million, respectively, to cover impaired loans.

NON-PERFORMING AND RESTRUCTURED LOANS

                         
As of May 31,

2004 2003 2002
(Dollar amounts in millions)


Non-performing loans
  $ 341     $     $ 1,011  
Percent of loans outstanding
    1.66 %     0.00 %     5.04 %
Percent of loans and guarantees outstanding
    1.57 %     0.00 %     4.57 %
 
Restructured loans
  $ 618     $ 629     $ 540  
Percent of loans outstanding
    3.02 %     3.23 %     2.69 %
Percent of loans and guarantees outstanding
    2.83 %     2.94 %     2.44 %
 
Total non-performing and restructured loans
  $ 959     $ 629     $ 1,551  
Percent of loans outstanding
    4.68 %     3.23 %     7.73 %
Percent of loans and guarantees outstanding
    4.40 %     2.94 %     7.01 %
 
Allowance for Loan Losses
CFC maintains an allowance for probable 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 the effect of economic and industry conditions on its borrowers.

CFC’s corporate credit committee makes recommendations of loans to be written off to CFC’s board of directors. Under current policy, CFC’s board of directors is required to approve all loan write-offs. In making its recommendation to write off all or a portion of a loan balance, CFC’s corporate credit committee considers various factors including cash flow analysis and the collateral securing the borrower’s loans. Since inception in 1969, CFC has recorded write-offs totaling $147 million and recoveries totaling $32 million for a net loan loss amount of $115 million. In the past five fiscal years, CFC has recorded write-offs totaling $50 million and recoveries totaling $15 million for a net loan loss of $35 million.

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Management believes that the allowance for loan losses is adequate to cover estimated probable portfolio losses. The following chart presents a summary of the allowance for loan losses at May 31, 2004, 2003 and 2002.

                           
2004 2003 2002
(Dollar amounts in millions)


Beginning balance
  $ 511     $ 478     $ 317  
Provision for loan losses
    55       43       186  
Change in allowance due to consolidation(1)
    6              
Net recoveries (write-offs)
    2       (10 )     (25 )
     
     
     
 
Ending balance
  $ 574     $ 511     $ 478  
     
     
     
 
Loan loss allowance by segment:
                       
 
Electric
  $ 234     $ 336     $ 339  
 
Telecommunications
    310       175       139  
 
Other
    30              
     
     
     
 
 
Total
  $ 574     $ 511     $ 478  
     
     
     
 
As a percentage of total loans outstanding
    2.80 %     2.62 %     2.38 %
As a percentage of total non-performing loans outstanding
    168.33 %           47.28 %
As a percentage of total restructured loans outstanding
    92.88 %     81.24 %     88.52 %


(1)  Represents the impact of consolidating NCSC including the increase to CFC’s loan loss allowance recorded as a cumulative effect of change in accounting principle and the balance of NCSC’s loan loss allowance on June 1, 2003.

The $63 million increase to the loan loss allowance at May 31, 2004 compared to May 31, 2003 is due to increases to the telecommunications and other loan loss allowance of $135 million and $30 million, respectively, offset by the $102 million decrease in the electric loan loss allowance. The increase to the telecommunications loan loss allowance was due to the increase in the allowance for loans classified as impaired and high risk. The increase in the other loan loss allowance was due to the increase in loans as a result of the consolidation of NCSC on June 1, 2003. The electric loan loss allowance decreased primarily as a result of a decrease in calculated impairment and to an improvement in weighted average risk rating as compared to the prior year. The $33 million increase to the loan loss allowance at May 31, 2003 compared to May 31, 2002 was due to an increase in the allowance for telecommunications loans classified as high risk.

 
Liabilities, Minority Interest and Equity
Liabilities, minority interest and equity totaled $21,350 million at May 31, 2004, an increase of $322 million or 2% from the balance of $21,028 million at May 31, 2003. CFC obtains funding in the capital markets through the issuance of commercial paper, medium-term notes, collateral trust bonds and subordinated deferrable debt which make up a large portion of the liabilities on the consolidated and combined balance sheets.
 
Liabilities
Total liabilities at May 31, 2004, were $20,633 million, an increase of $536 million from $20,097 million at May 31, 2003. The increase to liabilities was due to increases in notes payable due in one year of $244 million, long-term debt of $658 million, deferred income of $36 million and other liabilities of $3 million offset by decreases in accrued interest payable of $2 million, derivative liabilities of $225 million, guarantee liability of $35 million, subordinated deferrable debt of $100 million and subordinated certificates of $43 million.

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Notes Payable and Long-Term Debt
The following chart provides a breakout of debt outstanding.
                           
