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EX-32.2 - SECTION 906 CFO CERTIFICATION - NATIONAL RURAL UTILITIES COOPERATIVE FINANCE CORP /DC/nrufy2019q2form10-qxex322.htm
EX-32.1 - SECTION 906 CEO CERTIFICATION - NATIONAL RURAL UTILITIES COOPERATIVE FINANCE CORP /DC/nrufy2019q2form10-qxex321.htm
EX-31.2 - SECTION 302 CFO CERTIFICATION - NATIONAL RURAL UTILITIES COOPERATIVE FINANCE CORP /DC/nrufy2019q2form10-qxex312.htm
EX-31.1 - SECTION 302 CEO CERTIFICATION - NATIONAL RURAL UTILITIES COOPERATIVE FINANCE CORP /DC/nrufy2019q2form10-qxex311.htm
EX-10.6 - FIFTH AMENDED, RESTATED AND CONSOLIDATED BOND GUARANTEE AGREEMENT - NATIONAL RURAL UTILITIES COOPERATIVE FINANCE CORP /DC/nrucfcfy2019q2form10-qxex106.htm
EX-10.5 - FIFTH AMENDED, RESTATED AND CONSOLIDATED PLEDGE AGREEMENT - NATIONAL RURAL UTILITIES COOPERATIVE FINANCE CORP /DC/nrucfcfy2019q2form10-qxex105.htm
EX-10.4 - SERIES N FUTURE ADVANCE BOND - NATIONAL RURAL UTILITIES COOPERATIVE FINANCE CORP /DC/nrucfcfy2019q2form10-qex104.htm
EX-10.3 - SERIES N BOND PURCHASE AGREEMENT - NATIONAL RURAL UTILITIES COOPERATIVE FINANCE CORP /DC/nrucfcfy2019q2form10-qxex103.htm
EX-10.2 - AMENDED REVOLVING CREDIT AGREEMENT MATURING NOVEMBER 28, 2023 - NATIONAL RURAL UTILITIES COOPERATIVE FINANCE CORP /DC/nrucfcfy2019q2form10-qex102.htm
EX-10.1 - MENDED REVOLVING CREDIT AGREEMENT MATURING NOVEMBER 28, 2021 - NATIONAL RURAL UTILITIES COOPERATIVE FINANCE CORP /DC/nrucfcfy2019q2form10-qex101.htm

 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
__________________________
FORM 10-Q
__________________________

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended November 30, 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
__________________________
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 every Interactive Data File required to be submitted 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 such files).    Yes   No ☐

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a 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
 



TABLE OF CONTENTS
 
  
 
 
Page
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
  
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
  
 
  
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
  
 
 
 
 
 
 
 

i


INDEX OF MD&A TABLES
 
Table
  
 Description
 
Page
1
 
Summary of Selected Financial Data
 
3

2
 
Average Balances, Interest Income/Interest Expense and Average Yield/Cost
 
10

3
 
Rate/Volume Analysis of Changes in Interest Income/Interest Expense
 
13

4
 
Non-Interest Income
 
15

5
 
Derivative Average Notional Amounts and Average Interest Rates
 
16

6
 
Derivative Gains (Losses)
 
