Attached files

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EX-4.1 - EXHIBIT 4.1 FORM OF CAPITAL TERM CERTIFICATE - NATIONAL RURAL UTILITIES COOPERATIVE FINANCE CORP /DC/nrufy201810-kexhibit41xfor.htm
EX-32.2 - EXHIBIT 32.2 CFO SECTION 906 CERTIFICATION - NATIONAL RURAL UTILITIES COOPERATIVE FINANCE CORP /DC/nrufy201810-kexhibit322xcf.htm
EX-32.1 - EXHIBIT 32.1 CEO SECTION 906 CERTIFICATION - NATIONAL RURAL UTILITIES COOPERATIVE FINANCE CORP /DC/nrufy201810-kexhibit321xce.htm
EX-31.2 - EXHIBIT 31.2 CFO SECTION 302 CERTIFICATION - NATIONAL RURAL UTILITIES COOPERATIVE FINANCE CORP /DC/nrufy201810-kexhibit312xcf.htm
EX-31.1 - EXHIBIT 31.1 CEO SECTION 302 CERTIFICATION - NATIONAL RURAL UTILITIES COOPERATIVE FINANCE CORP /DC/nrufy201810-kexhibit311xce.htm
EX-23.1 - EXHIBIT 23.1 KMPG CONSENT - NATIONAL RURAL UTILITIES COOPERATIVE FINANCE CORP /DC/nrufy201810-kexhibit231xco.htm
EX-12 - EXHIBIT 12 COMPUTATION OF RATIO OF EARNINGS TO FIXED CHARGES - NATIONAL RURAL UTILITIES COOPERATIVE FINANCE CORP /DC/nrufy201810-kexhibit12xcom.htm
EX-10.2 - EXHIBIT 10.2 AMENDED AND RESTATED PRP PLAN - NATIONAL RURAL UTILITIES COOPERATIVE FINANCE CORP /DC/nrufy201810-kexhibit102xnr.htm



UNITED STATES
SECURITIES AND EXCHANGE
Washington, D.C. 20549
__________________________
FORM 10-K
__________________________
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended May 31, 2018
OR
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
 
52-0891669
(State or other jurisdiction of incorporation or organization)
 
(I.R.S. employer identification no.)
20701 Cooperative Way, Dulles, Virginia, 20166
(Address of principal executive offices) (Zip Code)
Registrant’s telephone number, including area code: (703) 467-1800
__________________________
Securities registered pursuant to Section 12(b) of the Act:
 
Title of Each Class
 
Name of Each Exchange on Which Registered
6.55% Collateral Trust Bonds, due 2018
 
New York Stock Exchange
7.35% Collateral Trust Bonds, due 2026
 
New York Stock Exchange
Securities Registered Pursuant to Section 12(g) of the Act: None
 
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes      No
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Act.    Yes      No
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      No
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes      No
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) 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 III of this Form 10-K or any amendment to this Form 10-K.
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act. Large accelerated filer      Accelerated filer   Non-accelerated filer   ☒  Smaller reporting company Emerging growth company
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transaction period for complying with any new or revised financial accounting standards provided pursuant to Section13(a) of the Exchange Act.
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes      No
The Registrant is a tax-exempt cooperative and therefore does not issue capital stock.
 




TABLE OF CONTENTS
 
  
 
 
Page
 
 
  
 
 
 
 
 
  
 
 
  
 
 
  
 
 
  
 
 
  
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
  
 
  
 
  
 
  
 
  
 
 
 
 
 
 
  
 
  
 
  
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
  
 
  
 
 
 
 
 
 
 
 
 
 

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ii



INDEX OF MD&A TABLES
Table
  
 Description
 
Page
1
 
Average Balances, Interest Income/Interest Expense and Average Yield/Cost
 
30

2
 
Rate/Volume Analysis of Changes in Interest Income/Interest Expense
 
32

3
 
Non-Interest Income
 
34

4
 
Derivative Average Notional Amounts and Average Interest Rates
 
35

5
 
Derivative Gains (Losses)
 
36

6
 
Non-Interest Expense
 
37

7
 
Loans Outstanding by Type and Member Class
 
38

8
 
Historical Retention Rate and Repricing Selection
 
39

9
 
Long-Term Loan Scheduled Principal Payments
 
39

10
 
Debt Product Types
 
40

11
 
Total Debt Outstanding and Weighted-Average Interest Rates
 
41

12
 
Member Investments
 
42

13
 
Collateral Pledged
 
43

14
 
Unencumbered Loans
 
44

15
 
Equity
 
45

16
 
Guarantees Outstanding
 
46

17
 
Maturities of Guarantee Obligations
 
47

18
 
Unadvanced Loan Commitments
 
47

19
 
Notional Maturities of Unadvanced Loan Commitments
 
48

20
 
Maturities of Notional Amount of Unconditional Committed Lines of Credit
 
49

21
 
Loan Portfolio Security Profile
 
51

22
 
Loan Geographic Concentration
 
53

23
 
Credit Exposure to 20 Largest Borrowers
 
54

24
 
Troubled Debt Restructured Loans
 
55

25
 
Nonperforming Loans
 
56

26
 
Net Charge-Offs (Recoveries)
 
56

27
 
Allowance for Loan Losses
 
58

28
 
Rating Triggers for Derivatives
 
59

29
 
Liquidity Reserve
 
60

30
 
Committed Bank Revolving Line of Credit Agreements
 
61

31
 
Short-Term Borrowings—Funding Sources
 
63

32
 
Short-Term Borrowings
 
63

33
 
Issuances and Repayments of Long-Term and Subordinated Debt
 
65

34
 
Projected Sources and Uses of Liquidity
 
66

35
 
Contractual Obligations
 
67

36
 
Credit Ratings
 
67

37
 
Interest Rate Gap Analysis
 
69

38
 
Financial Instruments
 
70

39
 
Loan Repricing
 
71

40
 
Adjusted Financial Measures—Income Statement
 
73

41
 
TIER and Adjusted TIER
 
73

42
 
Adjusted Financial Measures—Balance Sheet
 
74

43
 
Debt-to-Equity Ratio
 
75

44
 
Members’ Equity
 
75


iii



FORWARD-LOOKING STATEMENTS

This Annual Report on Form 10-K contains certain statements that are considered “forward-looking statements” within the Securities Act of 1933, as amended, and the Exchange Act of 1934, as amended. Forward-looking statements, which are based on certain assumptions and describe our future plans, strategies and expectations, are generally identified by our use of words such as “intend,” “plan,” “may,” “should,” “will,” “project,” “estimate,” “anticipate,” “believe,” “expect,” “continue,” “potential,” “opportunity” and similar expressions, whether in the negative or affirmative. All statements about future expectations or projections, including statements about loan volume, the appropriateness of the allowance for loan losses, operating income and expenses, leverage and debt-to-equity ratios, borrower financial performance, impaired loans, and sources and uses of liquidity, are forward-looking statements. Although we believe that the expectations reflected in our forward-looking statements are based on reasonable assumptions, actual results and performance may differ materially from our forward-looking statements due to several factors. Factors that could cause future results to vary from our forward-looking statements include, but are not limited to, general economic conditions, legislative changes including those that could affect our tax status, governmental monetary and fiscal policies, demand for our loan products, lending competition, changes in the quality or composition of our loan portfolio, changes in our ability to access external financing, changes in the credit ratings on our debt, valuation of collateral supporting impaired loans, charges associated with our operation or disposition of foreclosed assets, technological changes within the rural electric utility industry, regulatory and economic conditions in the rural electric industry, nonperformance of counterparties to our derivative agreements, the costs and effects of legal or governmental proceedings involving us or our members and the factors listed and described under “Item 1A. Risk Factors” of this Report. Except as required by law, we undertake no obligation to update or publicly release any revisions to forward-looking statements to reflect events, circumstances or changes in expectations after the date on which the statement is made.

PART I

Item 1.
Business
OVERVIEW

National Rural Utilities Cooperative Finance Corporation (“CFC”) is a member-owned cooperative association incorporated under the laws of the District of Columbia in April 1969. CFC’s principal purpose is to provide its members with financing to supplement the loan programs of the Rural Utilities Service (“RUS”) of the United States Department of Agriculture (“USDA”). CFC makes loans to its rural electric members so they can acquire, construct and operate electric distribution, generation and transmission (“power supply”) systems and related facilities. CFC also provides its members with credit enhancements in the form of letters of credit and guarantees of debt obligations. As a cooperative, CFC is owned by and exclusively serves its membership, which consists of not-for-profit entities or subsidiaries or affiliates of not-for-profit entities. CFC is exempt from federal income taxes under Section 501(c)(4) of the Internal Revenue Code. As a member-owned cooperative, CFC’s objective is not to maximize profit, but rather to offer members cost-based financial products and services. As described below under “Allocation and Retirement of Patronage Capital,” CFC annually allocates its net earnings, which consist of net income excluding the effect of certain noncash accounting entries, to (i) a cooperative educational fund; (ii) a general reserve, if necessary; (iii) members based on each member’s patronage of CFC’s loan programs during the year; and (iv) a members’ capital reserve. CFC funds its activities primarily through a combination of public and private issuances of debt securities, member investments and retained equity. As a Section 501(c)(4) tax-exempt, member-owned cooperative, we cannot issue equity securities.

Our financial statements include the consolidated accounts of CFC, National Cooperative Services Corporation (“NCSC”), Rural Telephone Finance Cooperative (“RTFC”) and subsidiaries created and controlled by CFC to hold foreclosed assets resulting from defaulted loans or bankruptcy. We did not carry any foreclosed assets on our consolidated balance sheet as of May 31, 2018 or May 31, 2017. Unless stated otherwise, references to “we,” “our” or “us” relate to CFC and its consolidated entities. All references to members within this document include members, associates and affiliates of CFC and its consolidated entities, except where indicated otherwise.

NCSC is a taxable cooperative incorporated in 1981 in the District of Columbia as a member-owned cooperative association. The principal purpose of NCSC is to provide financing to its members, entities eligible to be members of CFC and the for-profit and nonprofit entities that are owned, operated or controlled by, or provide significant benefit to Class A,

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B and C members of CFC. See “Members” below for a description of our member classes. NCSC’s membership consists of distribution systems, power supply systems and statewide and regional associations that were members of CFC as of May 31, 2018. CFC, which is the primary source of funding for NCSC, manages NCSC’s business operations under a management agreement that is automatically renewable on an annual basis unless terminated by either party. NCSC pays CFC a fee and, in exchange, CFC reimburses NCSC for loan losses under a guarantee agreement. As a taxable cooperative, NCSC pays income tax based on its reported taxable income and deductions. NCSC is headquartered with CFC in Dulles, Virginia.

RTFC is a taxable Subchapter T cooperative association originally incorporated in South Dakota in 1987 and reincorporated as a member-owned cooperative association in the District of Columbia in 2005. RTFC’s principal purpose is to provide financing for its rural telecommunications members and their affiliates. RTFC’s membership consists of a combination of not-for-profit and for-profit entities. CFC is the sole lender to and manages the business operations of RTFC through a management agreement that is automatically renewable on an annual basis unless terminated by either party. RTFC pays CFC a fee and, in exchange, CFC reimburses RTFC for loan losses under a guarantee agreement. As permitted under Subchapter T of the Internal Revenue Code, RTFC pays income tax based on its taxable income, excluding patronage-sourced earnings allocated to its patrons. RTFC is headquartered with CFC in Dulles, Virginia.

Our principal operations are currently organized for management reporting purposes into three business segments: CFC, NCSC and RTFC. We provide information on the financial performance of our business segments in “Note 14—Business Segments.”
OUR BUSINESS

Our business strategy and policies are set by our board of directors and may be amended or revised from time to time by the board of directors. We are a nonprofit tax-exempt cooperative finance organization, whose primary focus is to provide our members with the credit products they need to fund their operations. As such, our business focuses on lending to electric systems and securing access to capital through diverse funding sources at rates that allow us to offer competitively priced credit products to our members.

Focus on Electric Lending

CFC focuses on lending to its member electric utility cooperatives. Most of our electric cooperative borrowers continue to demonstrate stable operating performance and strong financial ratios. Our electric cooperative members experience limited competition as they generally operate in exclusive territories and the majority are not rate regulated. Loans to electric utility organizations represented approximately 99% of total loans outstanding as of both May 31, 2018 and 2017.

Maintain Diversified Funding Sources

We strive to maintain diversified funding sources beyond capital market offerings of debt securities. We offer various short- and long-term unsecured investment products to our members and affiliates, including commercial paper, select notes, daily liquidity fund notes, medium-term notes and subordinated certificates. While we continue to issue debt securities, such as secured collateral trust bonds, unsecured medium-term notes and dealer commercial paper, in the capital markets, we also have access to funds through bank revolving line of credit arrangements, government-guaranteed programs such as funding from the Federal Financing Bank that is guaranteed by RUS through the Guaranteed Underwriter Program (the “Guaranteed Underwriter Program”) as well as private placement note purchase agreements with the Federal Agricultural Mortgage Corporation (“Farmer Mac”). We provide additional information on our funding sources in “Item 7. MD&A—Consolidated Balance Sheet Analysis,” “Item 7. MD&A—Liquidity Risk,” “Note 5—Short-Term Borrowings,” “Note 6—Long-Term Debt,” “Note 7—Subordinated Deferrable Debt” and “Note 8—Members’ Subordinated Certificates.”

2



LOAN PROGRAMS

CFC lends to its members and associates. NCSC lends to its members, associates, entities eligible to be members of CFC and for-profit and nonprofit entities that are owned, operated or controlled by, or provide significant benefit, to CFC members. RTFC lends to its members, organizations affiliated with its members and associates. See “Item 1. Business—Members” for additional information on the entities that comprise our membership. Loans to NCSC associates may require a guarantee of repayment to NCSC from the CFC member cooperative with which it is affiliated. CFC, NCSC and RTFC loans generally contain provisions that restrict further borrower advances or trigger an event of default if there is any material adverse change in the business or condition, financial or otherwise, of the borrower.

CFC Loan Programs

Long-Term Loans

CFC’s long-term loans generally have the following characteristics:

terms of up to 35 years on a senior secured basis;
amortizing, bullet maturity or serial payment structures;
the property, plant and equipment financed by and securing the long-term loan has a useful life equal to or in excess of the loan maturity;
flexibility for the borrower to select a fixed interest rate for periods of one to 35 years or a variable interest rate; and
the ability for the borrower to select various tranches with either a fixed or variable interest rate for each tranche.