May 31, 2004 May 31, 2003 Increase/(Decrease)
(Dollar amounts in millions)


Notes payable:
                       
 
Commercial paper(1)
  $ 3,525     $ 1,886     $ 1,639  
 
Bank bid notes
    100       100        
 
Long-term debt with remaining maturities less than one year
    2,365       2,911       (546 )
 
Foreign currency valuation account
          150       (150 )
 
Notes payable reclassified as long-term(4)
    (4,650 )     (3,951 )     (699 )
     
     
     
 
Total notes payable
    1,340       1,096       244  
Long-term debt:
                       
 
Collateral trust bonds
    5,392       5,993       (601 )
 
Long-term notes payable
    107             107  
 
Medium-term notes
    6,276       5,882       394  
 
Foreign currency valuation account
    234       176       58  
 
Notes payable reclassified as long-term(4)
    4,650       3,951       699  
 
Long-term debt valuation allowance
          (1 )     1  
     
     
     
 
Total long-term debt
    16,659       16,001       658  
Subordinated deferrable debt
    550       650       (100 )
Members’ subordinated certificates
    1,665       1,708       (43 )
     
     
     
 
Total debt outstanding
  $ 20,214     $ 19,455     $ 759  
     
     
     
 
Percentage of fixed rate debt(2)
    70 %     64 %        
Percentage of variable rate debt(3)
    30 %     36 %        
Percentage of long-term debt
    93 %     94 %        
Percentage of short-term debt
    7 %     6 %        


(1)  Includes $223 million and $111 million related to the daily liquidity fund at May 31, 2004 and 2003, respectively.
(2)  Includes fixed rate collateral trust bonds, medium-term notes and subordinated deferrable debt plus commercial paper with rates fixed through interest rate exchange agreements and less any fixed rate debt that has been swapped to variable.
(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.
(4)  Reclassification of notes payable to long-term debt is based on CFC’s ability to borrow under its revolving credit agreements and refinance notes payable on a long-term basis, subject to the conditions therein.
 
Notes Payable
Notes payable, which consists of commercial paper, daily liquidity fund, bank bid notes and long-term debt due within one year, totaled $1,340 million, an increase of $244 million from the prior year. The increase was primarily due to the $1,639 million increase in commercial paper offset by the $699 million increase in the amount of short-term debt supported by revolving credit agreements and reclassified as long-term, a $546 million decrease in long-term debt maturing within one year and the $150 million decrease to the foreign currency valuation account. The foreign currency valuation account reflects the adjustment to CFC’s foreign denominated medium-term notes based on current foreign currency exchange rates. At May 31, 2004, CFC’s short-term debt consisted of $2,299 million in dealer commercial paper, $973 million in commercial paper issued to CFC’s members, $30 million in commercial paper issued to certain nonmembers, $100 million in bank bid notes, $223 million in the daily liquidity fund and $2,365 million in collateral trust bonds, medium-term notes and long-term notes payable that mature within one year. CFC

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reclassifies a portion of its short-term debt as long-term, based on the ability (subject to certain conditions) and intent, if necessary, to borrow under its revolving credit agreements. CFC reclassified $4,650 million and $3,951 million of short-term debt as long-term at May 31, 2004 and 2003, respectively.

Other information with regard to notes payable due within one year at May 31, is as follows:

                           
2004 2003 2002
(Dollar amounts in thousands)


Weighted average maturity of notes outstanding at year-end:(1)
Notes payable(2)
    20 days       18 days       24 days  
 
Long-term debt maturing within one year
    162 days       195 days       163 days  
 
Total
    76 days       123 days       89 days  
Average amount outstanding during the year(1):
                       
 
Notes payable(2)
  $ 3,173,167     $ 2,971,540     $ 4,933,166  
 
Long-term debt maturing within one year
    2,913,723       2,744,803       3,741,269  
     
     
     
 
 
Total
    6,086,890       5,716,343       8,674,435  
Maximum amount outstanding at any month-end during the year(1):
                       
 
Notes payable(2)
    3,758,428       3,681,822       6,943,445  
 
Long-term debt maturing within one year
    3,427,560       3,453,048       4,364,782  


(1)  Prior to reclassification of $4,650 million to long-term debt.
(2)  Includes the daily liquidity fund and bank bid notes and does not include long-term debt due in less than one year.

Commercial Paper

At May 31, 2004 and 2003, CFC had $3,302 million and $1,776 million, respectively, outstanding in commercial paper with a weighted average maturity of 21 days and 19 days, respectively. Commercial paper notes are issued with maturities up to 270 days and are senior unsecured obligations of CFC. Commercial paper sold directly by CFC and outstanding to CFC’s members and others totaled $1,003 million and $956 million at May 31, 2004 and 2003, respectively. Commercial paper sold through dealers totaled $2,299 million and $820 million at May 31, 2004 and 2003, respectively. Included in this amount, CFC has a program to issue commercial paper in Europe with $217 million outstanding at May 31, 2004, compared to no amount outstanding at May 31, 2003. The commercial paper sold in Europe may be denominated in foreign currencies. At May 31, 2004 and 2003, there were no amounts outstanding denominated in foreign currencies. The increase to the total amount of commercial paper outstanding at May 31, 2004, as compared to the prior year, was due to the increase to loans outstanding and an increase in the amount of backup liquidity available under CFC’s revolving credit agreements. In fiscal year 2004 and 2003, CFC limited its issuance of dealer commercial paper and bank bid notes to 15% or less of total debt outstanding, to reduce the dependency on its ability to continually roll over a large balance of commercial paper funding.

