NRUC

Business Context and Reporting Period

Company: National Rural Utilities Cooperative Finance Corporation (CFC) and Rural Telephone Finance Cooperative (RTFC).

Reporting Period: Quarterly period ended February 28, 2003 (Nine months ended February 28, 2003).

Business Overview: CFC is a private, not-for-profit cooperative providing supplemental financing to rural electric and telecommunications cooperatives. The financial statements combine CFC and RTFC results. CFC is exempt from federal income taxes under Section 501(c)(4), while RTFC is a taxable entity.

Key Financial Metrics

Liquidity: Cash and cash equivalents totaled $297.9 million. The company maintains $3.7 billion in revolving credit agreements, with no borrowings outstanding under these facilities as of the reporting date.

Material Changes vs. Prior Period

• Net Margin Surge: Net margin for the nine months ended Feb 28, 2003, increased to $639.4 million from $97.1 million in the prior year. This increase is primarily driven by a $533.8 million gain in the "SFAS 133 forward value" related to derivative instruments, rather than core operating performance.
• Operating Margin Decline: Adjusted operating margin (excluding SFAS 133 impacts) decreased. Gross margin fell to $109.1 million from $252.6 million due to lower interest rates reducing loan yields. However, the provision for loan losses decreased significantly to $68.3 million from $168.7 million.
• Equity Increase: Total equity rose by $635.2 million (195% increase), largely due to the $605 million increase in the fair value of derivative instruments recorded under SFAS 133.
• Loan Portfolio: Net loans decreased by $432 million. This was driven by a reduction in nonperforming and restructured loans (reclassified from CoServ and Deseret) and a decrease in intermediate-term loans, partially offset by an increase in long-term loans.
• Derivative Assets: Derivative assets increased to $894.9 million from $192.6 million due to the decreasing interest rate environment increasing the fair value of CFC's interest rate exchange agreements.

Guidance, Outlook, Risks, and Unusual Items

• CoServ Restructuring: CoServ Electric emerged from bankruptcy in December 2002. CFC received real estate and telecommunications assets valued at approximately $365 million as foreclosed assets. The remaining loan balance was restructured, and CoServ is required to make quarterly payments over 35 years. CFC may be obligated to provide up to $200 million in additional capital expenditure loans over the next 10 years.
• Deseret Reclassification: Loans to Deseret Generation & Transmission Cooperative ($536 million) were reclassified from "restructured" to "performing" as of Feb 28, 2003, following consistent payments under a 1996 restructuring agreement.
• Derivative Accounting (SFAS 133): The adoption of SFAS 133 has introduced significant volatility to reported net margins and equity. Management utilizes "Adjusted TIER" (Times Interest Earned Ratio) and "Adjusted Net Margin" (excluding SFAS 133 forward values) as primary performance measures. The Adjusted TIER for the nine months ended Feb 28, 2003, was 1.17, exceeding the 1.10 minimum objective.
• Credit Ratings: Standard & Poor's and Moody's have placed CFC's ratings on a "negative outlook" due to exposure to CoServ and the telecommunications sector. Fitch revised its outlook to "stable" in October 2002.
• Rating Triggers: CFC has $10.3 billion in notional derivative agreements with rating triggers. A downgrade to BBB+/Baa1 could allow counterparties to terminate $2.1 billion of agreements; a further downgrade could trigger termination of an additional $8.2 billion.
• Loan Loss Allowance: The allowance increased to $565.7 million (2.88% of total loans). Management believes the allowance is adequate, though future impairments on restructured loans (like CoServ) could increase if interest rates rise or performance deteriorates.

Investor Verification Checklist

• Derivative Valuation: Verify the sensitivity of the $605 million equity increase to changes in interest rate curves, as this is a non-cash accounting adjustment under SFAS 133.
• CoServ Performance: Monitor CoServ's ability to meet the 35-year payment schedule and the potential need for CFC to fund the $200 million capital expenditure commitment.
• Adjusted TIER: Confirm that the Adjusted TIER (1.17) remains above the 1.10 covenant threshold, as this is the primary metric for credit rating agencies and liquidity covenants.
• Loan Loss Provision: Assess the adequacy of the loan loss allowance given the reclassification of Deseret to performing and the ongoing non-accrual status of the restructured CoServ loan.
• Liquidity Refinancing: Review the maturity schedule of $2.55 billion in commercial paper and bank bid notes due within 12 months to ensure access to capital markets remains intact despite the negative outlook.