Borrowers typically have the option of selecting a fixed or variable interest rate at the time of each advance on long-term loan facilities. When selecting a fixed rate, the borrower has the option to choose a fixed rate for a term of one year through the final maturity of the loan. When the selected fixed interest rate term expires, the borrower may select another fixed rate for a term of one year through the remaining loan maturity or the current variable rate. Long-term fixed rates are set daily for new loan advances and loans that reprice. The fixed rate on each loan is generally determined on the day the loan is advanced or repriced based on the term selected. The variable rate is set on the first day of each month.

To be in compliance with the covenants in the loan agreement and eligible for loan advances, distribution systems generally must maintain an average modified debt service coverage ratio, as defined in the loan agreement, of 1.35 or greater. CFC may make long-term loans to distribution systems, on a case-by-case basis, that do not meet these general criteria. Power supply systems generally are required: (i) to maintain an average modified debt service coverage ratio, as defined in the loan agreement, of 1.00 or greater; (ii) to establish and collect rates and other revenue in an amount to yield margins for interest, as defined in an indenture, in each fiscal year sufficient to equal at least 1.00; or (iii) both. CFC may make long-term loans to power supply systems, on a case-by-case basis, that may include other requirements, such as maintenance of a minimum equity level.

Line of Credit Loans

Line of credit loans are designed primarily to assist borrowers with liquidity and cash management and are generally advanced at variable interest rates. Line of credit loans are typically revolving facilities. Certain line of credit loans require the borrower to pay off the principal balance for at least five consecutive business days at least once during each 12-month period. Line of credit loans are generally unsecured and may be conditional or unconditional facilities.

Line of credit loans also are made available as interim financing when a member either receives RUS approval to obtain a loan and is awaiting its initial advance of funds or submits a loan application that is pending approval from RUS (sometimes referred to as “bridge loans”). In these cases, when the borrower receives the RUS loan advance, the funds must be used to repay the bridge loans.

Syndicated Line of Credit Loans

A syndicated line of credit loan is typically a large financing offered by a group of lenders that work together to provide funds for a single borrower. Syndicated loans are generally unsecured, floating-rate loans that can be provided on a

3



revolving or term basis for tenors that range from several months to five years. Syndicated financings are arranged for borrowers on a case-by-case basis. CFC may act as lead lender, arranger and/or administrative agent for the syndicated facilities. CFC uses its best efforts to syndicate the loan requirements of certain borrowers. The success of such efforts depends on the financial position and credit quality of the borrower as well as market conditions.

NCSC Loan Programs

Long-Term Loans

NCSC’s long-term loans generally have the following characteristics:

terms of up to 35 years on a senior secured or unsecured basis;
amortizing, bullet maturity or serial payment structures;
the property, plant and equipment financed by and securing the long-term loan has a useful life equal to or in excess of the loan maturity;
flexibility for the borrower to select a fixed interest rate for periods of one to 35 years or a variable interest rate; and
the ability for the borrower to select various tranches with either a fixed or variable interest rate for each tranche.

NCSC allows borrowers to select a fixed interest rate or a variable interest rate at the time of each advance on long-term loan facilities. When selecting a fixed rate, the borrower has the option to choose a fixed rate for a term of one year through the final maturity of the loan. When the selected fixed interest rate term expires, the borrower may select another fixed rate for a term of one year through the remaining loan maturity or the current variable rate. The fixed rate on a loan generally is determined on the day the loan is advanced or repriced based on the term selected. The variable rate is set on the first day of each month.

Line of Credit Loans

NCSC also provides revolving line of credit loans to assist borrowers with liquidity and cash management on terms similar to those provided by CFC as described herein.

RTFC Loan Programs

Loans to rural local exchange carriers or holding companies of rural local exchange carriers represented 95% and 97% of RTFC’s total outstanding loans as of May 31, 2018 and 2017, respectively. Most of these rural telecommunications companies have diversified their operations and also provide broadband services.

Long-Term Loans

RTFC makes long-term loans to rural telecommunications systems for debt refinancing, construction or upgrades of infrastructure, acquisitions and other corporate purposes.

RTFC’s long-term loans generally have the following characteristics:

terms not exceeding 10 years on a senior secured basis;
amortizing or bullet maturity payment structures;
the property, plant and equipment financed by and securing the long-term loan has a useful life equal to or in excess of the loan maturity;
flexibility for the borrower to select a fixed interest rate for periods from one year to the final loan maturity or a variable interest rate; and
the ability for the borrower to select various tranches with either a fixed or variable interest rate for each tranche.

When a selected fixed interest rate term expires, generally the borrower may select another fixed-rate term or the current variable rate. The fixed rate on a loan is generally determined on the day the loan is advanced or converted to a fixed rate based on the term selected. The variable rate is set on the first day of each month.


4



To borrow from RTFC, a rural telecommunication system generally must be able to demonstrate the ability to achieve and maintain an annual debt service coverage ratio of 1.25. RTFC may make long-term loans to rural telecommunication systems, on a case-by-case basis, that do not meet this general criterion.

Line of Credit Loans

Line of credit loans are generally unsecured. Line of credit loans are designed primarily to assist borrowers with liquidity and cash management and generally are advanced at variable interest rates. Line of credit loans are typically revolving facilities and generally require the borrower to pay off the principal balance for at least five consecutive business days at least once during each 12-month period. Line of credit loans also are made available as interim financing, or bridge loans, when a borrower either receives RUS approval to obtain a loan and is awaiting its initial advance of funds or submits a loan application that is pending approval from RUS. RUS loan advances, when received, must be used to repay these bridge loans.

Loan Features and Options

Interest Rates

As a member-owned cooperative finance organization, we are a cost-based lender. As such, our interest rates are set based on a yield that we believe will generate a reasonable level of earnings to cover our cost of funding, general and administrative expenses and loan loss provision. Various standardized discounts may reduce the stated interest rates for borrowers meeting certain criteria related to performance, volume, collateral and equity requirements.

Conversion Option

Generally, a borrower may convert a long-term loan from a variable interest rate to a fixed interest rate at any time without a fee and convert a long-term loan from a fixed rate to another fixed rate or to a variable rate at any time based on current loan policies.

Prepayment Option

Generally, borrowers may prepay long-term fixed-rate loans at any time, subject to payment of an administrative fee and a make-whole premium, and prepay long-term variable-rate loans at any time, subject to payment of an administrative fee. Line of credit loans may be prepaid at any time without a fee.

Loan Security

Long-term loans made by CFC typically are senior secured on parity with other secured lenders (primarily RUS), if any, by all assets and revenue of the borrower, subject to standard liens typical in utility mortgages such as those related to taxes, worker’s compensation awards, mechanics’ and similar liens, rights-of-way and governmental rights. We are able to obtain liens on parity with liens for the benefit of RUS because RUS’ form of mortgage expressly provides for other lenders such as CFC to have a parity lien position if the borrower satisfies certain conditions or obtains a written lien accommodation from RUS. When we make loans to borrowers that have existing loans from RUS, we generally require those borrowers to either obtain such a lien accommodation or satisfy the conditions necessary for our loan to be secured on parity under the mortgage with the loan from RUS. As noted above, CFC line of credit loans generally are unsecured.

We provide additional information on our loan programs in “Item 7. MD&A—Consolidated Balance Sheet Analysis,” “MD&A—Off-Balance Sheet Arrangements” and “MD&A—Credit Risk.”

5



GUARANTEE PROGRAMS

When we guarantee our members’ debt obligations, we use the same credit policies and monitoring procedures for guarantees as for loans. If a member system defaults in its obligation to pay debt service, then we are obligated to pay any required amounts under our guarantees. Meeting our guarantee obligations satisfies the underlying obligation of our member systems and prevents the exercise of remedies by the guarantee beneficiary based upon a payment default by a member system. The member system is required to repay any amount advanced by us with interest pursuant to the documents evidencing the member system’s reimbursement obligation. We were not required to perform pursuant to any of our guarantee obligations during the year ended May 31, 2018.

Guarantees of Long-Term Tax-Exempt Bonds

We guarantee debt issued for our members’ construction or acquisition of pollution control, solid waste disposal, industrial development and electric distribution facilities. Governmental authorities issue such debt on a nonrecourse basis 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.

If a system defaults for failure to make the debt payments and any available debt service reserve funds have been exhausted, we are obligated to pay scheduled debt service under our guarantee. Such payment will prevent the occurrence of an event of payment default that would otherwise permit acceleration of the bond issue. The system is required to repay any amount that we advance pursuant to our guarantee plus interest on that advance. This repayment obligation, together with the interest thereon, is typically senior secured on parity with other lenders (including, in most cases, RUS), by a lien on substantially all of the system’s assets. If the security instrument is a common mortgage with RUS, then in general, we may not exercise remedies for up to two years following default. However, if the debt is accelerated under the common mortgage because of a determination that the related interest is not tax-exempt, the system’s obligation to reimburse us for any guarantee payments will be treated as a long-term loan. The system is required to pay us initial and/or ongoing guarantee fees in connection with these transactions.

Certain guaranteed long-term debt bears interest at variable rates that are adjusted at intervals of one to 270 days including weekly, every five weeks or semi-annually to a level favorable to their resale or auction at par. If funding sources are available, the member that issued the debt may choose a fixed interest rate on the debt. When the variable rate is reset, holders of variable-rate debt have the right to tender the debt for purchase at par. In some transactions, we have committed to purchase this debt as liquidity provider if it cannot otherwise be re-marketed. If we hold the securities, the member cooperative pays us the interest earned on the bonds or interest calculated based on our short-term variable interest rate, whichever is greater. The system is required to pay us stand-by liquidity fees in connection with these transactions.

Letters of Credit

In exchange for a fee, we issue irrevocable letters of credit to support members’ obligations to energy marketers, other third parties and to the USDA Rural Business and Cooperative Development Service. Each letter of credit 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 us within one year from the date of the draw, with interest accruing from the draw date at our line of credit variable interest rate.

The Federal Communications Commission (“FCC”) has designated CFC as an acceptable source for letters of credit in support of FCC programs that encourage deployment of high-speed broadband services throughout rural America. The designation allows CFC to provide credit support for rural electric and telecommunication cooperatives that participate in programs designed to increase deployment of broadband services to underserved rural areas.

Other Guarantees

We may provide other guarantees as requested by our members. Other guarantees are generally unsecured with guarantee fees payable to us.


6



We provide additional information on our guarantee programs and outstanding guarantee amounts as of May 31, 2018 and 2017 in “Item 7. MD&A—Off-Balance Sheet Arrangements,” “Item 7. MD&A—Credit Risk—Loan and Guarantee Portfolio Credit Risk” and “Note 12—Guarantees.”
INVESTMENT POLICY

We invest funds in accordance with policies adopted by our board of directors. Pursuant to our current investment policy, an Investment Management Committee was established to oversee and administer our investments with the objective of seeking returns consistent with the preservation of principal and maintenance of adequate liquidity. The Investment Management Committee may direct funds to be invested in: direct obligations of, or obligations guaranteed by, the United States or agencies thereof and investments in government-sponsored enterprises, certain financial institutions in the form of overnight investment products and Eurodollar deposits, bankers’ acceptances, certificates of deposit, working capital acceptances or other deposits. Other permitted investments include highly rated obligations, such as commercial paper, certain obligations of foreign governments, municipal securities, asset backed securities, mortgage-backed securities and certain corporate bonds. In addition, we may invest in overnight or term repurchase agreements. All of these investments are subject to requirements, and limitations set forth in our investment policy.
INDUSTRY

Overview

Since the enactment of the Rural Electrification Act in 1936, RUS has financed the construction of electric generating plants, transmission facilities and distribution systems to provide electricity to rural areas. Today, with CFC membership comprised, in part, of rural electric utility systems in 49 states and three 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.

RUS makes loan guarantees and provides other forms of financial assistance to rural electric system borrowers. Under the Rural Electrification Act, RUS is authorized to make direct loans to systems that qualify for the hardship program (5% interest rate), the municipal rate program (based on a municipal government obligation index) and a Treasury rate program (at Treasury plus 0.125%). RUS also is authorized to guarantee loans that bear interest at a rate agreed upon by the borrower and the lender (which generally has been the Federal Financing Bank). RUS exercises oversight of borrowers’ operations. Its loans and guarantees are secured by a mortgage or indenture on substantially all of the system’s assets and revenue.

Leading up to CFC’s formation in 1969, there was a growing need for capital for electric cooperatives to build new electric facilities due to growth in rural America. The electric cooperatives formed CFC so a source of financing would be available to them to supplement the RUS loan programs and to mitigate uncertainty related to government funding.

CFC aggregates the combined strength of its rural electric member cooperatives to access the public capital markets and other funding sources. CFC works cooperatively with RUS; however, CFC is not a federal agency or a government-sponsored enterprise. Our members are not required to have outstanding loans from RUS as a condition of borrowing from CFC. CFC meets the financial needs of its rural members by:

providing bridge loans required by borrowers in anticipation of receiving RUS funding;
providing financial products not otherwise available from RUS including lines of credit, letters of credit, guarantees on tax-exempt financing, weather-related disaster recovery lines of credit, unsecured loans and investment products such as commercial paper, member capital securities, select notes and medium-term notes;
meeting the financing needs of those rural electric systems that repay or prepay their RUS loans and replace the government loans with private capital; and
providing financing to RUS-eligible rural electric systems for infrastructure; including for those facilities that are not eligible for financing from RUS.


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Many electric cooperatives are making investments in fiber to support core electric plant communications. Some of these electric cooperatives are leveraging these fiber assets to offer broadband services, either directly or through partnering with local telecommunication companies and others.

Electric Member Operating Environment

In general, electric cooperatives have not been significantly impacted by the effects of retail deregulation. There were 19 states that had adopted programs that allow consumers to choose their supplier of electricity as of May 31, 2018. Depending on the state, the choices can range from being limited to commercial and industrial consumers to “retail choice” for all consumers. In most states, cooperatives have been exempted from or have been allowed to opt out of the regulations allowing for competition. In states offering retail competition, it is important to note that while consumers may be able to choose their energy supplier, the electric utility still receives compensation for the necessary service of delivering electricity to consumers through its utility transmission and distribution plant. 