Bank Bid Notes

CFC obtains funds from various banking institutions under bank bid note arrangements, similar to bank lines of credit. The notes are issued for terms up to three months and are unsecured obligations of CFC. At May 31, 2004 and 2003, CFC had $100 million outstanding in bank bid notes and these notes had a weighted average maturity of 20 days and 17 days, respectively.

Daily Liquidity Fund

CFC’s daily liquidity fund, consisting of funds invested by CFC’s members, totaled $223 million as of May 31, 2004 compared to $111 million at May 31, 2003. These funds are available on demand by the member investor, not subject to stated maturity dates, and the notes are unsecured obligations of CFC.

Long-Term Debt

During fiscal year 2004, long-term debt outstanding increased by $658 million compared to the prior year-end. The increase in long-term debt outstanding was due primarily to increases of $394 million in

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medium-term notes, an increase of $699 million to the amount of short-term debt supported by the revolving credit agreements and reclassified as long-term debt and an increase of $107 million due to the consolidation of NCSC long-term notes payable offset by a decrease of $601 million to collateral trust bonds. The increase to long-term debt in fiscal year 2004 was required to fund the increase in long-term loans, especially the refinancing of member 5% RUS loans.
 
Collateral Trust Bonds
At May 31, 2004, CFC had $7,292 million in collateral trust bonds outstanding. Collateral trust bonds are issued for terms of two years to 30 years. Under its collateral trust bond indentures, CFC must pledge as collateral cash, permitted investments or eligible mortgage notes from its distribution system borrowers, in an amount at least equal to the outstanding principal amount of collateral trust bonds. At May 31, 2004, CFC had pledged $7,476 million in mortgage notes, $222 million of RUS guaranteed loans qualifying as permitted investments and $2 million in cash. During fiscal year 2004, CFC issued a total of $1,300 million in collateral trust bonds. In September 2003, CFC issued $200 million of 3.25% collateral trust bonds due 2007 and $500 million of 4.375% collateral trust bonds due 2010. In February 2004, CFC issued $600 million of 4.75% collateral trust bonds due 2014. Virtually all collateral trust bonds were offered to investors in underwritten public offerings. A total of $1,900 million of collateral trust bonds are scheduled to mature during fiscal year 2005 and are reported as notes payable due within one year.
 
Medium-Term Notes
At May 31, 2004, CFC had $6,967 million outstanding in medium-term notes. Medium-term notes are senior unsecured obligations of CFC and are issued for terms of nine months to 30 years. Medium-term notes outstanding to CFC’s members totaled $275 million at May 31, 2004. The remaining $6,692 million were sold through dealers to investors. A total of $456 million of medium-term notes are scheduled to mature during fiscal year 2005.

At May 31, 2004 and 2003, CFC had a total of $1,339 million and $1,587 million, respectively, of foreign denominated debt. As a result of issuing debt in foreign currencies, CFC must adjust the value of the debt reported on the consolidated and combined balance sheets for changes in foreign currency exchange rates since the date of issuance. To the extent that the current exchange rate is different than the exchange rate at the time of issuance, there will be a change in the value of the foreign denominated debt. At May 31, 2004 and 2003, CFC recorded $234 million and $326 million, respectively, in the foreign currency valuation account as an increase to the value of debt reported on the consolidated and combined balance sheets since issuance. The adjustment to the value of the debt for the current period is reported on the consolidated and combined statements of operations as foreign currency adjustments. At the time of issuance of all foreign denominated debt, CFC enters into a cross currency or cross currency interest rate exchange agreements to fix the exchange rate on all principal and interest payments through maturity.

 
Long-Term Notes Payable
At May 31, 2004, CFC had $116 million in long-term notes payable. Long-term notes payable represents unsecured obligations issued by NCSC to provide funding to its members. Payments are due on the long-term notes payable from 2005 through 2022, with a total of $9 million due in fiscal year 2005.
 
Subordinated Deferrable Debt
At May 31, 2004 and 2003, CFC had $550 million and $650 million, respectively, outstanding in subordinated deferrable debt. Subordinated deferrable debt represents quarterly income capital securities and subordinated notes that are unsecured obligations of CFC, subordinate and junior in right of payment to senior debt and the debt obligations guaranteed by CFC, but senior to subordinated certificates. Subordinated deferrable debt has been issued for periods of up to 49 years. CFC has the right at any time and from time to time during the term of the subordinated deferrable debt to suspend interest payments for a period not exceeding 20 consecutive quarters. CFC has the right to call the subordinated deferrable debt any time after five years, at par. To date, CFC has not exercised its option to suspend interest payments. In October 2003, CFC effected the early redemption of the 7.375% quarterly income capital

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securities totaling $200 million issued in August 1998. CFC redeemed these securities at par, and $6 million of unamortized issuance costs and discounts recorded at the time of issuance were included as part of the funding cost for the year ended May 31, 2004. In February 2004, CFC issued $100 million of 6.10% subordinated notes due 2044.
 
