NRUC

Business Context and Reporting Period

Company: National Rural Utilities Cooperative Finance Corporation (CFC)
Filing Type: Form 10-Q (Quarterly Report)
Period Ended: November 30, 2010
Business Overview: CFC is a tax-exempt cooperative lender providing cost-based financial products to rural electric and telecommunications members. It consolidates results with Rural Telephone Finance Cooperative (RTFC) and National Cooperative Services Corporation (NCSC). The company does not issue equity capital stock.

Key Financial Metrics

Material Changes vs. Prior Period

• Profitability Surge: Net income attributable to CFC increased significantly to $87.4 million for the quarter (up from $24.0 million in the prior year quarter) and $50.3 million for the six-month period (up from $40.2 million). This was driven by a $27.3 million recovery of loan losses and a $47.3 million gain on derivatives.
• Loan Portfolio Reduction: Total loans outstanding decreased by $201 million to $19.14 billion. This decline was primarily due to a $472 million reduction in non-performing loans related to the Innovative Communications Corporation (ICC) bankruptcy settlement.
• Derivative Volatility: Non-interest income swung from a loss of $3.1 million in the prior year quarter to a gain of $47.3 million, largely due to changes in the fair value of interest rate swaps (forward value) and reduced cash settlement expenses.
• Debt Structure: The company shifted funding mix toward lower-cost commercial paper. Subordinated deferrable debt decreased by $125 million following a redemption in September 2010.

Outlook, Risks, and Unusual Items

• ICC Settlement (Unusual Item): On October 6, 2010, CFC took control of ICC's USVI operating entities as partial satisfaction of loans. This resulted in a $328 million charge-off, a $128 million fair value transfer to foreclosed assets, and a $216 million total investment in foreclosed assets. While the charge-off reduced the loan balance, the recovery of loan losses offset the impact on net income.
• Foreclosed Assets: Foreclosed assets increased to $255 million, primarily due to the ICC acquisition. The company recorded a $1.5 million market adjustment loss on these assets for the quarter.
• Interest Rate Outlook: Management expects to lower the overall effective borrowing rate for the remainder of fiscal year 2011 through refinancing maturing debt. They have locked in rates on $250 million of debt repricing in January 2011, expecting annual savings of $7 million.
• Liquidity: The company maintains $3.39 billion in available revolving credit lines. Management expects sufficient liquidity to fund operations for the next 12-18 months.
• Risks: Primary risks include liquidity risk, interest rate risk, and counterparty risk related to derivatives. The company has rating triggers on $8.4 billion of derivative notional amounts; a downgrade could require net payments of up to $94.5 million.

Investor Verification Checklist

• Derivative Accounting: Verify the sustainability of the $47.3 million derivative gain, which is largely non-cash (forward value) and highly sensitive to interest rate curve movements.
• Loan Loss Allowance Adequacy: Confirm the $225.5 million allowance is sufficient given the remaining $66 million exposure to ICC and $26 million to Naknek Electric Association, despite the recent recovery.
• Foreclosed Asset Valuation: Monitor the valuation of the $255 million in foreclosed assets, particularly the ICC USVI entities, as fair value estimates are subject to adjustment within one year of transfer.
• Debt Maturities: Review the $1.49 billion in long-term debt maturing within one year and the company's ability to refinance at favorable rates.
• Non-GAAP Reconciliations: Review the reconciliation of Adjusted TIER and Adjusted Debt-to-Equity ratios, as these are the primary metrics used for covenant compliance and management evaluation.