The electric industry is facing a potential decrease to kilowatt-hour sales due to technology advances that increase energy efficiency of all appliances and devices used in the home and in businesses as well as from distributed generation in the form of rooftop solar and home generators (“behind-the-meter generation”). Electric cooperatives are facing the same issues, but in general to a lesser extent than investor-owned power systems. Electric cooperatives have options available to mitigate the impact of such issues, such as rate structures to ensure that costs are appropriately recovered for grid and other necessary ancillary services. To date, we have not seen negative impacts in the electric cooperative financial results due to behind-the-meter generation.

Regulatory Oversight

There are 11 states in which some or all electric cooperatives are subject to state regulatory oversight of their rates and tariffs (terms and conditions) by state utility commissions. Those states are Arizona, Arkansas, Hawaii, Kentucky, Louisiana, Maine, Maryland, New Mexico, Vermont, Virginia and West Virginia.

Regulatory jurisdiction by state commissions generally includes rate and tariff regulation, the issuance of securities and the enforcement of service territory as provided for by state law.

Parts II and III of the Federal Power Act (“FPA”) provide the Federal Energy Regulatory Commission (“FERC”) with regulatory authority over three aspects of electric power:

the transmission of electric energy in interstate commerce;
the sale of electric energy at wholesale in interstate commerce; and
the approval and enforcement of reliability standards affecting all users, owners and operators of the bulk power system.

The FERC also regulates the issuance of securities by public utilities under the FPA provided the state commission does not.

Our distribution and power supply members are subject to regulation by various federal, regional, state and local authorities with respect to the environmental effects of their operations. At the federal level, the U.S. Environmental Protection Agency (“EPA”) from time to time proposes rulemakings that could force the electric utility industry to incur capital costs to comply with potential new regulations and possibly retire coal-fired generating capacity. Since there are only 11 states in which some or all electric cooperatives are subject to state regulatory oversight of their rates and tariffs, in most cases any associated costs of compliance can be passed on to cooperative consumers without additional regulatory approval. One EPA rulemaking is the Clean Power Plan (“CPP”). Falling under Section 111(d) of the federal Clean Air Act, the CPP is designed to cut carbon emissions (from 2005 levels) from existing fossil fuel-fired power plants by 32% by 2030. The CPP is presently under legal review by United States Court of Appeals for the District of Columbia Circuit and the United States Supreme Court has stayed the rule pending disposition of this appeal. On October 16, 2017, the EPA officially proposed to repeal the CPP. In a future regulatory action, the EPA is expected to replace the CPP with a more narrowly focused rule.

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LENDING COMPETITION

RUS is the largest lender to electric cooperatives. RUS provides long-term secured loans. CFC provides financial products and services, primarily in the form of long-term secured and short-term unsecured loans, to its electric cooperative members to supplement RUS financing, to provide loans to members that have elected not to borrow from RUS, and to bridge long-term financing provided by RUS.

CFC’s primary competitor is CoBank, ACB, a federally chartered instrumentality of the United States that is a member of the Farm Credit System. CFC also competes with banks, other financial institutions and the capital markets to provide loans and other financial products to our members. As a result, we are competing with the customer service, pricing and funding options our members are able to obtain from these sources. We attempt to minimize the effect of competition by offering a variety of loan options and value-added services and by leveraging the working relationships developed with the majority of our members over the past 49 years. Further, on an annual basis, we allocate substantially all net earnings to members (i) in the form of patronage capital, which reduces our members’ effective cost of borrowing, and (ii) through the members’ capital reserve. The value-added services that we provide include, but are not limited to, benchmarking tools, financial models, publications and various conferences, meetings and training workshops.

In order to meet other financing needs of our members, we offer options that include credit support in the form of letters of credit and guarantees, loan syndications and loan participations. Our credit products are tailored to meet the specific needs of each member cooperative, and we often offer specific transaction structures that our competitors do not provide. CFC also offers certain risk mitigation products and interest rate discounts on secured, long-term loans for its members that meet certain criteria, including performance, volume, collateral and equity requirements.

CFC has established certain funds to benefit its members. Since 1981, CFC has set aside a portion of its annual net earnings in a cooperative educational fund to promote awareness and appreciation of the cooperative principles. As directed by the CFC Board of Directors, a portion of the contributions to the fund are distributed through the electric cooperative statewide associations. Since 1986, CFC has supported its members’ efforts to protect their service territories from erosion or takeover by other utilities through assistance from the Cooperative System Integrity Fund, which is funded through voluntary contributions from members. Amounts from the Integrity Fund are distributed to applicants who establish that: (i) all or a significant portion of their consumers, services or facilities face a hostile threat of acquisition or annexation by a competing entity; (ii) face a significant threat in their ability to continue to provide non-electric energy services to customers; or (iii) are facing regulatory, judicial or legislative challenges that threaten their existence under the cooperative business model.

Our rural electric borrowers are mostly private companies; thus, the overall size of the rural electric lending market cannot be determined from public information. We estimate the size of the overall rural electric lending market from the annual financial and statistical reports filed with us by our members using calendar year data; however, there are certain limitations with regard to these estimates, including the following:

while the underlying data included in the financial and statistical reports may be audited, the preparation of the financial and statistical reports is not audited;
in some cases, not all members provide the annual financial and statistical reports on a timely basis to be included in summarized results; and
the financial and statistical reports do not include comprehensive data on indebtedness by lenders other than RUS.

The following table displays long-term debt outstanding to CFC, RUS and other lenders in the electric cooperative industry as of December 31, 2017 and 2016, based on financial data reported to us by our electric utility cooperative members. The data as of December 31, 2017 was provided by 812 distribution systems and 58 power supply systems, while the data as of December 31, 2016 was provided by 807 electric cooperative distribution systems and 58 power supply systems.

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December 31,
 
 
2017
 
2016
(Dollars in thousands)
 
Debt
Outstanding
 
% of Total
 
Debt
Outstanding
 
% of Total
Total long-term debt reported by members:(1)
 
 
 
 
 
 
 
 
Distribution
 
$
48,147,703

 
 
 
$
47,362,415

 
 
Power supply
 
47,862,984

 
 
 
47,853,905

 
 
Less: Long-term debt funded by RUS
 
(39,180,420
)
 
 
 
(39,273,545
)
 
 
Members’ non-RUS long-term debt
 
$
56,830,267

 
 
 
$
55,942,775

 
 
 
 
 
 
 
 
 
 
 
Funding source of members’ long-term debt:
 
 
 
 
 
 
 
 
Long-term debt funded by CFC
 
$
22,671,264

 
40
%
 
$
22,083,606

 
39
%
Long-term debt funded by other lenders
 
34,159,003

 
60

 
33,859,169

 
61

Members’ non-RUS long-term debt
 
$
56,830,267

 
100
%
 
$
55,942,775

 
100
%
____________________________ 
(1) Reported amounts are based on member-provided information, which may not have been subject to audit by an independent accounting firm.

Members’ long-term debt funded by CFC, by type, as of December 31, 2017 and 2016 is summarized further below.
 
 
December 31,
 
 
2017
 
2016
(Dollars in thousands)
 
Debt
Outstanding
 
% of Total
 
Debt
Outstanding
 
% of Total
Distribution
 
$
18,489,086

 
82
%
 
$
17,825,633

 
81
%
Power supply
 
4,182,178

 
18

 
4,257,973

 
19

Long-term debt funded by CFC
 
$
22,671,264

 
100
%
 
$
22,083,606

 
100
%

We are not able to specifically identify the amount of debt our members have outstanding to CoBank, ACB, from either the annual financial and statistical reports our members file with us or from CoBank, ACB’s public disclosure; however, we believe CoBank, ACB, is the additional lender, along with CFC and RUS, with significant long-term debt outstanding to rural electric cooperatives.
REGULATION

General
CFC, NCSC and RTFC are not subject to direct federal regulatory oversight or supervision with regard to lending. CFC, NCSC and RTFC are subject to state and local jurisdiction commercial lending and tax laws that pertain to business conducted in each state, including but not limited to lending laws, usury laws and laws governing mortgages. These state and local laws regulate the manner in which we make loans and conduct other types of transactions. The statutes, regulations and policies to which the companies are subject may change at any time. In addition, the interpretation and application by regulators of the laws and regulations to which we are subject may change from time to time. Certain of our contractual arrangements, such as those pertaining to funding obtained through the Guaranteed Underwriter Program, provide for the Federal Financing Bank and RUS to periodically review and assess CFC’s compliance with program terms and conditions.

Derivatives Regulation

CFC engages in over-the-counter derivative transactions to manage interest rate risk. As an end user of derivative financial instruments, CFC is subject to regulations that apply to derivatives generally. The Dodd-Frank Act (“DFA”), enacted July 2010, resulted in, among other things, comprehensive regulation of the over-the-counter (“OTC”) derivatives market. The DFA provides for an extensive framework for the regulation of OTC derivatives, including mandatory clearing, exchange

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trading and transaction reporting of certain OTC derivatives. In August 2013, the U.S. Commodities Futures Trading Commission (“CFTC”) issued a final rule “Clearing Exemption for Certain Swaps Entered into by Cooperatives,” which created an exemption from mandatory clearing for cooperatives. In April 2016, the CFTC issued a final rule “Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants,” which includes an exemption from margin requirements for uncleared swaps for cooperatives that are financial end users. CFC is an exempt cooperative end user of derivative financial instruments and does not participate in the derivatives markets for speculative, trading or investing purposes and does not make a market in derivatives.
MEMBERS

Our consolidated membership, after taking into consideration entities that are members of both CFC and NCSC and eliminating memberships between CFC, NCSC and RTFC, totaled 1,449 members and 216 associates as of May 31, 2018.

CFC

CFC’s bylaws provide that cooperative or nonprofit corporations, public corporations, utility districts and other public bodies that received or are eligible to receive a loan or commitment for a loan from RUS or any successor agency (as well as subsidiaries, federations or statewide and regional associations that are wholly owned or controlled by such entities) are eligible for membership. One of the criteria for eligibility for RUS financing is a “rural area” test. CFC relies on the definition of “rural” as specified in the Rural Electrification Act, as amended. “Rural” is defined in the Rural Electrification Act as any area other than a city, town or unincorporated area that has a population of less than 20,000, or any area within the service area of a borrower who, at the date of enactment of the Food, Conservation and Energy Act of 2008, had an outstanding RUS electric loan. The definition of “rural” under the act permits an area to be defined as “rural” regardless of the development of such area subsequent to the approval of the outstanding loan. Thus, those entities that received or qualify for financing from RUS are eligible to apply for membership, upon approval of membership by the CFC Board of Directors, and subsequently to borrow from CFC regardless of whether there is an outstanding loan with RUS. There are no requirements to maintain membership, although the board has the authority to suspend a member under certain circumstances. CFC has not suspended a member to date.

CFC has the following types of members, all of which are not-for-profit entities or subsidiaries or affiliates of not-for-profit entities.

Class A – Distribution Systems

Cooperative or nonprofit corporations, public corporations, utility districts and other public bodies, which received or are eligible to receive a loan or commitment for a loan from RUS or any successor agency, and that are engaged or planning to engage in furnishing utility services to their members and patrons for their use as ultimate consumers. The majority of our distribution system members are consumer-owned electric cooperatives.

Distribution systems are utilities engaged in retail sales of electricity to residential and commercial consumers in their defined service areas. Such sales are generally on an exclusive basis using the distribution system’s infrastructure, including substations, wires and related support systems. Distribution systems vary in size from small systems that serve a few thousand customers to large systems that serve more than 200,000 customers. Thus, the amount of loan funding required by different distribution systems varies significantly. Distribution systems may serve customers in more than one state.

Most distribution systems have long-term power purchase contracts with their power supply systems, which are owned and controlled by the member distribution systems. Wholesale power for resale also comes from other sources, including power supply contracts with government agencies, investor-owned utilities and other entities, and, in some cases, the distribution systems own generating facilities.

Class B – Power Supply Systems

Cooperative or nonprofit corporations that are federations of Class A members or of other Class B members, or both, or that are owned and controlled by Class A members or by other Class B members, or both, and that are engaged or planning to

11



engage in furnishing utility services primarily to Class A members or other Class B members. Our power supply system members are member-owned electric cooperatives.

The power supply systems vary in size from one with thousands of megawatts of power generation capacity to systems that have no generating capacity, which generally operate transmission lines to supply certain distribution systems or manage power supply purchase arrangements for the benefit of their distribution system members. Thus, the amount of loan funding required by different power supply systems varies significantly. Power supply members may serve distribution systems located in more than one state.

The wholesale power supply contracts with their distribution system members permit the power supply system, subject to regulatory approval in certain instances, to establish rates to produce revenue sufficient to cover debt service, to meet the cost of operation and maintenance of all power supply systems and related facilities and to pay the cost of any power and energy purchased for resale.

Class C – Statewide and Regional Associations

Statewide and regional associations that are wholly owned or controlled by Class A members or Class B members, or both, or that are wholly owned subsidiaries of a CFC member, and that do not furnish utility services but supply other forms of service to their members. Certain states have an organization that represents and serves the distribution systems and power supply systems located in the state. Such statewide organizations provide training and legislative, regulatory, media and related services.

Class D – National Associations of Cooperatives

National associations of cooperatives that are Class A, Class B and Class C members, provided said national associations have, at the time of admission to membership in CFC, members domiciled in at least 80% of the states in the United States. National Rural Electric Cooperative Association (“NRECA”) is our sole Class D member. NRECA provides training, sponsors regional and national meetings, and provides legislative, regulatory, media and related services for nearly all rural electric cooperatives.

CFC Class A, B, C and D members are eligible to vote on matters put to a vote of the membership. Associates are not eligible to vote on matters put to a vote of the membership.

CFC’s membership as of May 31, 2018 consisted of:

841 Class A distribution systems;
67 Class B power supply systems;
64 Class C statewide and regional associations, including NCSC; and
1 Class D national association of cooperatives.

In addition, CFC has associates that are nonprofit groups or entities organized on a cooperative basis that are owned, controlled or operated by Class A, B, C or D members and are engaged in or plan to engage in furnishing non-electric services primarily for the benefit of the ultimate consumers of CFC members. CFC had 47 associates, including RTFC, as of May 31, 2018.