Subordinated Certificates
Subordinated certificates include both membership subordinated certificates and loan and guarantee subordinated certificates, all of which are subordinate to other CFC debt. As a condition of becoming a CFC member, CFC generally requires the purchase of membership subordinated certificates. At May 31, 2004 and 2003, membership subordinated certificates totaled $650 million and $644 million, respectively. These certificates generally mature in 100 years and pay interest at 5% per annum. At May 31, 2004, loan and guarantee subordinated certificates totaled $1,015 million and carried a weighted average interest rate of 1.29% compared to $1,064 million with a weighted average interest rate of 1.47% at May 31, 2003. Loan subordinated certificates decreased by $7 million and guarantee subordinated certificates decreased by $42 million from May 31, 2003 to May 31, 2004. The loan and guarantee certificates are long-term instruments, which may amortize at a rate equivalent to that of the loan or guarantee to which they relate. The decrease to the loan and guarantee subordinated certificates of $49 million for the year ended May 31, 2004 is primarily due to the reduction of guarantee certificates held by NCSC. NCSC’s investment in CFC was eliminated in consolidation at May 31, 2004, but was included in the balance at May 31, 2003. On a combined basis, subordinated certificates carried a weighted average interest rate of 2.69% compared to a rate of 2.76% for the prior year. Loan and guarantee subordinated certificates may be required to be purchased in conjunction with the receipt of a loan or credit enhancement based on the member’s leverage ratio (total debt and credit enhancements from CFC divided by total equity investments in CFC). Members that have a leverage ratio with CFC in excess of a level in the policy are required to purchase additional subordinated certificates as a condition to receiving a long-term loan or credit enhancement. CFC paid a total of $47 million in interest to holders of subordinated certificates in both fiscal years 2004 and 2003.
 
Minority Interest
Minority interest on the consolidated balance sheet at May 31, 2004 was $21 million. There was no minority interest reported at May 31, 2003. The minority interest reported at May 31, 2004 represents RTFC and NCSC members’ equity, to which CFC’s members have no claim. In consolidation, the amount of the subsidiary equity to which the parent company’s members have no claim is shown as minority interest. CFC does not own any interest in RTFC and NCSC, but is required to consolidate under FIN 46(R) as it is the primary beneficiary of a variable interest in RTFC and NCSC. RTFC and NCSC are members of CFC. RTFC and NCSC are considered variable interest entities because they are very thinly capitalized, dependent on CFC for all funding and operated by CFC under a management agreement. CFC is considered the primary beneficiary of the variable interests in RTFC and NCSC due to a guarantee agreement, under which it is responsible for absorbing the majority of expected losses. At May 31, 2003, CFC and RTFC were combined, which results in the addition of the equity of both companies after the elimination of intercompany transactions. On June 1, 2003, a total $20 million of RTFC equity was reclassified from the combined equity at May 31, 2003 to minority interest.

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Equity
The following chart provides a breakout of the equity balances.
                           
Increase/
May 31, 2004 May 31, 2003 (Decrease)
(Dollar amounts in millions)


Membership fees
  $ 1     $ 1     $  
Education fund
    1       2       (1 )
Members’ capital reserve
    131       90       41  
Allocated net margin
    352       361       (9 )
Unallocated margin(1)
    (2 )           (2 )
     
     
     
 
 
Total members’ equity
    483       454       29  
Prior year cumulative derivative forward value and foreign currency adjustments(2)
    523       10       513  
Current period derivative forward value(2)(3)
    (233 )     757       (990 )
Current period foreign currency adjustments(2)
    (65 )     (243 )     178  
     
     
     
 
Total retained equity
    708       978       (270 )
Accumulated other comprehensive loss(2)
    (12 )     (47 )     35  
     
     
     
 
Total equity
  $ 696     $ 931     $ (235 )
     
     
     
 


(1)  NCSC equity is included in consolidated equity rather than minority interest since it is currently in a deficit equity position and therefore represents a charge to CFC.
(2)  Items related to the adoption of SFAS 133 and adjustments to value debt denominated in foreign currencies at the reporting date.
(3)  Represents total derivative forward value loss excluding NCSC’s derivative forward value gain of $4 million for the year ended May 31, 2004 which is included in members’ equity.

Applicants are required to pay a one-time fee to become a member. The fee varies from two hundred dollars to one thousand dollars depending on the membership class. CFC is required by the District of Columbia cooperative law to have a methodology to allocate its net margin to its members. CFC maintains the current year net margin as unallocated through the end of its fiscal year. At that time, CFC’s board of directors allocates its net margin to its members in the form of patronage capital and to board approved reserves. Currently, CFC has two such board approved reserves, the education fund and the members’ capital reserve. CFC adjusts the net margin it allocates to its members and board approved reserves to exclude the non-cash impacts of SFAS 133 and 52. CFC allocates a small portion, less than 1%, of adjusted net margin annually to the education fund as required by cooperative law. Funds from the education fund are disbursed annually to the statewide cooperative organizations to fund the teaching of cooperative principles in the service territories of the cooperatives in each state. The board of directors determines the amount of adjusted net margin that is allocated to the members’ capital reserve, if any. The members’ capital reserve represents margins that are held by CFC to increase equity retention. The margins held in the members’ capital reserve have not been specifically allocated to any member, but may be allocated to individual members in the future as patronage capital if authorized by CFC’s board of directors. All remaining adjusted net margin is allocated to CFC’s members in the form of patronage capital. CFC bases the amount of adjusted net margin allocated to each member on the members’ patronage of the CFC lending programs in the year that the adjusted net margin was earned. Members recognize allocations in the form of patronage capital as income when allocated by CFC. There is no impact on CFC’s total equity as a result of allocating the annual adjusted net margin to members in the form of patronage capital or to board approved reserves. CFC annually retires a portion of the patronage capital allocated to members in prior years. CFC’s total equity is reduced by the amount of patronage capital retired to its members and by amounts disbursed from board approved reserves.

