NRUC

Business Context and Reporting Period

Company: National Rural Utilities Cooperative Finance Corporation (CFC) and Rural Telephone Finance Cooperative (RTFC).
Reporting Period: Fiscal year ended May 31, 2002.
Business Model: CFC is a private, not-for-profit cooperative providing low-cost capital to rural electric and telecommunications utility members. It supplements the loan programs of the Rural Utilities Service (RUS) and lends 100% of requirements for members electing not to borrow from RUS. CFC is exempt from federal income taxes under IRC Section 501(c)(4), while RTFC is a taxable entity under Subchapter T.

Key Financial Metrics

Note: Net Margin for 2002 includes a $70.1 million gain related to the adoption of SFAS 133 (Accounting for Derivative Instruments).

Material Changes vs. Prior Period

• Net Margin Increase: Net margin increased 26% to $168.3 million, driven by a $70.1 million gain from SFAS 133 adoption and an improved gross margin spread (1.69% vs. 1.44% in 2001). This was partially offset by a significant increase in the provision for loan losses.
• Loan Loss Provision: The provision for loan losses surged 90% to $199.3 million (from $105.2 million) to cover increased specific reserves for impaired borrowers (notably CoServ) and higher credit concentration risks.
• Operating Income Decline: Operating income decreased 14% to $1,186.5 million due to lower interest rates on the loan portfolio (average rate dropped from 7.36% to 5.98%), despite a 5% increase in average loan volume.
• Debt Structure: Long-term debt increased by $3.48 billion, primarily due to the issuance of medium-term notes and collateral trust bonds, offset by a decrease in notes payable reclassified as long-term.
• Nonperforming Loans: Nonperforming loans increased dramatically from $0.8 million to $1,011.3 million, almost entirely due to the default of CoServ Electric ($1,003 million).

Guidance, Outlook, and Risks

• Accounting Changes: The adoption of SFAS 133 on June 1, 2001, introduced volatility to reported net margins and equity. Management expects this volatility to continue as fair values of derivatives fluctuate with interest rates.
• Credit Concentration: The ten largest borrowers represent 26% of total loans and guarantees. Management plans to strictly monitor this concentration to manage credit risk.
• Restructured Borrowers:
  • CoServ: Classified as nonperforming. CFC and CoServ filed joint plans of liquidation and reorganization in June 2002. CFC expects to assume CoServ's real estate lending position and receive proceeds from the sale of its telecommunications assets.
  • Deseret: Performing under its restructure agreement. CFC received $54 million in excess cash flow payments in 2002, recovering prior write-offs.
• Market Risks: CFC faces interest rate risk (funding fixed-rate loans with variable-rate debt) and liquidity risk (access to capital markets). All three major rating agencies placed CFC's long-term ratings on negative outlook at May 31, 2002, citing exposure to CoServ and general electric utility sector concerns.
• Loan Growth: Loan growth is expected to remain moderate. Electric loan growth is anticipated from borrowers who prepaid RUS loans and are ineligible for RUS insured loans for ten years.

Investor Verification Checklist

• CoServ Resolution: Verify the status of the joint liquidation/reorganization plans filed in June 2002 and the expected recovery value of the $1,003 million nonperforming loan.
• Loan Loss Adequacy: Assess whether the $507 million allowance (2.53% of total loans) is sufficient given the specific reserves for impaired loans ($202 million) and the high concentration of the top ten borrowers.
• Rating Agency Actions: Monitor credit rating agency reports for potential downgrades or changes in outlook, which could impact borrowing costs and access to capital markets.
• SFAS 133 Impact: Review future quarterly reports to understand the volatility in net margin caused by fair value adjustments on derivative instruments.
• Refinancing Needs: Confirm CFC's ability to refinance $2.88 billion of debt maturing in fiscal year 2003, particularly given the negative rating outlook.