NCSC

Membership in NCSC includes organizations that are Class A, B or C members of CFC, or eligible for such membership and are approved for membership by the NCSC Board of Directors.

NCSC’s membership consisted of 440 distribution systems, two power supply systems and five statewide associations as of May 31, 2018. All of NCSC’s members also were CFC members. CFC, however, is not a member of NCSC. In addition to members, NCSC had 165 associates as of May 31, 2018. NCSC’s associates may include members of CFC, entities eligible to be members of CFC and for-profit and not-for-profit entities that are owned, controlled or operated by or provide significant benefit to Class A, B and C members of CFC.



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RTFC

Membership in RTFC is limited to cooperative corporations, private corporations, public corporations, nonprofit corporations, utility districts and other public bodies that are approved by the RTFC Board of Directors and are actively borrowing or are eligible to borrow from RUS’s traditional infrastructure loan program. These companies must be engaged directly or indirectly in furnishing telephone services as the licensed incumbent carrier. Holding companies, subsidiaries and other organizations that are owned, controlled or operated by members are referred to as affiliates, and are eligible to borrow from RTFC. Associates are organizations that provide non-telecommunications services to rural telecommunications companies that are approved by the RTFC Board of Directors. Neither affiliates nor associates are eligible to vote at meetings of the members.

RTFC’s membership consisted of 477 members as of May 31, 2018. RTFC also had five associates as of May 31, 2018. CFC is not a member of RTFC.

The business affairs of CFC, NCSC and RTFC are governed by separate boards of directors for each entity. We provide additional information on CFC’s corporate governance in “Item 10. Directors, Executive Officers and Corporate Governance.”
TAX STATUS

In 1969, CFC obtained a ruling from the Internal Revenue Service recognizing CFC’s exemption from the payment of federal income taxes as an organization described under Section 501(c)(4) of the Internal Revenue Code. In order for CFC to maintain its exemption under Section 501(c)(4) of the Internal Revenue Code, CFC must be “not organized for profit” and must be “operated exclusively for the promotion of social welfare” within the meaning of that section of the tax code. The Internal Revenue Service determined that CFC is an organization that is “operated exclusively for the promotion of social welfare” because the ultimate beneficiaries of its lending activities, like those of the RUS loan program, are the consumers of electricity produced by rural electric systems, the communities served by these systems and the nation as a whole.

As an organization described under Section 501(c)(4) of the Internal Revenue Code, no part of CFC’s net earnings can inure to the benefit of any private shareholder or individual. This requirement is referred to as the private inurement prohibition and was added to Section 501(c)(4) of the Internal Revenue Code in 1996. A legislative exception allows organizations like CFC to continue to make allocations of net earnings to members in accordance with its cooperative status.

CFC believes its operations have not changed materially from those described to the Internal Revenue Service in its exemption filing. CFC reviews the impact on operations of any new activity or potential change in product offerings or business in general to determine whether such change in activity or operations would be inconsistent with its status as an organization described under Section 501(c)(4).

NCSC is a taxable cooperative that pays income tax based on its taxable income and deductions.

RTFC is a taxable cooperative under Subchapter T of the Internal Revenue Code and is not subject to income taxes on income from patronage sources that is allocated to its borrowers, as long as the allocation is properly noticed and at least 20% of the amount allocated is retired in cash prior to filing the applicable tax return. RTFC pays income tax based on its taxable income and deductions, excluding amounts allocated to its borrowers.
ALLOCATION AND RETIREMENT OF PATRONAGE CAPITAL

District of Columbia cooperative law requires cooperatives to allocate net earnings to patrons, to a general reserve in an amount sufficient to maintain a balance of at least 50% of paid-up capital and to a cooperative educational fund, as well as permits additional allocations to board-approved reserves. District of Columbia cooperative law also requires that a cooperative’s net earnings be allocated to all patrons in proportion to their individual patronage and each patron’s allocation be distributed to the patron unless the patron agrees that the cooperative may retain its share as additional capital.


13



CFC

Annually, the CFC Board of Directors allocates its net earnings to its patrons in the form of patronage capital, to a cooperative educational fund, to a general reserve, if necessary, and to other board-approved reserves. Net earnings are calculated by adjusting net income to exclude the noncash effects of the accounting for derivative financial instruments. Net losses, if any, are not allocated to board approved reserves or members and do not affect amounts previously allocated as patronage capital or to the reserves. Net earnings are first applied against prior-period losses, if any, before an allocation of patronage capital is made. CFC has never experienced an adjusted net loss.

An allocation to the general reserve is made, if necessary, to maintain the balance of the general reserve at 50% of the membership fees collected. CFC’s bylaws require the allocation to the cooperative educational fund to be at least 0.25% of its net earnings. Funds from the cooperative educational fund are disbursed annually to statewide cooperative organizations to fund the teaching of cooperative principles and for other cooperative education programs.

Currently, CFC has one additional board-approved reserve, the members’ capital reserve. The CFC Board of Directors determines the amount of net earnings that is allocated to the members’ capital reserve, if any. The members’ capital reserve represents net earnings that CFC holds to increase equity retention. The net earnings held in the members’ capital reserve have not been specifically allocated to members, but may be allocated to individual members in the future as patronage capital if authorized by the CFC Board of Directors.
 
All remaining net earnings are allocated to CFC’s members in the form of patronage capital. The amount of net earnings allocated to each member is based on the member’s patronage of CFC’s lending programs during the year. No interest is earned by members on allocated patronage capital. There is no effect on CFC’s total equity as a result of allocating net earnings to members in the form of patronage capital or to board-approved reserves. The CFC Board of Directors has voted annually on whether or not to retire a portion of the patronage capital allocation. Upon retirement, patronage capital is paid out in cash to the members to which it was allocated. CFC’s total equity is reduced by the amount of patronage capital retired to its members and by amounts disbursed from board-approved reserves.
 
Pursuant to CFC’s bylaws, the CFC Board of Directors determines the method, basis, priority and order of retirement of amounts allocated. The current policy of the CFC Board of Directors is to retire 50% of the prior fiscal year’s allocated net earnings following the end of each fiscal year and to hold the remaining 50% for 25 years to fund operations. The amount and timing of future retirements remains subject to annual approval by the CFC Board of Directors, and may be affected by CFC’s financial condition and other factors. The CFC Board of Directors has the authority to change the current practice for allocating and retiring net earnings at any time, subject to applicable cooperative law.

NCSC

In accordance with District of Columbia cooperative law and its bylaws and board policies, NCSC allocates its net earnings to a cooperative educational fund, to a general reserve, if necessary, and to other board-approved reserves. Net earnings are calculated by adjusting net income to exclude the noncash effects of the accounting for derivative financial instruments. Net losses, if any, are not allocated to board-approved reserves and do not affect amounts previously allocated to the reserves.

Pursuant to NCSC’s bylaws, the NCSC Board of Directors shall determine the method, basis, priority and order of amounts allocated. An allocation to the general reserve is made, if necessary, to maintain the balance of the general reserve at 50% of the membership fees collected. There is no effect on NCSC's total equity due to the allocation of net earnings to board-approved reserves. NCSC’s bylaws require the allocation to the cooperative educational fund to be at least 0.25% of its net earnings. Funds from the cooperative educational fund are disbursed annually to fund the teaching of cooperative principles and for other cooperative education programs.

RTFC

In accordance with District of Columbia cooperative law and its bylaws and board policies, RTFC allocates its net earnings to its patrons, a cooperative educational fund and a general reserve, if necessary. Net losses are not allocated to members and do not affect amounts previously allocated as patronage capital or to the reserves. Current period earnings are first applied against any prior year losses before allocating patronage capital.

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Pursuant to RTFC’s bylaws, the RTFC Board of Directors shall determine the method, basis, priority and order of retirement of amounts allocated. RTFC’s bylaws require that it allocate at least 1% of net earnings to a cooperative educational fund. Funds from the cooperative educational fund are disbursed annually to fund the teaching of cooperative principles and for other cooperative education programs. An allocation to the general reserve is made, if necessary, to maintain the balance of the general reserve at 50% of the membership fees collected. The remainder is allocated to borrowers in proportion to their patronage. RTFC provides notice to its members of the amount allocated and retires 20% of the allocation for that year in cash prior to the filing of the applicable tax return. Any additional amounts are retired as determined by the RTFC Board of Directors with due regard for RTFC’s financial condition. There is no effect on RTFC's total equity due to the allocation of net earnings to members or board-approved reserves. The retirement of amounts previously allocated to members or amounts disbursed from board-approved reserves reduces RTFC's total equity.
EMPLOYEES

We had 254 employees as of May 31, 2018. We believe that our relations with our employees are good.
AVAILABLE INFORMATION

Our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and any amendments to these reports, are available for free at www.nrucfc.coop as soon as reasonably practicable after they are electronically filed with or furnished to the U.S. Securities and Exchange Commission (“SEC”). These reports also are available for free on the SEC’s website at www.sec.gov. Information posted on our website is not incorporated by reference into this Form 10-K.

Item 1A.
Risk Factors

Our financial condition, results of operations and liquidity are subject to various risks and uncertainties inherent in our business. If any of the events or circumstances described in the following risks actually occur, our business, liquidity, financial condition or results of operations could be adversely affected. The risks described below are the risks we consider to be material to our business. Other risks and uncertainties, including those not currently known to us, could also negatively impact our business, results of operations and financial condition. You should consider the following risks together with all of the other information in this Annual Report on Form 10-K.
RISK FACTORS

If we are unable to access the capital markets or other external sources for funding, our liquidity position may be negatively affected and we may not have sufficient funds to meet all of our financial obligations as they become due.
We depend on access to the capital markets and other sources of financing, such as our bank revolving credit agreements, investments from our members, private debt issuances through Farmer Mac and through the Guaranteed Underwriter Program, to fund new loan advances and refinance our long- and short-term debt and, if necessary, to fulfill our obligations under our guarantee and repurchase agreements. Market disruptions, downgrades to our long-term and/or short-term debt ratings, adverse changes in our business or performance, downturns in the electric industry and other events over which we have no control may deny or limit our access to the capital markets and/or subject us to higher costs for such funding. Our access to other sources of funding also could be limited by the same factors, by adverse changes in the business or performance of our members, by the banks committed to our revolving credit agreements or Farmer Mac, or by changes in federal law or the Guaranteed Underwriter Program. Our funding needs are determined primarily by scheduled short- and long-term debt maturities and the amount of our loan advances to our borrowers relative to the scheduled payment amortization of loans previously made by us. If we are unable to timely issue debt into the capital markets or obtain funding from other sources, we may not have the funds to meet all of our obligations as they become due.

A reduction in the credit ratings for our debt could adversely affect our liquidity and/or cost of debt.
Our credit ratings are important to maintaining our liquidity position. We currently contract with three nationally recognized statistical rating organizations to receive ratings for our secured and unsecured debt and our commercial paper. In order to access the commercial paper markets at current levels, we believe that we need to maintain our current ratings for commercial paper of P1 from Moody’s Investors Service (“Moody’s”), A-1 from S&P Global Inc. (“S&P”) and F-1 from

15



Fitch Ratings Inc. (“Fitch”). Changes in rating agencies’ rating methodology, actions by governmental entities or others, losses from impaired loans and other factors could adversely affect the credit ratings on our debt. A reduction in our credit ratings could adversely affect our liquidity and competitive position, increase our borrowing costs or limit our access to the capital markets and the sources of financing available to us. A significant increase in our cost of borrowings and interest expense could cause us to sustain losses or impair our liquidity by requiring us to seek other sources of financing, which may be difficult to obtain.

Our ability to maintain compliance with the covenants related to our revolving credit agreements, collateral trust bond and medium-term note indentures and debt agreements could affect our ability to retire patronage capital, result in the acceleration of the repayment of certain debt obligations, adversely impact our credit ratings and hinder our ability to obtain financing.
We must maintain compliance with all covenants and conditions related to our revolving credit agreements and debt indentures. We are required to maintain a minimum average adjusted times interest earned ratio (“adjusted TIER”) for the six most recent fiscal quarters of 1.025 and an adjusted leverage ratio of no more than 10-to-1. In addition, we must maintain loans pledged as collateral for various debt issuances at or below 150% of the related secured debt outstanding as a condition to borrowing under our revolving credit agreements. If we were unable to borrow under the revolving credit agreements, our short-term debt ratings would likely decline, and our ability to issue commercial paper could become significantly impaired. Our revolving credit agreements also require that we earn a minimum annual adjusted TIER of 1.05 in order to retire patronage capital to members. See “MD&A—Non-GAAP Financial Measures” for additional information on our adjusted measures and a reconciliation to the most comparable GAAP measures.

Pursuant to our collateral trust bond indentures, we are required to maintain eligible pledged collateral at least equal to 100% of the principal amount of the bonds issued under the indenture. Pursuant to one of our collateral trust bond indentures and our medium-term note indenture, we are required to limit senior indebtedness to 20 times the sum of our members’ equity, subordinated deferrable debt and members’ subordinated certificates. If we were in default under our collateral trust bond or medium-term note indentures, the existing holders of these securities have the right to accelerate the repayment of the full amount of the outstanding debt principal of the security before the stated maturity of such debt. That acceleration of debt repayments poses a significant liquidity risk, as we might not have enough cash or committed credit available to repay the debt. In addition, if we are not in compliance with the collateral trust bond and medium-term note covenants, we would be unable to issue new debt securities under such indentures. If we were unable to issue new collateral trust bonds and medium-term notes, our ability to fund new loan advances and refinance maturing debt would be impaired.

We are required to pledge eligible distribution system or power supply system loans as collateral equal to at least 100% of the outstanding balance of debt issued under a revolving note purchase agreement with Farmer Mac. We also are required to pledge distribution or power supply loans as collateral equal to at least 100% of the outstanding balance of debt under the Guaranteed Underwriter Program. Collateral coverage less than 100% for either of these debt programs constitutes an event of default, which if not cured within 30 days, could result in creditors accelerating the repayment of the outstanding debt principal before the stated maturity. An acceleration of the repayment of debt could pose a liquidity risk if we had insufficient cash or committed credit available to repay the debt. In addition, we would be unable to issue new debt securities under the applicable debt agreement, which could impair our ability to fund new loan advances and refinance maturing debt.