At May 31, 2004, equity totaled $696 million, a reduction of $235 million from May 31, 2003. On June 1, 2003, a total of $20 million of RTFC equity was reclassified as minority interest. During the year ended

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May 31, 2004, CFC retired a total of $71 million of patronage capital to its members and had a net loss of $178 million which was offset by a reduction to the other comprehensive loss related to derivatives of $35 million.
 
Contractual Obligations
The following table summarizes CFC’s contractual obligations at May 31, 2004 and the related principal amortization and maturities by fiscal year.
                                                         
Principal Amortization and Maturities

(Dollar amounts in millions) Outstanding Remaining
Instrument Balance 2005 2006 2007 2008 2009 Years








Notes payable(1)
  $ 5,990     $ 5,990     $     $     $     $     $  
Long-term debt(2)
    12,009             3,431       1,592       1,080       479       5,427  
Subordinated deferrable debt
    550                                     550  
Members’ subordinated certificates (3)
    1,078       10       13       18       8       22       1,007  
     
     
     
     
     
     
     
 
Total contractual obligations
  $ 19,627     $ 6,000     $ 3,444     $ 1,610     $ 1,088     $ 501     $ 6,984  
     
     
     
     
     
     
     
 

(1)  Includes commercial paper, bank bid notes, daily liquidity fund and long-term debt due in less than one year prior to reclassification of $4,650 million to long-term debt.
(2)  Excludes $4,650 million reclassification from notes payable.
(3)  Excludes loan subordinated certificates totaling $587 million that amortize annually based on the outstanding balance of the related loan. There are many items that impact the amortization of a loan, such as loan conversions, loan repricing at the end of an interest rate term, prepayments, etc, thus CFC is unable to maintain an amortization schedule for these certificates. Over the past three years, annual amortization on these certificates has averaged $30 million. In fiscal year 2004, amortization represented 5% of amortizing loan subordinated certificates outstanding.
 
Off-Balance Sheet Obligations
Guarantees
The following chart provides a breakout of guarantees outstanding by type and by segment.
                             
Increase/
May 31, 2004 May 31, 2003 (Decrease)
(Dollar amounts in thousands)


Long-term tax-exempt bonds
  $ 781     $ 900     $ (119 )
Debt portions of leveraged lease transactions
    15       34       (19 )
Indemnifications of tax benefit transfers
    160       185       (25 )
Letters of credit
    307       314       (7 )
Other guarantees
    68       471       (403 )
     
     
     
 
   
Total
  $ 1,331     $ 1,904     $ (573 )
     
     
     
 
 
Electric
  $ 1,302     $ 1,899     $ (597 )
 
Telecommunications
          5       (5 )
 
Other
    29             29  
     
     
     
 
   
Total
  $ 1,331     $ 1,904     $ (573 )
     
     
     
 

The decrease in total guarantees outstanding at May 31, 2004 compared to May 31, 2003 was due primarily to the consolidation of NCSC and normal amortization on tax-exempt bonds and tax benefit transfers. At May 31, 2003, CFC had guaranteed $476 million of NCSC debt obligations. In consolidation the NCSC debt is brought onto the consolidated balance sheet which eliminates the guarantee. Thus, the $476 million of guarantees of NCSC debt obligations were eliminated and $29 million of NCSC guarantees of its members’ obligations were added to the total consolidated guarantees.

At May 31, 2004 and 2003, CFC had recorded a guarantee liability totaling $19 million and $54 million, respectively, which represents CFC’s contingent and non-contingent exposure related to its guarantees of its members’ debt obligations. CFC’s contingent guarantee liability at May 31, 2004 and 2003 totaled

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$19 million and $53 million, respectively, based on management’s estimate of CFC’s exposure to losses within the guarantee portfolio. At May 31, 2004 and 2003, 97.8% and 99.7% of guarantees, respectively, were related to the electric segment. The remaining amount at May 31, 2004 was for the other segment. CFC uses factors such as internal borrower risk rating, remaining maturity periods, corporate bond default probabilities and estimated recovery rates in estimating its contingent exposure. The decrease in the contingent guarantee liability of $34 million is primarily due to the decrease in guarantee exposure due to the consolidation of NCSC debt that is guaranteed by CFC on June 1, 2003. The remaining balance of the total guarantee liability of less than $1 million at May 31, 2004 and $1 million at May 31, 2003 relates to CFC’s non-contingent obligation to stand ready to perform over the term of its guarantees that it has entered into since January 1, 2003. CFC’s non-contingent obligation is estimated based on guarantee fees received for guarantees issued. The fees are deferred and amortized on the straight-line method into operating income over the term of the guarantees. CFC has recorded a non-contingent obligation for all new guarantees since January 1, 2003 in accordance with FIN 45, Guarantor’s Accounting and Disclosure Requirement for Guarantees, Including Indirect Guarantees of Indebtedness of Others (an interpretation of FASB Statements No. 5, 57, and 107 and rescission of FASB Interpretation No. 34). CFC received and deferred fees of $0.5 million and $0.8 million for each of the periods from January 1, 2003 to May 31, 2003 and for the year ended May 31, 2004, respectively, related to new guarantees issued during the periods.