17

7
 
Non-Interest Expense
 
18

8
 
Loans Outstanding by Type and Member Class
 
19

9
 
Historical Retention Rate and Repricing Selection
 
20

10
 
Total Debt Outstanding
 
21

11
 
Member Investments
 
22

12
 
Collateral Pledged
 
23

13
 
Unencumbered Loans
 
24

14
 
Equity
 
25

15
 
Guarantees Outstanding
 
26

16
 
Maturities of Guarantee Obligations
 
27

17
 
Unadvanced Loan Commitments
 
27

18
 
Notional Maturities of Unadvanced Loan Commitments
 
27

19
 
Maturities of Notional Amount of Unconditional Committed Lines of Credit
 
28

20
 
Loan Portfolio Security Profile
 
30

21
 
Credit Exposure to 20 Largest Borrowers
 
31

22
 
Troubled Debt Restructured Loans
 
33

23
 
Allowance for Loan Losses
 
34

24
 
Rating Triggers for Derivatives
 
35

25
 
Available Liquidity
 
36

26
 
Committed Bank Revolving Line of Credit Agreements
 
37

27
 
Short-Term Borrowings—Funding Sources
 
39

28
 
Short-Term Borrowings
 
39

29
 
Issuances and Maturities of Long-Term and Subordinated Debt
 
40

30
 
Principal Maturity of Long-Term and Subordinated Debt
 
40

31
 
Projected Sources and Uses of Liquidity
 
41

32
 
Credit Ratings
 
42

33
 
Interest Rate Gap Analysis
 
44

34
 
Adjusted Financial Measures—Income Statement
 
45

35
 
TIER and Adjusted TIER
 
45

36
 
Adjusted Financial Measures—Balance Sheet
 
46

37
 
Debt-to-Equity Ratio
 
46

38
 
Members’ Equity
 
46


ii


PART I—FINANCIAL INFORMATION

Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A)
FORWARD-LOOKING STATEMENTS

This Quarterly Report on Form 10-Q contains certain statements that are considered “forward-looking statements” within the Securities Act of 1933, as amended, and the Securities 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” in our Annual Report on Form 10-K for the fiscal year ended May 31, 2018 (“2018 Form 10-K”). 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.
INTRODUCTION

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. 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. NCSC is a taxable member-owned cooperative that may provide financing to members of CFC, government or quasi-government entities which own electric utility systems that meet the Rural Electrification Act definition of “rural” and for-profit and nonprofit entities that are owned, operated or controlled by, or provide significant benefits to certain members of CFC. RTFC is a taxable Subchapter T cooperative association that provides financing for its rural telecommunications members and their affiliates. CFC did not hold, and did not have any subsidiaries or other entities that held, foreclosed assets as of November 30, 2018 or May 31, 2018. See “Item 1. Business—Overview” in our 2018 Form 10-K for additional 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.

1



Our principal operations are currently organized for management reporting purposes into three business segments: CFC, NCSC and RTFC. Loans to members totaled $25,294 million as of November 30, 2018, of which 96% was attributable to CFC. Total revenue, which consists of net interest income and fee and other income, was $153 million for the six months ended November 30, 2018, of which 99% was attributable to CFC. We provide information on the financial performance of each of our business segments in “Note 13—Business Segments.”

Management monitors a variety of key indicators to evaluate our business performance. The following MD&A is intended to provide the reader with an understanding of our consolidated 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. The MD&A section is provided as a supplement to, and should be read in conjunction with our unaudited condensed consolidated financial statements and related notes in this Report, our audited consolidated financial statements and related notes in our 2018 Form 10-K and additional information contained in our 2018 Form 10-K, including the risk factors discussed under “Part I—Item 1A. Risk Factors,” as well as any risk factors identified under “Part II—Item 1A. Risk Factors” in this Report.
SUMMARY OF SELECTED FINANCIAL DATA

Table 1 provides a summary of consolidated selected financial data for the three and six months ended November 30, 2018 and 2017, and as of November 30, 2018 and 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 (“AOCI”). 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 “Non-GAAP Financial Measures” for a detailed reconciliation of these adjusted measures to the most comparable GAAP measures.


2



Table 1: Summary of Selected Financial Data
 
 
Three Months Ended November 30,
 
 
 
Six Months Ended November 30,
 
 
(Dollars in thousands)
 
2018
 
2017
 
Change
 
2018
 
2017
 
Change
Statement of income
 
 
 
 
 
 
 
 
 
 
 
 
Interest income
 
$
281,253

 
$
265,823

 
   6%
 
$
559,744

 
$
531,738

 
   5%
Interest expense
 
(204,166
)
 
(195,170
)
 
5
 
(414,397
)
 
(387,901
)
 
7
Net interest income
 
77,087

 
70,653

 
9
 
145,347

 
143,837

 
1
Fee and other income
 
4,321

 
5,542

 
(22)
 