Changes in the level and direction of interest rates or our ability to successfully manage interest rate risk could adversely affect our financial results and condition.
Our earnings are largely dependent on net interest income. Our interest rate risk exposure is primarily related to the funding of a fixed-rate loan portfolio. We have a matched funding objective that is intended to manage the funding of asset and liability repricing terms within a range of total assets based on the current environment and extended outlook for interest rates. We maintain a limited unmatched position, or interest rate gap, on our fixed-rate assets within a targeted range of adjusted total assets to provide us with funding flexibility.

Our primary strategies for managing interest rate risk include the use of derivatives and limiting the amount of fixed-rate assets that can be funded by variable-rate debt to a specified percentage of total assets based on prevailing market conditions. We face the risk that changes in interest rates could reduce our net interest income and our earnings, especially if actual conditions turn out to be materially different than those we assumed. Fluctuations in interest rates, including changes

16



in the relationship between short-term rates and long-term rates may affect the pricing of loans to borrowers and our cost of funds, which could adversely affect the difference between the interest that we earn on assets and the interest we pay on liabilities used to fund assets. Such changes may also affect our ability to hedge various forms of market and interest rate risk and may decrease the effectiveness of those hedges in helping to manage such risks, which could cause our interest rate gap to exceed our targeted range and have an adverse impact on net interest income, earnings and cash flows. See “Item 7. MD&A—Market Risk” for additional information.

We are subject to credit risk that a borrower or other counterparty may not be able to meet its contractual obligations in accordance with agreed-upon terms, which could result in significantly higher, unexpected losses.
Our loan portfolio, which represents the largest component of assets on our balance sheet, accounts for the substantial majority of exposure to credit risk. We had total loans outstanding of $25,168 million as of May 31, 2018. We reserve for credit losses in our loan portfolio by establishing an allowance for loan losses through a provision charge to earnings. The amount of the allowance for loan losses, which was $19 million as of May 31, 2018, is based on our assessment of credit losses inherent in our loan portfolio as of each balance sheet date, taking into consideration management's continuing evaluation of credit risk related to: industry concentrations; macro-economic conditions; specific credit risks; loan loss experience; current loan portfolio quality; present political and regulatory conditions; and unidentified losses and risks inherent in the current loan portfolio. We consider the process for determining the amount of the allowance as one of our critical accounting policies because it involves significant judgments and assumptions about highly complex and inherently uncertain matters, and the use of reasonably different estimates and assumptions could have a material impact on our results of operations or financial condition. Management believes that the allowance for loan losses appropriately reflects credit losses inherent in our loan portfolio as of May 31, 2018. However, our actual credit losses could exceed our estimate of probable losses due to changes in economic conditions that adversely affect borrowers, new information regarding existing loans, identification of additional problem loans and other factors, both within and outside of our control. In those cases, we may be required to increase the allowance for loan losses through an increase in the provision for loan losses, which would reduce net income and may have a material adverse effect on our financial results.

Adverse changes, developments or uncertainties in the rural electric utility industry could adversely impact the operations or financial performance of our member electric cooperatives, which, in turn, could have an adverse impact on our financial results.
Our focus as a tax-exempt, member-owned finance cooperative is on lending to our rural member electric utility cooperatives, which is the primary source of our revenue. As a result of lending primarily to our members, we have a loan portfolio with single-industry concentration. Loans to rural electric utility cooperatives accounted for approximately 99% of our total loans outstanding as of May 31, 2018. While we historically have experienced limited defaults and very low credit losses in our electric utility loan portfolio, factors that have a negative impact on the operations of our member rural electric cooperatives could cause a deterioration in their financial performance and the value of the collateral securing their loans, which could impair their ability to repay us in accordance with the terms of their loan. In such case, it may be necessary to increase our allowance for loan losses, which would result in an increase in the provision for loan losses and a decrease in our net income.

We may obtain entities or other assets through foreclosure, which would subject us to the same performance and financial risks as any other owner or operator of similar businesses or assets.
As a financial institution, from time to time we may obtain entities and assets of borrowers in default through foreclosure proceedings. If we become the owner and operator of entities or assets obtained through foreclosure, we are subject to the same performance and financial risks as any other owner or operator of similar assets or entities. In particular, the value of the foreclosed assets or entities may deteriorate and have a negative impact on our results of operations. We assess foreclosed assets, if any, for impairment periodically as required under generally accepted accounting principles in the United States (“GAAP”). Impairment charges, if required, represent a reduction to earnings in the period of the charge. There may be substantial judgment used in the determination of whether such assets are impaired and in the calculation of the amount of the impairment. In addition, when foreclosed assets are sold to a third party, the sale price we receive may be below the amount previously recorded in our financial statements, which will result in a loss being recorded in the period of the sale.


17



The nonperformance of our derivative counterparties could impair our financial results.
We use interest rate swaps to manage our interest rate risk. There is a risk that the counterparties to these agreements will not perform as agreed, which could adversely affect our results of operations. The nonperformance of a counterparty on an agreement would result in the derivative no longer being an effective risk management tool, which could negatively affect our overall interest rate risk position. In addition, if a counterparty fails to perform on our derivative obligation, we could incur a financial loss to replace the derivative with another counterparty and/or a loss through the failure of the counterparty to pay us amounts owed. We were in a net payable position, after taking into consideration master netting agreements, for all of our interest rate swaps as of May 31, 2018.

A decline in our credit rating could trigger payments under our derivative agreements, which could impair our financial results.
We have certain interest rate swaps that contain credit risk-related contingent features referred to as rating triggers. Under certain rating triggers, 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 prevailing fair value, excluding credit risk, of the underlying derivative instrument. These rating triggers are based on our senior unsecured credit ratings by Moody’s and S&P. Based on our interest rate swap agreements subject to rating triggers, if all agreements for which we owe amounts were terminated as of May 31, 2018 and our senior unsecured ratings fell below Baa3 by Moody’s or below BBB- by S&P, we would have been required to make a payment of up to $81 million as of that date. In calculating the required payments, we only considered agreements that, when netted for each counterparty pursuant to a master netting agreement, would require a payment upon termination. In the event that we are required to make a payment as a result of a rating trigger, it could have a material adverse impact on our financial results.

Advances in technology may change the way electricity is generated and transmitted, which could adversely affect the business operations of our members and negatively impact the credit quality of our loan portfolio and financial results.
Advances in technology could reduce demand for power supply systems and distribution services. The development of alternative technologies that produce electricity, including solar cells, wind power and microturbines, has expanded and could ultimately provide affordable alternative sources of electricity and permit end users to adopt distributed generation systems that would allow them to generate electricity for their own use. As these and other technologies, including energy conservation measures, are created, developed and improved, the quantity and frequency of electricity usage by rural customers could decline. Advances in technology and conservation that cause our electric system members’ power supply, transmission and/or distribution facilities to become obsolete prior to the maturity of loans secured by these assets could have an adverse impact on the ability of our members to repay such loans, which could result in an increase in nonperforming or restructured loans. These conditions could negatively impact the credit quality of our loan portfolio and financial results.

Breaches of our information technology systems, or those managed by third parties, may damage relationships with our members or subject us to reputational, financial, legal or operational consequences.
Cyber-related attacks pose a risk to the security of our members’ strategic business information and the confidentiality and integrity of our data, which includes strategic and proprietary information. Security breaches may occur through the actions of third parties, employee error, malfeasance, technology failures or other irregularities. Any such breach or unauthorized access could result in a loss of this information, a loss of integrity of this information, a delay or inability to provide service of affected products, damage to our reputation, including a loss of confidence in the security of our products and services, and significant legal and financial exposure. Because the techniques used to obtain unauthorized access, disable or degrade service or sabotage systems change frequently, we may be unable to anticipate these techniques or implement adequate preventative measures. As a result, cyber-related attacks may remain undetected for an extended period and may be costly to remediate.

Our business depends on the reliable and secure operation of computer systems, network infrastructure, and other information technology managed by third parties including, but not limited to: our service providers for external storage and processing of our information on cloud-based systems; our consulting and advisory firms and contractors that have access to our confidential and proprietary data; and administrators for our employee payroll and benefits management. We have limited control and visibility over third-party systems that we rely on for our business. The occurrence of a cyber-related

18



attack, breach, unauthorized access, or other cybersecurity event could result in damage to our third parties’ operations. The failure of third parties to provide services agreed upon through service level agreements, whether as a result of the occurrence of a cyber-related attack or other event, could result in the loss of access to our data, the loss of integrity of our data, disruptions to our corporate functions, loss of business opportunities, reputational damage, or otherwise adversely impact our financial results and result in significant costs and liabilities.

While CFC maintains insurance coverage that, subject to policy terms and conditions, covers certain aspects of cyber risks, including business interruptions caused by cyber-related attacks on information technology systems managed by third parties, such insurance coverage may be insufficient to cover all losses. Our failure to comply with applicable laws and regulations regarding data security and privacy could result in fines, sanctions and litigation. Additionally, new regulation in the areas of data security and privacy may increase our costs and our members’ costs.

Loss of our tax-exempt status could adversely affect our earnings.
CFC has been recognized by the Internal Revenue Service as an organization for which income is exempt from federal taxation under Section 501(c)(4) of the Internal Revenue Code (other than any net income from an unrelated trade or business). In order to maintain CFC’s tax-exempt status, it must continue to operate exclusively for the promotion of social welfare by operating on a cooperative basis for the benefit of its members by providing them cost-based financial products and services consistent with sound financial management, and no part of CFC’s net earnings may inure to the benefit of any private shareholder or individual other than the allocation or return of net earnings or capital to its members in accordance with CFC’s bylaws and incorporating statute in effect in 1996.

If CFC were to lose its status as a 501(c)(4) organization, it would become a taxable cooperative and would be required to pay income tax based on its taxable income. If this event occurred, we would evaluate all options available to modify CFC’s structure and/or operations to minimize any potential tax liability.

As a tax-exempt cooperative and nonbank financial institution, our lending activities are not subject to the regulations and oversight of U.S. financial regulators such as the Federal Reserve, the Federal Deposit Insurance Corporation or the Office of Comptroller of Currency. Because we are not under the purview of such regulation, we could engage in activities that could expose us to greater credit, market and liquidity risk, reduce our safety and soundness and adversely affect our financial results.
Financial institutions subject to regulations, oversight and monitoring by U.S. financial regulators are required to maintain specified levels of capital and may be restricted from engaging in certain lending-related and other activities that could adversely affect the safety and soundness of the financial institution or are considered conflicts of interest. As a tax-exempt, nonbank financial institution, we are not subject to the same oversight and supervision. There is no federal financial regulator that monitors compliance with our risk policies and practices or that identifies and addresses potential deficiencies that could adversely affect our financial results. Without regulatory oversight and monitoring, there is a greater potential for us to engage in activities that could pose a risk to our safety and soundness relative to regulated financial institutions.
Competition from other lenders could adversely impact our financial results.
We compete with other lenders for the portion of the rural utility loan demand for which RUS will not lend and for loans to members that have elected not to borrow from RUS. The primary competition for the non-RUS loan volume is from CoBank, ACB, a federally chartered instrumentality of the United States that is a member of the Farm Credit System. As a government-sponsored enterprise, CoBank, ACB has the benefit of an implied government guarantee with respect to its funding. Competition may limit our ability to raise rates to adequately cover increases in costs, which could have an adverse impact on our results of operations, and increasing interest rates to cover costs could cause a reduction in new lending business.

Our elected directors also serve as officers or directors of certain of our individual member cooperatives, which may result in a potential conflict of interest with respect to loans, guarantees and extensions of credit that we may make to or on behalf of such member cooperatives.
In accordance with our charter documents and the purpose for which we were formed, we lend only to our members and associates. CFC’s directors are elected or appointed from our membership, with 10 director positions filled by directors of members, 10 director positions filled by general managers or chief executive officers of members, two positions appointed

19



by NRECA and one at-large position that must, among other things, be a director, financial officer, general manager or chief executive of one of our members. CFC currently has loans outstanding to members that are affiliated with CFC directors and may periodically extend new loans to such members. The relationship of CFC’s directors to our members may give rise to conflicts of interests from time to time. See “Item 13. Certain Relationships and Related Transactions, and Director Independence—Review and Approval of Transactions with Related Persons” for a description of our policies with regard to approval of loans to members affiliated with CFC directors.

Item 1B.
Unresolved Staff Comments

None.

Item 2.
Properties

CFC owns approximately 141,000 square feet of office, meeting and storage space that serves as its headquarters in Loudoun County, Virginia.

Item 3.
Legal Proceedings

From time to time, CFC is subject to certain legal proceedings and claims in the ordinary course of business, including litigation with borrowers related to enforcement or collection actions. Management presently believes that the ultimate outcome of these proceedings, individually and in the aggregate, will not materially harm our financial position, liquidity, or results of operations. CFC establishes reserves for specific legal matters when it determines that the likelihood of an unfavorable outcome is probable and the loss is reasonably estimable. Accordingly, no reserve has been recorded with respect to any legal proceedings at this time.

Item 4.
Mine Safety Disclosures

Not applicable.

PART II

Item 5.
Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

Not applicable.


20


Item 6. Selected Financial Data

The following table provides a summary of consolidated selected financial data for the five-year period ended May 31, 2018. In addition to financial measures determined in accordance with generally accepted accounting principles in the United States (“GAAP”), management also evaluates performance based on certain non-GAAP measures and metrics, which we refer to as “adjusted” measures. Certain financial covenant provisions in our credit agreements are also based on non-GAAP financial measures. Our key non-GAAP financial measures are adjusted net income, adjusted net interest income, adjusted interest expense, adjusted net interest yield, adjusted times interest earned ratio (“adjusted TIER”) and adjusted debt-to-equity ratio. The most comparable GAAP measures are net income, net interest income, interest expense, net interest yield, TIER and debt-to-equity ratio, respectively. The primary adjustments we make to calculate these non-GAAP measures consist of (i) adjusting interest expense and net interest income to include the impact of net periodic derivative cash settlements; (ii) adjusting net income, senior debt and total equity to exclude the non-cash impact of the accounting for derivative financial instruments; (iii) adjusting senior debt to exclude the amount that funds CFC member loans guaranteed by RUS, subordinated deferrable debt and members’ subordinated certificates; and (iv) adjusting total equity to include subordinated deferrable debt and members’ subordinated certificates and exclude cumulative derivative forward value gains and losses and accumulated other comprehensive income. We believe our non-GAAP adjusted measures, which are not a substitute for GAAP and may not be consistent with similarly titled non-GAAP measures used by other companies, provide meaningful information and are useful to investors because management evaluates performance based on these metrics, and certain financial covenants in our committed bank revolving line of credit agreements and debt indentures are based on adjusted measures. See “Item 7. MD&A—Non-GAAP Financial Measures” for a detailed reconciliation of these adjusted measures to the most comparable GAAP measures.