The following table summarizes CFC’s off-balance sheet obligations at May 31, 2004 and the related principal amortization and maturities by fiscal year.

                                                         
Principal Amortization and Maturities

(Dollar amounts in millions) Outstanding Remaining
Instrument Balance 2005 2006 2007 2008 2009 Years








Guarantees(1)
  $ 1,331     $ 247     $ 123     $ 110     $ 82     $ 81     $ 688  


(1)  On a total of $725 million of tax-exempt bonds, CFC has unconditionally agreed to purchase bonds tendered in connection with periodic interest rate resets or called for redemption if the remarketing agents have not sold such bonds to other purchasers.

Contingent Off-Balance Sheet Commitments

Unadvanced Commitments
At May 31, 2004, CFC had unadvanced commitments totaling $11,577 million, a decrease of $112 million compared to the balance of $11,689 million at May 31, 2003. Unadvanced commitments include loans approved by CFC for which loan contracts have been approved and executed, but funds have not been advanced. The majority of the short-term unadvanced commitments provide backup liquidity to CFC borrowers; therefore, CFC does not anticipate funding most such commitments. Approximately 49% and 48% of the outstanding commitments at May 31, 2004 and 2003, respectively, were for short-term or line of credit loans. Approximately 33% of the unadvanced commitments at May 31, 2004 and 2003 were approved under the Power Vision Program and will expire if not advanced within 60 months of approval unless the draw period is extended by CFC. Under the Power Vision Program, CFC performed a review of the majority of its distribution borrowers and pre-approved them for a certain amount of loans for future electric plant additions. Amounts approved but not advanced are available for a period of five years. All above mentioned credit commitments contain material adverse change clauses, thus to qualify for the advance of funds under all commitments, CFC must be satisfied that there has been no material change since the loan was approved.

Unadvanced commitments do not represent off-balance sheet liabilities of CFC and have not been included in the chart summarizing off-balance sheet obligations above. CFC has no obligation to advance amounts to a borrower that does not meet the minimum conditions in effect at the time the loan was approved. If there has been a material adverse change in the borrower’s financial condition, CFC is not required to advance funds. Therefore, CFC classifies unadvanced commitments as contingent liabilities. Amounts advanced under these commitments would be classified as performing loans since the members are required to be in good financial condition to be eligible to receive the advance of funds.

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Ratio Analysis
Leverage Ratio
The leverage ratio is calculated by dividing total liabilities and guarantees outstanding by total equity. Based on this formula, the leverage ratio at May 31, 2004 was 31.57, an increase from 23.64 at May 31, 2003. The increase in the leverage ratio is due to an increase of $536 million to total liabilities and a decrease of $235 million in total equity offset by a decrease of $573 million in guarantees, as discussed above under the Liabilities, Minority Interest and Equity section and the Off-Balance Sheet Obligations section of “Liquidity and Capital Resources”. For the purpose of covenant compliance on its revolving credit agreements and for internal management purposes, CFC adjusts the leverage ratio calculation to exclude derivative liabilities, foreign currency valuation account and debt used to fund RUS guaranteed loans from total liabilities, to exclude from total liabilities and include in total equity subordinated deferrable debt and subordinated certificates, to use members’ equity rather than total equity and to include minority interest as equity. At May 31, 2004 and May 31, 2003, the adjusted leverage ratio was 7.03 and 6.65, respectively. See “Non-GAAP Financial Measures” for further explanation and a reconciliation of the adjustments CFC makes in its leverage ratio calculation. The increase in the adjusted leverage ratio is due to an increase in adjusted liabilities of $998 million and a decrease in adjusted equity of $93 million offset by a decrease of $573 million in guarantees. The increase in adjusted liabilities is primarily due to the $993 million increase in debt required to fund the outstanding loan balance. The decrease in adjusted equity is due primarily to the patronage capital retirement of $71 million, the reclassification of RTFC member’s equity to minority interest of $20 million and the decrease to subordinated deferrable debt and subordinated certificates of $100 million and $43 million, respectively, partly offset by the adjusted net margin of $96 million, cumulative effect of change in accounting principle of $22 million and minority interest of $21 million. CFC will retain the flexibility to further amend its policies to retain members’ investments in CFC consistent with contractual obligations and maintaining acceptable financial ratios. In addition to the adjustments CFC makes to the leverage ratio in the “Non-GAAP Financial Measures” section, guarantees to CFC member systems that have an investment grade rating from Moody’s Investors Service and Standard & Poor’s Corporation are excluded from the calculation of the leverage ratio under the terms of the revolving credit agreement.
 
