NRUC

Business Context and Reporting Period

Company: National Rural Utilities Cooperative Finance Corporation (CFC), a private, not-for-profit cooperative providing financing to rural electric and telecommunications cooperatives.

Reporting Period: Quarterly Report (Form 10-Q) for the period ended November 30, 2002.

Operations: CFC operates two primary segments: rural electric lending and rural telecommunications lending (via Rural Telephone Finance Cooperative). The company is exempt from federal income taxes under Section 501(c)(4).

Key Financial Metrics

Note: Net Margin for the six months ended Nov 30, 2002, includes a $258.4 million gain from SFAS 133 forward value adjustments on derivatives.

Material Changes vs. Prior Period

• Net Margin Surge: Net margin increased by $203.2 million (193%) compared to the prior year period. This increase is primarily driven by a $232 million increase in SFAS 133 forward value adjustments due to changes in interest rates, rather than core operating performance.
• Operating Loss: Core operations recorded a loss of $8.7 million for the six months ended Nov 30, 2002, compared to an operating margin of $42.9 million in the prior year. This was caused by a $91 million decrease in gross margin (due to lower interest rates) partially offset by a $42 million decrease in the provision for loan losses.
• Loan Portfolio: Net loans to members decreased by $672 million (3%) to $18.9 billion. This decrease was largely due to the reduction of nonperforming and restructured loans following the CoServ bankruptcy resolution.
• Derivative Assets: Derivative assets increased significantly to $557 million (from $193 million at May 31, 2002) due to the decreasing interest rate environment increasing the fair value of interest rate exchange agreements.
• Foreclosed Assets: The company recorded $327 million in foreclosed assets, primarily real estate and telecommunications assets received from CoServ as part of its bankruptcy reorganization.

Guidance, Outlook, and Risks

• CoServ Resolution: CoServ emerged from bankruptcy in December 2002. CFC received real estate and telecommunications assets valued at approximately $352 million. The remaining loan balance was restructured, with CoServ 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 Restructuring: Deseret Generation & Transmission Cooperative continues to perform under its 1996 restructuring agreement. CFC anticipates Deseret will make required payments in fiscal year 2003, reducing the loan balance to an estimated $525 million.
• Interest Rate Environment: CFC anticipates gross margins for fiscal year 2003 will be lower than the 1.69% earned in fiscal year 2002 due to competitive pressures and lower interest rates passed to borrowers.
• 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.
• Liquidity: CFC has $3.7 billion in revolving credit agreements to support liquidity. It expects to refinance $2.6 billion of maturing debt in the next 12 months.
• Accounting Volatility: Management notes that SFAS 133 accounting for derivatives will continue to cause volatility in reported net margins and equity, though these are non-cash adjustments that will reverse over the life of the instruments.

Investor Verification Checklist

• SFAS 133 Impact: Verify the sustainability of the $308 million net margin by excluding the $258 million non-cash derivative gain to assess core operational profitability.
• CoServ Asset Realization: Monitor the actual sale proceeds of the $327 million in foreclosed assets (real estate and telecom) received from CoServ to ensure they meet fair value estimates.
• Loan Loss Provision: Review the adequacy of the $574 million allowance for loan losses, specifically regarding the $177 million specific reserve for impaired borrowers (CoServ and Deseret).
• Refinancing Risk: Assess the ability to refinance $2.6 billion of maturing medium-term notes and collateral trust bonds given the negative credit outlook from two major rating agencies.
• Derivative Counterparty Risk: Confirm the credit ratings of counterparties for the $13.7 billion in interest rate exchange agreements, noting that rating triggers could force termination if CFC's credit rating falls below Baa1/BBB+.