Five-Year Summary of Selected Financial Data
 
 
Year Ended May 31,
 
Change
(Dollars in thousands)
 
2018

2017

2016

2015

2014
 
2018 vs. 2017
 
2017 vs. 2016
Statement of operations
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Interest income
 
$
1,077,357

 
$
1,036,634

 
$
1,012,636

 
$
952,976

 
$
957,540

 
   4%
 
   2%
Interest expense
 
(792,735
)
 
(741,738
)
 
(681,850
)
 
(635,684
)
 
(654,655
)
 
7
 
9
Net interest income
 
284,622

 
294,896


330,786


317,292


302,885

 
(3)
 
(11)
Fee and other income
 
17,578

 
19,713

 
21,785

 
36,783

 
17,762

 
(11)
 
(10)
Total revenue
 
302,200

 
314,609

 
352,571

 
354,075

 
320,647

 
(4)
 
(11)
Benefit (provision) for loan losses
 
18,575

 
(5,978
)
 
646

 
21,954

 
(3,498
)
 
**
 
**
Derivative gains (losses) (1)
 
231,721

 
94,903

 
(309,841
)
 
(196,999
)
 
(34,421
)
 
144
 
**
Results of operations of foreclosed assets
 

 
(1,749
)
 
(6,899
)
 
(120,148
)
 
(13,494
)
 
**
 
(75)
Operating expenses(2) 
 
(90,884
)
 
(86,226
)
 
(86,343
)
 
(76,530
)
 
(72,566
)
 
5
 
0
Other non-interest expense
 
(1,943
)
 
(1,756
)
 
(1,593
)
 
(870
)
 
(1,738
)
 
11
 
10
Income (loss) before income taxes
 
459,669

 
313,803

 
(51,459
)
 
(18,518
)
 
194,930

 
46
 
**
Income tax expense
 
(2,305
)
 
(1,704
)
 
(57
)
 
(409
)
 
(2,004
)
 
35
 
2,889
Net income (loss)
 
$
457,364

 
$
312,099

 
$
(51,516
)
 
$
(18,927
)
 
$
192,926

 
47
 
**
 
 
 
 
 
 
 
 
 
 
 
 

 
 
Adjusted operational financial measures
 


 


 


 
 
 
 
 

 
 
Adjusted interest expense(3)
 
$
(867,016
)
 
$
(826,216
)
 
$
(770,608
)
 
$
(718,590
)
 
$
(728,617
)
 
   5%
 
   7%
Adjusted net interest income(3)
 
210,341

 
210,418

 
242,028

 
234,386

 
228,923

 
0
 
(13)
Adjusted net income(3)
 
151,362

 
132,718

 
169,567

 
95,166

 
153,385

 
14
 
(22)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Selected ratios
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Fixed-charge coverage ratio/TIER(4)
 
1.58

 
1.42

 
0.92

 
0.97

 
1.29

 
16 bps
 
50 bps
Adjusted TIER(3)
 
1.17

 
1.16

 
1.22

 
1.13

 
1.21

 
1
 
(6)
Net interest yield(5)
 
1.12
%
 
1.20
%
 
1.43
 %
 
1.47
%
 
1.42
%
 
(8)
 
(23)
Adjusted net interest yield(3)(6)
 
0.83

 
0.86

 
1.05

 
1.08

 
1.07

 
(3)
 
(19)
Net charge-off rate(7)
 
0.00

 
0.01

 
0.00

 
0.00

 
0.01

 
(1)
 
1

21


 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Year Ended May 31,
 
Change
(Dollars in thousands)
 
2018
 
2017
 
2016
 
2015
 
2014
 
2018 vs. 2017
 
2017 vs. 2016
Balance sheet
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Cash and cash equivalents
 
$
230,999

 
$
166,615

 
$
204,540

 
$
248,836

 
$
338,715

 
   39%
 
   (19)%
Investment securities
 
608,851

 
92,554

 
87,940

 
84,472

 
55,177

 
558
 
5
Loans to members(8)
 
25,178,608

 
24,367,044

 
23,162,696

 
21,469,017

 
20,476,642

 
3
 
5
Allowance for loan losses
 
(18,801
)
 
(37,376
)
 
(33,258
)
 
(33,690
)
 
(56,429
)
 
(50)
 
12
Loans to members, net
 
25,159,807

 
24,329,668


23,129,438


21,435,327


20,420,213

 
3
 
5
Total assets
 
26,690,204

 
25,205,692

 
24,270,200

 
22,846,059

 
22,190,685

 
6
 
4
Short-term borrowings
 
3,795,910

 
3,342,900

 
2,938,848

 
3,127,754

 
4,099,331

 
14
 
14
Long-term debt
 
18,714,960

 
17,955,594

 
17,473,603

 
16,244,794

 
14,475,635

 
4
 
3
Subordinated deferrable debt
 
742,410

 
742,274

 
742,212

 
395,699

 
395,627

 
0
 
0
Members’ subordinated certificates
 
1,379,982

 
1,419,025

 
1,443,810

 
1,505,420

 
1,612,191

 
(3)
 
(2)
Total debt outstanding
 
24,633,262

 
23,459,793

 
22,598,473

 
21,273,667

 
20,582,784

 
5
 
4
Total liabilities
 
25,184,351

 
24,106,887

 
23,452,822

 
21,934,273

 
21,220,311

 
4
 
3
Total equity
 
1,505,853

 
1,098,805

 
817,378

 
911,786

 
970,374

 
37
 
34
Guarantees(9)
 
805,161

 
889,617

 
909,208

 
986,500

 
1,064,822

 
(9)
 
(2)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Selected ratios—period end
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Allowance coverage ratio(10)
 
0.07
%
 
0.15
%
 
0.14
 %
 
0.16
%
 
0.28
%
 
(8) bps
 
1 bp
Debt-to-equity ratio(11)
 
16.72

 
21.94

 
28.69

 
24.06

 
21.87

 
(522)
 
(675)
Adjusted debt-to-equity ratio(3)
 
6.18

 
5.95

 
5.82

 
6.26

 
5.90

 
23
 
13
____________________________ 
**Calculation of percentage change is not meaningful.
(1)Consists of interest rate swap cash settlements and forward value gains (losses). Derivative cash settlement amounts represent net periodic contractual interest accruals related to derivatives not designated for hedge accounting. Derivative forward value gains (losses) represent changes in fair value during the period, excluding net periodic contractual interest accruals, related to derivatives not designated for hedge accounting and expense amounts reclassified into income related to the cumulative transition loss recorded in accumulated other comprehensive income as of June 1, 2001, as a result of the adoption of the derivative accounting guidance that required derivatives to be reported at fair value on the balance sheet.
(2)Consists of salaries and employee benefits and the other general and administrative expenses components of non-interest expense, each of which are presented separately on our consolidated statements of operations.
(3)See “Non-GAAP Financial Measures” for details on the calculation of these non-GAAP adjusted measures and the reconciliation to the most comparable GAAP measures.
(4)Calculated based on net income (loss) plus interest expense for the period divided by interest expense for the period. The fixed-charge coverage ratios and TIER were the same during each period presented because we did not have any capitalized interest during these periods.
(5)Calculated based on net interest income for the period divided by average interest-earning assets for the period.
(6)Calculated based on adjusted net interest income for the period divided by average interest-earning assets for the period.
(7)Calculated based on net charge-offs (recoveries) for the period divided by average total outstanding loans for the period.
(8)Consists of the outstanding principal balance of member loans plus unamortized deferred loan origination costs, which totaled $11 million as of both May 31, 2018 and 2017, and $10 million as of May 31, 2016, 2015 and 2014.
(9)Reflects the total amount of member obligations for which CFC has guaranteed payment to a third party as of the end of each period. This amount represents our maximum exposure to loss, which significantly exceeds the guarantee liability recorded on our consolidated balance sheets. See “Note 12—Guarantees” for additional information.  
(10)Calculated based on the allowance for loan losses at period end divided by total outstanding loans at period end.
(11)Calculated based on total liabilities at period end divided by total equity at period end.


22



Item 7.
Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”)

INTRODUCTION

Our financial statements include the consolidated accounts of National Rural Utilities Cooperative Finance Corporation (“CFC”), National Cooperative Services Corporation (“NCSC”) and Rural Telephone Finance Cooperative (“RTFC”), and subsidiaries created and controlled by CFC to hold foreclosed assets. CFC did not hold, and did not have any subsidiaries or other entities that held, foreclosed assets as of May 31, 2018 or May 31, 2017. See “Item 1. Business—Overview” for information on the business activities of each of these entities. Unless stated otherwise, references to “we,” “our” or “us” relate to CFC and its consolidated entities. All references to members within this document include members, associates and affiliates of CFC and its consolidated entities.

Management monitors a variety of key indicators to evaluate our business performance. In addition to financial measures determined in accordance with GAAP, management also evaluates performance based on certain non-GAAP measures, which we refer to as “adjusted” measures. We identify our non-GAAP adjusted measures in “Item 6. Selected Financial Data” and provide a reconciliation to the most comparable GAAP measures below under “Non-GAAP Financial Measures.”

The following MD&A is intended to provide the reader with an understanding of our results of operations, financial condition and liquidity by discussing the factors influencing changes from period to period and the key measures used by management to evaluate performance, such as net interest income, net interest yield, loan growth, debt-to-equity ratio and credit quality metrics. MD&A is provided as a supplement to, and should be read in conjunction with, our audited consolidated financial statements and related notes in this Annual Report on Form 10-K for the fiscal year ended
May 31, 2018 and the information contained elsewhere in this report, including the risk factors discussed under “Part I—Item 1A. Risk Factors” in this report.
EXECUTIVE SUMMARY

Our primary objective as a member-owned cooperative lender is to provide cost-based financial products to our rural electric members while maintaining a sound financial position required for investment-grade credit ratings on our debt instruments. Our objective is not to maximize net income; therefore, the rates we charge our member-borrowers reflect our adjusted interest expense plus a spread to cover our operating expenses, a provision for loan losses and earnings sufficient to achieve interest coverage to meet our financial objectives. Our goal is to earn an annual minimum adjusted TIER of 1.10 and to maintain an adjusted debt-to-equity ratio at approximately or below 6.00-to-1.

We are subject to period-to-period volatility in our reported GAAP results due to changes in market conditions and differences in the way our financial assets and liabilities are accounted for under GAAP. Our financial assets and liabilities expose us to interest-rate risk. We use derivatives, primarily interest rate swaps, as part of our strategy in managing this risk. Our derivatives are intended to economically hedge and manage the interest-rate sensitivity mismatch between our financial assets and liabilities. We are required under GAAP to carry derivatives at fair value on our consolidated balance sheet; however, the financial assets and liabilities for which we use derivatives to economically hedge are carried at amortized cost. Changes in interest rates and spreads result in periodic fluctuations in the fair value of our derivatives, which may cause volatility in our earnings because we do not apply hedge accounting for our interest rate swaps. As a result, the mark-to-market changes in our interest rate swaps are recorded in earnings. Based on the composition of our interest rate swaps, we generally record derivative losses in earnings when interest rates decline and derivative gains when interest rates rise. This earnings volatility generally is not indicative of the underlying economics of our business, as the derivative forward fair value gains or losses recorded each period may or may not be realized over time, depending on the terms of our derivative instruments and future changes in market conditions that impact the periodic cash settlement amounts of our interest rate swaps. As such, management uses our adjusted non-GAAP results to evaluate our operating performance. Our adjusted results include realized net periodic interest rate swap settlement amounts but exclude the impact of unrealized forward fair value gains and losses. Our financial debt covenants are also based on our non-GAAP adjusted results, as the forward fair value gains and losses related to our interest rate swaps do not affect our cash flows, liquidity or ability to service our debt.


23


Financial Performance

Reported Results

We reported net income of $457 million and a TIER of 1.58 for fiscal year ended May 31, 2018 (“fiscal year 2018”), compared with a net income of $312 million and a TIER of 1.42 for fiscal year 2017, and a net loss of $52 million and a TIER of 0.92 for fiscal year 2016. Our debt-to-equity ratio decreased to 16.72 as of May 31, 2018, from 21.94 as of May 31, 2017, primarily due to an increase in equity resulting from our reported net income of $457 million for fiscal year 2018, which was partially offset by patronage capital retirement of $45 million in September 2017.

The variance of $145 million between our reported net income of $457 million for fiscal year 2018 and net income of $312 million for fiscal year 2017 was driven by an increase in derivative gains of $137 million and a favorable shift in the provision for loan losses of $24 million, partially offset by a decrease in net interest income of $10 million and an increase in operating expenses of $5 million. We recognized derivative gains of $232 million in fiscal year 2018, compared with derivative gains of $95 million in the prior fiscal year, both of which were attributable to a net increase in the fair value of our pay-fixed swaps as interest rates increased across the swap curve during each period. The increase in interest rates, however, was more pronounced during fiscal year 2018, which resulted in significantly higher derivative gains relative to fiscal year 2017. We recorded a benefit for loan losses of $18 million in fiscal year 2018, compared with a provision of $6 million in fiscal year 2017. The benefit for loan losses was attributable to a reduction in our allowance for loan losses due to changes in the loss severity, or recovery rate, assumptions used in determining the collective allowance for our electric distribution and power supply loan portfolios to reflect management’s current assessment of expected losses in the event of default on a loan in these portfolios. The decrease in net interest income resulted from compression in the net interest yield, which was partially offset by an increase of 3% in average interest-earning assets. The net interest yield declined by 8 basis points to 1.12%, reflecting the impact of an overall increase in our average cost of funds due to the increase in interest rates during fiscal year 2018, which resulted in a higher average cost for our short-term and variable-rate borrowings.