Debt to Equity Ratio
The debt to equity ratio is calculated by dividing total liabilities outstanding by total equity. The debt to equity ratio, based on this formula, at May 31, 2004 was 29.66, an increase from 21.59 at May 31, 2003. The increase in the debt to equity ratio was due to decreases of $235 million in equity and an increase of $536 million to total liabilities, as discussed above and under the Liabilities, Minority Interest and Equity section of “Liquidity and Capital Resources”. For internal management purposes, CFC adjusts the debt to equity ratio calculation to exclude derivative liabilities, foreign currency valuation account and debt used to fund RUS guaranteed loans from total liabilities, to exclude from total liabilities and include in total equity subordinated deferrable debt and subordinated certificates, to use members’ equity rather than total equity and to include minority interest as equity. At May 31, 2004 and May 31, 2003, the adjusted debt to equity ratio was 6.54 and 5.97, respectively. See “Non-GAAP Financial Measures” for further explanation and a reconciliation of the adjustments CFC makes in its debt to equity ratio calculation. The increase in the adjusted debt to equity ratio is due to an increase in adjusted liabilities of $998 million and a decrease in adjusted equity of $93 million. CFC will retain the flexibility to further amend its policies to retain members’ investments in CFC consistent with contractual obligations and maintaining acceptable financial ratios.

CFC’s management is committed to maintaining the adjusted leverage and adjusted debt to equity ratios within a range required for a strong credit rating. CFC’s policy regarding the purchase of loan subordinated certificates 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, 7% of the loan for power supply systems and 10% of the loan for all other systems. For credit facilities above a certain dollar amount, or for other reasons, the borrower may be required to purchase interest bearing certificates in amounts determined appropriate by CFC based on the

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circumstances of the transaction. CFC also created a members’ capital reserve, in which a portion of the adjusted net margin is held annually rather than allocated to the members. CFC can allocate the members’ capital reserve to its members if it chooses. CFC’s management will continue to monitor the adjusted leverage and adjusted debt to equity ratios. If required, additional policy changes will be made to maintain the adjusted ratios within an acceptable range.
 
Revolving Credit Agreements
At May 31, 2004 and 2003, CFC had three revolving credit agreements totaling $4,650 million and $3,806 million, respectively, which were used principally to provide liquidity support for CFC’s outstanding commercial paper and the adjustable or floating/fixed rate bonds which CFC has guaranteed and of which CFC is standby purchaser. Under three-year agreements in effect at May 31, 2004 and May 31, 2003, CFC could borrow $1,740 million and $1,028 million, respectively. At May 31, 2004 and May 31, 2003, there were two 364-day agreements totaling $2,910 million and $2,778 million, respectively. The two 364-day agreements in place at May 31, 2003 were replaced on June 30, 2003. Under one 364-day agreement, the amount that CFC could borrow increased from $2,378 million at May 31, 2003 to $2,523 million and there was no change to the amount of the second 364-day agreement for $400 million.

The three revolving credit agreements were replaced on March 30, 2004 with three new agreements totaling $4,400 million. In April 2004, the commitments under the agreements increased to $4,650 million. CFC replaced its three-year agreement in effect at May 31, 2003 totaling $1,028 million with a new three-year agreement totaling $1,740 million and expiring on March 30, 2007. The two 364-day agreements were replaced with two 364-day agreements totaling $2,910 million. Under one 364-day agreement, the amount that CFC could borrow decreased from $2,523 million to $1,740 million at May 31, 2004. Under the other 364-day agreement, the amount that CFC could borrow increased from $400 million to $1,170 million at May 31, 2004. Both 364-day agreements have a revolving credit period that terminates on March 29, 2005 during which CFC can borrow, and such borrowings outstanding at that date may be converted to a one-year term loan at the end of the revolving credit period with a 0.250 of 1% per annum fee on the outstanding principal amount of the term loan. The facility fee for the three-year facility is 0.100 of 1% per annum based on the pricing schedules in place at March 30, 2004. The facility fee for the 364-day facilities is 0.085 of 1% per annum based on the pricing schedules in place at March 30, 2004. Up-front fees of between 0.070 to 0.160 of 1% were paid to the banks based on their commitment level in each of the agreements, totaling $4 million. Each agreement contains a provision under which if borrowings exceed 50% of total commitments, a utilization fee of 0.150 of 1% per annum must be paid on the outstanding balance.

The revolving credit agreements require CFC to achieve an average adjusted TIER over the six most recent fiscal quarters of at least 1.025 and prohibits the retirement of patronage capital unless CFC achieves an adjusted TIER of at least 1.05 as of the preceding fiscal year end. Under the credit agreements in effect at May 31, 2004, the adjusted TIER represents the cost of funds adjusted to include the derivative cash settlements, plus minority interest net margin, plus net margin prior to the cumulative effect of change in accounting principle and dividing that total by the cost of funds adjusted to include the derivative cash settlements. The revolving credit agreements prohibit CFC from incurring senior debt in an amount in excess of ten times the sum of subordinated deferrable debt, members’ subordinated certificates, minority interest and total equity. For the purpose of the revolving credit agreements, net margin, senior debt and total equity are adjusted to exclude the non-cash adjustments related to SFAS 133 and 52. Senior debt includes guarantees; however, it excludes:
•  guarantees for members where the long-term unsecured debt of the member is rated at least BBB+ by Standard & Poor’s Corporation or Baa1 by Moody’s Investors Service;
•  indebtedness incurred to fund RUS guaranteed loans; and
•  the payment of principal and interest by the member on the guaranteed indebtedness if covered by insurance or reinsurance provided by an insurer having an insurance financial strength rating of AAA by Standard & Poor’s Corporation or a financial strength rating of Aaa by Moody’s Investors Service.