The variance of $364 million between our reported net income of $312 million for fiscal year 2017 and net loss of $52 million for fiscal year 2016 was driven by mark-to-market changes in the fair value of our derivatives. We recognized derivative gains of $95 million in fiscal year 2017, largely due to an overall increase in interest rates during the year. In contrast, we recognized derivative losses of $310 million in fiscal year 2016, attributable to a decline in longer-term interest rates and a flattening of the swap curve. The favorable impact of the shift of $405 million to derivative gains in fiscal year 2017 was partially offset by a reduction in net interest income of $36 million, resulting from a decrease in the net interest yield of 23 basis points to 1.20%, which was partially offset by an increase in average interest-earning assets.

Adjusted Non-GAAP Results

Our adjusted net income totaled $151 million and our adjusted TIER was 1.17 for fiscal year 2018, compared with adjusted net income of $133 million and adjusted TIER of 1.16 for fiscal year 2017, and adjusted net income of $170 million and adjusted TIER of 1.22 for fiscal year 2016. Our adjusted debt-to-equity ratio increased to 6.18 as of May 31, 2018, from 5.95 as of May 31, 2017, predominately due to an increase in debt outstanding to fund loan growth.

The increase in adjusted net income of $18 million in fiscal year 2018 from fiscal year 2017 was primarily driven by the favorable shift in the provision for loan losses of $24 million, partially offset by the increase in operating expenses of $5 million. While our adjusted net interest yield decreased by 3 basis points to 0.83%, largely due to an increase in our adjusted average cost of borrowings, adjusted net interest income of $210 million was flat because of the increase in average interest-earning assets of 3%.

The decrease in adjusted net income of $37 million in fiscal year 2017 from the prior fiscal year was primarily driven by a decrease in adjusted net interest income of $32 million, resulting from a reduction in the adjusted interest yield of 19 basis points to 0.86%, which was partially offset by the increase in average interest-earning assets of 6%.

Lending Activity

Loans to members totaled $25,179 million as of May 31, 2018, an increase of $812 million, or 3%, from May 31, 2017. The increase was primarily due to an increase in CFC distribution loans of $726 million, an increase in NCSC loans of

24


$173 million and an increase in RTFC loans of $9 million, which was partially offset by a decrease in CFC power supply loans of $107 million.

Long-term loan advances totaled $2,203 million during fiscal year 2018, with approximately 67% of those advances for capital expenditures by members and 24% for the refinancing of loans made by other lenders. CFC had long-term fixed-rate loans totaling $904 million that were scheduled to reprice during fiscal year 2018. Of this total, $742 million repriced to a new long-term fixed rate; $157 million repriced to a long-term variable rate; and $5 million was repaid in full.

Financing Activity

We issue debt primarily to fund growth in our loan portfolio. As such, our outstanding debt volume generally increases and decreases in response to member loan demand. As total outstanding loans increased during fiscal year 2018, our debt also increased. Total debt outstanding was $24,633 million as of May 31, 2018, an increase of $1,173 million, or 5%, from May 31, 2017. The increase was primarily attributable to an increase in dealer medium-term notes of $638 million; an increase in the Federal Agricultural Mortgage Corporation (“Farmer Mac”) notes payable of $378 million; an aggregate increase in member commercial paper, select notes and daily liquidity fund notes of $230 million; and an increase in dealer commercial paper outstanding of $65 million. These increases were partially offset by a decrease in notes payable to the Federal Financing Bank and guaranteed by RUS under the Guaranteed Underwriter Program of $129 million.

We provide additional information on our financing activities below under “Consolidated Balance Sheet Analysis—Debt” and “Liquidity Risk.”

Outlook for the Next 12 Months

We currently expect that our net interest income, net interest yield, adjusted net interest income and adjusted net interest yield will increase over the next 12 months as a result of a projected decrease in our average cost of funds and an increase in average outstanding loans. We have scheduled maturities of higher-cost debt over the next 12 months, including $1,830 million in collateral trust bonds with a weighted average coupon rate of 6.98%. On July 12, 2018, we redeemed $300 million of the $1 billion aggregate principal amount of 10.375% collateral trust bonds due November 1, 2018, leaving a remaining outstanding amount of $700 million. We expect that we will be able to replace this higher-cost debt with lower-cost funding, which will reduce our aggregate weighted average cost of funds. We expect the amount of long-term loan advances to exceed anticipated loan repayments over the next 12 months, resulting in an increase in average outstanding loans.

Long-term debt scheduled to mature over the next 12 months totaled $2,745 million as of May 31, 2018. We believe we have sufficient liquidity from the combination of existing cash and cash equivalents, member loan repayments, committed bank revolving lines of credit and our ability to issue debt in the capital markets, to our members and in private placements, to meet the demand for member loan advances and satisfy our obligations to repay long-term debt maturing over the next 12 months. As of May 31, 2018, sources of liquidity available for access, which we refer to as our liquidity reserves, totaled$7,147 million, consisting of (i) $231 million in cash and cash equivalents, (ii) up to $1,225 million available under committed loan facilities under the Guaranteed Underwriter Program, (iii) up to $3,082 million available under committed bank revolving line of credit agreements, (iv) up to $200 million available under a committed revolving note purchase agreement with Farmer Mac, and (v) up to $2,409 million available under a revolving note purchase agreement with Farmer Mac, subject to market conditions.

We believe we can continue to roll over the outstanding member short-term debt of $2,632 million as of May 31, 2018, based on our expectation that our members will continue to reinvest their excess cash in our commercial paper, daily liquidity fund notes, select notes and medium-term notes. Although we expect to continue accessing the dealer commercial paper market to help meet our liquidity needs, we intend to manage our short-term wholesale funding risk by maintaining outstanding dealer commercial paper at an amount below $1,250 million for the foreseeable future. We expect to continue to be in compliance with the covenants under our committed bank revolving line of credit agreements, which will allow us to mitigate roll-over risk as we can draw on these facilities to repay dealer or member commercial paper that cannot be refinanced with similar debt.


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While we are not subject to bank regulatory capital rules, we generally aim to maintain an adjusted debt-to-equity ratio at approximately or below 6.00-to-1. Our adjusted debt-to-equity ratio was 6.18 as of May 31, 2018, above our targeted threshold due to the increase in debt outstanding to fund loan growth. Due to anticipated asset growth, we expect our adjusted debt-to-equity ratio to be above 6.00-to-1 over the next 12 months.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES

The preparation of financial statements in accordance with GAAP requires management to make a number of judgments, estimates and assumptions that affect the amount of assets, liabilities, income and expenses in the consolidated financial statements. Understanding our accounting policies and the extent to which we use management’s judgment and estimates in applying these policies is integral to understanding our financial statements. We provide a discussion of our significant accounting policies under “Note 1—Summary of Significant Accounting Policies.”

We have identified certain accounting policies as critical because they involve significant judgments and assumptions about highly complex and inherently uncertain matters, and the use of reasonably different estimates and assumptions could have a material impact on our results of operations or financial condition. Our most critical accounting policies and estimates involve the determination of the allowance for loan losses and fair value. We evaluate our critical accounting estimates and judgments required by our policies on an ongoing basis and update them as necessary based on changing conditions. Management has discussed significant judgments and assumptions in applying our critical accounting policies with the Audit Committee of our board of directors. See “Item 1A. Risk Factors” for a discussion of the risks associated with management’s judgments and estimates in applying our accounting policies and methods.

Allowance for Loan Losses

We maintain an allowance for loan losses that represents management’s estimate of probable losses inherent in our loan portfolio as of each balance sheet date. Our allowance for loan losses includes a collective allowance for loans in our portfolio that are not individually impaired and a specific allowance for loans identified as individually impaired. Our allowance for loan losses decreased by $18 million to $19 million as of May 31, 2018, from $37 million as of May 31, 2017.

Collective Allowance

The collective loss reserve is calculated using an internal model to estimate probable incurred losses for segments within our loan portfolio that have similar risk characteristics. Our segments are based on member borrower type, which are further stratified into loan pools based on borrower risk ratings. As part of our credit risk-management process, we regularly evaluate each borrower and loan facility in our loan portfolio and assign an internal risk rating. Our borrower risk rating is intended to reflect probability of default. We engage an independent third party to perform an annual review of a sample of borrowers and loan facilities to corroborate our internally assigned risk ratings. We determine the collective allowance by applying loss factors to the outstanding principal balance of each loan pool. The loss factors consist of a probability of default, or default rate, and the loss given default, or loss severity. The probability of default is based on an estimated loss emergence period of five years. We utilize third-party industry default data for estimated default rates. We utilize our historical loss experience for each borrower type to estimate loss severity, which we refer to as our recovery rates. The historical recovery rates for each borrower type may be adjusted based on management’s consideration and assessment of current conditions and relevant factors, such as recent trends in credit performance, historical variability of recovery rates and additional analysis of long-term loss severity experience, changes in risk management practices, current and past underwriting standards, specific industry issues and trends and general economic conditions.

Specific Allowance

The specific allowance for individually impaired loans that are not collateral dependent is calculated based on the difference between the recorded investment in the loan and the present value of the expected future cash flows, discounted at the loan’s effective interest rate. If the loan is collateral dependent, we measure the impairment based on the current fair value of the collateral less estimated selling costs. Loans are considered to be collateral dependent if repayment of the loan is expected to be provided solely by the underlying collateral and there are no other available and reliable sources of repayment.



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Key Assumptions

Determining the appropriateness of the allowance for loan losses is subject to numerous estimates and assumptions requiring significant management judgment about matters that involve a high degree of subjectivity and are difficult to predict. The key assumptions in determining our collective allowance that require significant management judgment and may have a material impact on the amount of the allowance include: our evaluation of the risk profile of various loan portfolio segments and internally assigned borrower risk ratings; the estimated loss emergence period; the selection of third-party proxy data to estimate the probability of default; our historical loss experience and assumptions regarding recovery rates in the event of default; and management’s judgment in the selection and evaluation of qualitative factors to assess the overall current level of exposure within our loan portfolio. The key assumptions in determining our specific allowance that require significant management judgment and may have a material impact on the amount of the allowance include estimating the amount and timing of expected cash flows from impaired loans and estimating the value of underlying collateral, each of which impacts loss severity and certain cash flow assumptions. The degree to which any particular assumption affects the allowance for loan losses depends on the severity of the change and its relationship to the other assumptions.

We regularly evaluate the underlying assumptions used in determining the allowance for loan losses and periodically update our assumptions to better reflect present conditions, including current trends in credit performance and borrower risk profile, portfolio concentration risk, changes in risk-management practices, changes in the regulatory environment, general economic trends and other factors specific to our loan portfolio segments. In the fourth quarter of fiscal year 2018, we increased the recovery rate assumptions used in determining the collective allowance for our electric distribution and power supply loan portfolios to reflect management’s current assessment of expected losses in the event of default on a loan in these portfolios. The increase in recovery rate assumptions for these electric utility loan portfolios was the primary driver of the $18 million reduction in our allowance for loan losses to $19 million as of May 31, 2018, from $37 million as of
May 31, 2017.

Our electric utility loan portfolio has continued to exhibit strong credit performance. In fiscal year 2018, for the fifth consecutive fiscal year, we had no payment defaults, charge-offs, delinquent loans or nonperforming loans in our electric utility loan portfolio. In addition, 93% of the loans in our total loan portfolio were secured as of May 31, 2018, up from 92% as of May 31, 2017. Although we downgraded one electric distribution cooperative and its subsidiary, which had combined total loans outstanding of $165 million, to substandard as of May 31, 2018, they are current with regard to all payments of principal and interest on their loans and we currently do not anticipate a default. Therefore, the loans outstanding to this borrower and its subsidiary were not deemed to be impaired as of May 31, 2018. In the event of a default, we currently expect to collect substantially all of the outstanding amount based on our historical average recovery rate for the electric distribution and power supply loan portfolios.

Sensitivity Analysis

As noted above, our allowance for credit losses is sensitive to a variety of factors. While management uses its best judgment to assess loss data and other factors to determine the allowance for loan losses, changes in our loss assumptions, adjustments to assigned borrower risk ratings, the use of alternate external data sources or other factors could affect our estimate of probable credit losses inherent in the portfolio as of each balance sheet date, which would also impact the related provision for loan losses recognized in our consolidated statements of operations. For example, changes in the inputs below, without taking into consideration the impact of other potential offsetting or correlated inputs, would have the following effect on our allowance of loan losses as of May 31, 2018.

A 10% increase or decrease in the default rates for all of our portfolio segments would result in a corresponding increase or decrease of approximately $2 million.
A 1% increase or decrease in the recovery rates for all of our portfolio segments would result in a corresponding decrease or increase of approximately $4 million.
A one-notch downgrade in the internal borrower risk ratings for our entire loan portfolio would result in an increase of approximately $22 million, while a one-notch upgrade would result in a decrease of approximately $11 million.

These sensitivity analyses are intended to provide an indication of the isolated impact of hypothetical alternative assumptions on our allowance for loan losses. Because management evaluates a variety of factors and inputs in determining the allowance for loan losses, these sensitivity analyses are not considered probable and do not imply an expectation of

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future changes in loss rates or borrower risk ratings. Given current processes employed in estimating the allowance for loan losses, management believes the inherent loss rates and currently assigned risk ratings are appropriate. It is possible that others performing the analyses, given the same information, may at any point in time reach different reasonable conclusions that could be significant to our consolidated financial statements.

We provide additional information on the methodology for determining the allowance for loan losses in “Note 1—Summary of Significant Accounting Policies” and changes in our allowance for loan losses in “Note 4—Loans.” Also refer to “Note 4—Loans” for information on the credit quality of our loan portfolios.

Fair Value

Certain of our financial instruments are carried at fair value on our consolidated balance sheet, with changes in fair value recorded either through earnings or other comprehensive income (loss) in accordance with applicable accounting standards. These include our available-for-sale investment securities and derivatives. The determination of fair value is important for certain other assets that are periodically evaluated for impairment using fair value, such as individually impaired loans.

Fair value is defined as the price that would be received for an asset or paid to transfer a liability in an orderly transaction between market participants on the measurement date (also referred to as an exit price). The fair value accounting guidance provides a three-level fair value hierarchy for classifying fair value measurement techniques. This hierarchy is based on the markets in which the assets or liabilities trade and whether the inputs to the valuation techniques used to measure fair value are observable or unobservable. Fair value measurement is assigned a level based on the lowest level of any input that is significant to the fair value measurement in its entirety. The three levels of the fair value hierarchy are summarized below:

Level 1: Quoted prices (unadjusted) in active markets for identical assets or liabilities
Level 2: Observable market-based inputs, other than quoted prices in active markets for identical assets or liabilities
Level 3: Unobservable inputs

The degree of management judgment involved in determining fair value is dependent upon the availability of quoted prices in active markets or observable market parameters. When quoted prices and observable data in active markets are not fully available, management’s judgment is necessary to estimate fair value. Changes in market conditions, such as reduced liquidity in the capital markets or changes in secondary market activities, may reduce the availability and reliability of quoted prices or observable data used to determine fair value.

Significant judgment may be required to determine whether certain assets and liabilities measured at fair value are classified as Level 2 or Level 3. In making this determination, we consider all available information that market participants use to measure fair value, including observable market data, indications of market liquidity and orderliness, and our understanding of the valuation techniques and significant inputs used. Based upon the specific facts and circumstances, judgments are made regarding the significance of Level 3 inputs used in determining the fair value of the asset or liability in its entirety. If Level 3 inputs are considered significant, the valuation technique is classified as Level 3. The process for determining fair value using unobservable inputs is generally more subjective and involves a high degree of management judgment and assumptions.

Financial instruments recorded at fair value on a recurring basis, which consisted primarily of financial instruments, including available-for-sale investment securities, deferred compensation investments and derivatives, represented 1% of our total assets as of both May 31, 2018 and 2017, and 1% and 2%, respectively, of total liabilities as of May 31, 2018 and 2017. The fair value of these financial instruments was determined using either Level 1 or 2 inputs. We did not have any financial instruments recorded at fair value on a recurring basis for which the fair value was determined using Level 3 inputs as of May 31, 2018 and 2017.

We discuss the valuation inputs and assumptions used in determining the fair value, including the extent to which we have relied on significant unobservable inputs to estimate fair value, in “Note 13—Fair Value Measurement.”

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RECENT ACCOUNTING CHANGES AND OTHER DEVELOPMENTS

See “Note 1—Summary of Significant Accounting Policies” for information on recently issued accounting standards and the expected impact of the adoption of these accounting standards. To the extent we believe the adoption of new accounting standards has had or will have a material impact on our consolidated results of operations, financial condition or liquidity, we also discuss the impact in the applicable section(s) of this MD&A.
CONSOLIDATED RESULTS OF OPERATIONS

The section below provides a comparative discussion of our consolidated results of operations between fiscal year 2018 and 2017 and between fiscal year 2017 and 2016. Following this section, we provide a comparative analysis of our consolidated balance sheets as of May 31, 2018 and 2017. You should read these sections together with our “Executive Summary—Outlook for the Next 12 Months” where we discuss trends and other factors that we expect will affect our future results of operations.

Net Interest Income

Net interest income represents the difference between the interest income earned on our interest-earning assets, which includes loans and investment securities, and the interest expense on our interest-bearing liabilities. Our net interest yield represents the difference between the yield on our interest-earning assets and the cost of our interest-bearing liabilities plus the impact from non-interest bearing funding. We expect net interest income and our net interest yield to fluctuate based on changes in interest rates and changes in the amount and composition of our interest-earning assets and interest-bearing liabilities. We do not fund each individual loan with specific debt. Rather, we attempt to minimize costs and maximize efficiency by proportionately funding large aggregated amounts of loans.

Table 1 presents our average balance sheets for fiscal years 2018, 2017 and 2016, and for each major category of our interest-earning assets and interest-bearing liabilities, the interest income earned or interest expense incurred, and the average yield or cost. Table 1 also presents non-GAAP adjusted interest expense, adjusted net interest income and adjusted net interest yield, which reflect the inclusion of net accrued periodic derivative cash settlements in interest expense. We provide reconciliations of our non-GAAP adjusted measures to the most comparable GAAP measures under “Non-GAAP Financial Measures.”



29



Table 1: Average Balances, Interest Income/Interest Expense and Average Yield/Cost
 
 
Year Ended May 31,
(Dollars in thousands)
 
2018
 
2017
 
2016
Assets:
 
Average Balance
 
Interest Income/Expense
 
Average Yield/Cost
 
Average Balance
 
Interest Income/Expense
 
Average Yield/Cost
 
Average Balance
 
Interest Income/Expense
 
Average Yield/Cost
Long-term fixed-rate loans(1)
 
$
22,570,209

 
$
1,000,492

 
4.43
%
 
$
21,896,200

 
$
980,173

 
4.48
%
 
$
20,734,387

 
$
959,701

 
4.63
%
Long-term variable-rate loans
 
925,910

 
27,152

 
2.93

 
799,412

 
19,902

 
2.49

 
708,801

 
19,858

 
2.80

Line of credit loans
 
1,402,555

 
38,195

 
2.72

 
1,124,471

 
25,389

 
2.26

 
1,031,548

 
24,864

 
2.41

TDR loans (2)
 
12,885

 
889

 
6.90

 
14,349

 
905

 
6.31

 
12,947

 
512

 
3.95

Nonperforming loans
 

 

 

 

 

 

 
3,164

 
142

 
4.49

Other income, net(3)
 

 
(1,185
)
 

 

 
(1,082
)
 

 

 
(1,088
)
 

Total loans
 
24,911,559

 
1,065,543

 
4.28

 
23,834,432

 
1,025,287

 
4.30

 
22,490,847

 
1,003,989

 
4.46

Cash, time deposits and investment securities
 
512,517

 
11,814

 
2.31

 
734,095

 
11,347

 
1.55

 
639,060

 
8,647

 
1.35

Total interest-earning assets
 
$
25,424,076

 
$
1,077,357

 
4.24
%
 
$
24,568,527

 
$
1,036,634

 
4.22
%
 
$
23,129,907

 
$
1,012,636

 
4.38
%
Other assets, less allowance for loan losses
 
644,563

 
 
 
 
 
574,682

 
 
 
 
 
808,479

 
 
 
 
Total assets
 
$
26,068,639

 
 
 
 
 
$
25,143,209

 
 
 
 
 
$
23,938,386

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Liabilities:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Short-term borrowings
 
$
3,294,573

 
$
50,616

 
1.54
%
 
$
3,185,084

 
$
26,684

 
0.84
%
 
$
2,995,530

 
$
14,728

 
0.49
%
Medium-term notes
 
3,361,484

 
111,814

 
3.33

 
3,345,410

 
99,022

 
2.96

 
3,412,061

 
86,270

 
2.53

Collateral trust bonds
 
7,625,182

 
336,079

 
4.41

 
7,293,251

 
340,854

 
4.67

 
6,917,265

 
333,338

 
4.82

Guaranteed Underwriter Program notes payable
 
4,956,417

 
140,551

 
2.84

 
4,873,520

 
142,661

 
2.93

 
4,649,532

 
143,240

 
3.08

Farmer Mac notes payable
 
2,578,793

 
56,004

 
2.17

 
2,355,324

 
33,488

 
1.42

 
2,124,552

 
20,529

 
0.97

Other notes payable
 
33,742

 
1,509

 
4.47

 
39,314

 
1,780

 
4.53

 
44,621

 
2,051

 
4.60

Subordinated deferrable debt
 
742,336

 
37,661

 
5.07

 
742,203

 
37,657

 
5.07

 
435,488

 
21,245

 
4.88

Subordinated certificates
 
1,396,449

 
58,501

 
4.19

 
1,433,657

 
59,592

 
4.16

 
1,458,376

 
60,449

 
4.14

Total interest-bearing liabilities
 
$
23,988,976

 
$
792,735

 
3.30
%
 
$
23,267,763

 
$
741,738

 
3.19
%
 
$
22,037,425

 
$
681,850

 
3.09
%
Other liabilities
 
822,745

 
 
 
 
 
921,749

 
 
 
 
 
1,036,907

 
 
 
 
Total liabilities
 
24,811,721

 
 
 
 
 
24,189,512

 
 
 
 
 
23,074,332

 
 
 
 
Total equity
 
1,256,918

 
 
 
 
 
953,697

 
 
 
 
 
864,054

 
 
 
 
Total liabilities and equity
 
$
26,068,639

 
 
 
 
 
$
25,143,209

 
 
 
 
 
$
23,938,386

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Net interest spread(4)
 
 
 
 
 
0.94
%
 
 
 
 
 
1.03
%
 
 
 
 
 
1.29
%
Impact of non-interest bearing funding(5)
 
 
 
 
 
0.18

 
 
 
 
 
0.17

 
 
 
 
 
0.14

Net interest income/net interest yield(6)
 
 
 
$
284,622

 
1.12
%
 
 
 
$
294,896

 
1.20
%
 
 
 
$
330,786

 
1.43
%
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Adjusted net interest income/adjusted net interest yield:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Interest income
 
 
 
$
1,077,357

 
4.24
%
 
 
 
$
1,036,634

 
4.22
%
 
 
 
$
1,012,636

 
4.38
%
Interest expense
 
 
 
792,735

 
3.30

 
 
 
741,738

 
3.19

 
 
 
681,850

 
3.09

Add: Net accrued periodic derivative cash settlement(7)
 
 
 
74,281

 
0.69

 
 
 
84,478

 
0.80

 
 
 
88,758

 
0.89

Adjusted interest expense/adjusted average cost(8)
 
 
 
$
867,016

 
3.61
%
 
 
 
$
826,216

 
3.55
%
 
 
 
$
770,608

 
3.50
%
Adjusted net interest spread(4)
 
 
 
 
 
0.63
%
 
 
 
 
 
0.67
%
 
 
 
 
 
0.88
%
Impact of non-interest bearing funding
 
 
 
 
 
0.20

 
 
 
 
 
0.19

 
 
 
 
 
0.17

Adjusted net interest income/adjusted net interest yield(9)
 
 
 
$
210,341

 
0.83
%
 
 
 
$
210,418

 
0.86
%
 
 
 
$
242,028

 
1.05
%

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____________________________ 
(1)Interest income on long-term, fixed-rate loans includes loan conversion fees, which are generally deferred and recognized as interest income using the effective interest method.
(2)Troubled debt restructuring (“TDR”) loans.
(3)Consists of late payment fees and net amortization of deferred loan fees and loan origination costs.
(4)Net interest spread represents the difference between the average yield on interest-earning assets and the average cost of interest-bearing liabilities. Adjusted net interest spread represents the difference between the average yield on total interest-earning assets and the adjusted average cost of total interest-bearing liabilities.
(5)Includes other liabilities and equity.
(6)Net interest yield is calculated based on net interest income for the period divided by total average interest-earning assets for the period.
(7)Represents the impact of net accrued periodic interest rate swap settlements during the period, which is added to interest expense to derive non-GAAP adjusted interest expense. The average (benefit)/cost associated with derivatives is calculated based on net accrued periodic interest rate swap settlements during the period divided by the average outstanding notional amount of derivatives during the period. The average outstanding notional amount of interest rate swaps was $10,816 million, $10,590 million and $9,993 million for fiscal year 2018, 2017 and 2016, respectively.
(8)Adjusted interest expense represents interest expense plus net accrued periodic interest rate swap settlements during the period. Net accrued periodic derivative cash settlements are reported on our consolidated statements of operations as a component of derivative gains (losses). Adjusted average cost is calculated based on adjusted interest expense for the period divided by total average interest-bearing liabilities during the period.
(9)Adjusted net interest yield is calculated based on adjusted net interest income for the period divided by total average interest-earning assets for the period.

Table 2 displays the change in net interest income between periods and the extent to which the variance is attributable to: (i) changes in the volume of our interest-earning assets and interest-bearing liabilities or (ii) changes in the interest rates of these assets and liabilities. The table also presents the change in adjusted net interest income between periods. Because of the numerous simultaneous volume and rate changes during any period, it is not possible to precisely allocate such changes between volume and rate. Changes that are not solely due to either volume or rate are allocated to these categories on a pro-rata basis based on the absolute value of the change due to average volume and average rate.
 

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Table 2: Rate/Volume Analysis of Changes in Interest Income/Interest Expense
 
 
2018 vs. 2017
 
2017 vs. 2016
 
 
Total

Variance due to:(1)
 
Total
 
Variance due to:(1)
(Dollars in thousands)
 
Variance
 
Volume
 
Rate
 
Variance
 
Volume
 
Rate
Interest income:
 
 
 
 
 
 
 
 
 
 
 
 
Long-term fixed-rate loans
 
$
20,319

 
$
30,172

 
$
(9,853
)
 
$
20,472

 
$
53,775

 
$
(33,303
)
Long-term variable-rate loans
 
7,250

 
3,149

 
4,101

 
44

 
2,539

 
(2,495
)
Line of credit loans
 
12,806

 
6,279

 
6,527

 
525

 
2,240

 
(1,715
)
Restructured loans
 
(16
)
 
(92
)
 
76

 
393

 
55

 
338

Nonperforming loans
 

 

 

 
(142
)
 
(142
)
 

Other income, net
 
(103
)
 

 
(103
)
 
6

 

 
6

Total loans
 
40,256

 
39,508

 
748

 
21,298

 
58,467

 
(37,169
)
Cash, time deposits and investment securities
 
467

 
(3,425
)
 
3,892

 
2,700

 
1,286

 
1,414

Interest income
 
$
40,723

 
$
36,083

 
$
4,640

 
$
23,998

 
$
59,753

 
$
(35,755
)
 
 
 
 
 
 
 
 
 
 
 
 
 
Interest expense:
 
 
 
 
 
 
 
 
 
 
 
 
Short-term borrowings
 
$
23,932

 
$
917

 
$
23,015

 
$
11,956

 
$
932

 
$
11,024

Medium-term notes
 
12,792

 
476

 
12,316

 
12,752

 
(1,685
)
 
14,437

Collateral trust bonds
 
(4,775
)
 
15,513

 
(20,288
)
 
7,516

 
18,118

 
(10,602
)
Guaranteed Underwriter Program notes payable
 
(2,110
)
 
2,427

 
(4,537
)
 
(579
)
 
6,900

 
(7,479
)
Farmer Mac notes payable
 
22,516
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