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As of May 31, 2004 and 2003, CFC was in compliance with all covenants and conditions under its revolving credit agreements in place at that time and there were no borrowings outstanding under such agreements. As of May 31, 2004 and 2003, CFC’s adjusted TIER over the six most recent fiscal quarters as defined by the agreements in place at that time, was 1.15 and 1.15, respectively. As of May 31, 2004 and 2003, CFC’s adjusted TIER for the fiscal year end, as defined by the agreements in place at that time, was 1.12 and 1.17, respectively. As of May 31, 2004 and 2003, CFC’s leverage ratio, as defined by the agreements in place at that time, was 6.87 and 6.48, respectively.

The revolving credit agreements do not contain a material adverse change clause or ratings triggers that limit the banks’ obligations to fund under the terms of the agreements.

Based on the ability to borrow under the bank line facilities, CFC classified $4,650 million and $3,951 million, respectively, of its notes payable outstanding as long-term debt at May 31, 2004 and May 31, 2003.

Asset/Liability Management

A key element of CFC’s funding operations 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 margin and retain liquidity. Throughout the asset/liability management discussion, the term repricing refers to the resetting of interest rates for a loan and does not represent the maturity of a loan. Therefore, loans that reprice do not represent amounts that will be available to service debt or fund CFC’s operations.

 
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 maturity of the fixed rate loan portfolio. It is CFC’s funding objective to manage the matched funding of asset and liability repricing terms within a range of 3% of total assets excluding derivative assets. At May 31, 2004, CFC had $13,839 million of fixed rate assets amortizing or repricing, funded by $11,392 million of fixed rate liabilities maturing during the next 30 years and $2,193 million of members’ equity and members’ subordinated certificates, a portion of which does not have a scheduled maturity. The difference of $254 million, or 1.19% of total assets and 1.22% of total assets excluding derivative assets, represents the fixed rate assets maturing during the next 30 years in excess of the fixed rate debt and equity, which are funded with variable rate debt. CFC funds variable rate assets which reprice monthly with short-term liabilities, primarily commercial paper, collateral trust bonds and medium-term notes issued with a fixed rate and swapped to a variable rate, medium-term notes issued at a variable rate, subordinated certificates, members’ equity and bank bid notes. CFC funds fixed rate loans with fixed rate collateral trust bonds, medium-term notes, subordinated deferrable debt, members’ subordinated certificates and members’ equity. With the exception of members’ subordinated certificates, which are generally issued at rates below CFC’s long-term cost of funding and with extended maturities, and commercial paper, CFC’s liabilities have average maturities that closely match the repricing terms (but not the maturities) 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, subordinated deferrable debt and medium-term notes were issued with early redemption provisions. To the extent borrowers are allowed to convert their fixed rate loans to a variable interest rate and to the extent it is beneficial, CFC takes advantage of these early redemption provisions. However, because conversions and prepayments can take place at different intervals from early redemptions, CFC charges conversion and prepayment fees designed to compensate for any additional interest rate risk assumed by CFC.

CFC makes use of an interest rate gap analysis in the funding of its long-term fixed rate loan portfolio. The analysis compares the scheduled fixed rate loan amortizations and repricings against the scheduled fixed rate debt and members’ subordinated certificate amortizations to determine the fixed rate funding gap

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for each individual year and for the portfolio as a whole. There are no scheduled maturities for the members’ equity, primarily unretired patronage capital allocations. The non-amortizing members’ subordinated certificates either mature at the time of the related loan or guarantee or 100 years from issuance (50 years in the case of a small portion of certificates). Accordingly, it is assumed in the funding analysis that non-amortizing members’ subordinated certificates and members’ equity are first used to “fill” any fixed rate funding gaps. The remaining gap represents the amount of excess fixed rate funding due in that year or the amount of fixed rate assets that are assumed to be funded by short-term variable rate debt, primarily commercial paper. The interest rate associated with the assets and debt maturing or members’ equity and members’ certificates is used to calculate an adjusted TIER for each year and for the portfolio as a whole. The schedule allows CFC to analyze the impact on the overall adjusted TIER of issuing a certain amount of debt at a fixed rate for various maturities, prior to issuance of the debt. See “Non-GAAP Financial Measures” for further explanation and reconciliation of the adjustments to TIER.

The following chart shows the scheduled amortization and repricing of fixed rate assets and liabilities outstanding at May 31, 2004.

INTEREST RATE GAP ANALYSIS
(Fixed Rate Assets/Liabilities)
As of May 31, 2004
                                                             
Over Over Over Over
1 year 3 years 5 years 10 years
but but but but
1 year 3 years 5 years 10 years 20 years Over
or less or less