7,506

 
9,487

 
(21)
Total revenue
 
81,408

 
76,195

 
7
 
152,853

 
153,324

 
Benefit for loan losses
 
1,788

 
304

 
488
 
1,897

 
602

 
215
Derivative gains (1)
 
63,343

 
125,593

 
(50)
 
70,526

 
79,395

 
(11)
Results of operations of foreclosed assets
 

 
(10
)
 
**
 

 
(34
)
 
**
Operating expenses(2) 
 
(23,870
)
 
(21,914
)
 
9
 
(47,075
)
 
(43,550
)
 
8
Other non-interest expense
 
(2,700
)
 
(618
)
 
337
 
(10,194
)
 
(1,140
)
 
794
Income before income taxes
 
119,969

 
179,550

 
(33)
 
168,007

 
188,597

 
(11)
Income tax expense
 
(243
)
 
(827
)
 
(71)
 
(303
)
 
(859
)
 
(65)
Net income
 
$
119,726

 
$
178,723

 
(33)
 
$
167,704

 
$
187,738

 
(11)
Adjusted operational financial measures
 
 
 
 
 
 
 
 
 
 
 
 
Adjusted interest expense(3)
 
$
(215,971
)
 
$
(214,805
)
 
   1%
 
$
(439,031
)
 
$
(427,758
)
 
     3%
Adjusted net interest income(3)
 
65,282

 
51,018

 
28
 
120,713

 
103,980

 
16
Adjusted net income(3)
 
44,578

 
33,495

 
33
 
72,544

 
68,486

 
6
 
 
 
 
 
 
 
 
 
 
 
 
 
Selected ratios
 
 
 
 
 
 
 
 
 
 
 
 
Fixed-charge coverage ratio/TIER(4)
 
1.59

 
1.92

 
(33) bps
 
1.40

 
1.48

 
(8) bps
Adjusted TIER(3)
 
1.21

 
1.16

 
5
 
1.17

 
1.16

 
1
Net interest yield(5)
 
1.19
%
 
1.12
%
 
7
 
1.12
%
 
1.14
%
 
(2)
Adjusted net interest yield(3)(6)
 
1.01

 
0.81

 
20
 
0.93

 
0.83

 
10
 
 
 
 
 
 
 
 
 
 
 
 
 


3



 
 
 
 
 
 
 
 
November 30, 2018
 
May 31, 2018
 
Change
Balance sheet
 
 
 
 
 
 
 
 
 
 
 
 
Cash, cash equivalents and restricted cash
 
 
 
 
 
 
 
$
242,932

 
$
238,824

 
     2%
Investment securities
 
 
 
 
 
 
 
645,059

 
609,851

 
6
Loans to members(7)
 
 
 
 
 
 
 
25,294,175

 
25,178,608

 
Allowance for loan losses
 
 
 
 
 
 
 
(16,904
)
 
(18,801
)
 
  (10)
Loans to members, net
 
 
 
 
 
 
 
25,277,271

 
25,159,807

 
Total assets
 
 
 
 
 
 
 
26,829,758

 
26,690,204

 
  1
Short-term borrowings
 
 
 
 
 
 
 
4,100,606

 
3,795,910

 
  8
Long-term debt
 
 
 
 
 
 
 
18,477,156

 
18,714,960

 
  (1)
Subordinated deferrable debt
 
 
 
 
 
 
 
742,480

 
742,410

 
Members’ subordinated certificates
 
 
 
 
 
 
 
1,376,689

 
1,379,982

 
Total debt outstanding
 
 
 
 
 
 
 
24,696,931

 
24,633,262

 
Total liabilities
 
 
 
 
 
 
 
25,202,620

 
25,184,351

 
Total equity
 
 
 
 
 
 
 
1,627,138

 
1,505,853

 
  8
Guarantees(8)
 
 
 
 
 
 
 
771,422

 
805,161

 
  (4)
 
 
 
 
 
 
 
 
 
 
 
 
 
Selected ratios period end
 
 
 
 
 
 
 
 
 
 
 

Allowance coverage ratio(9)
 
 
 
 
 
 
 
0.07
%
 
0.07
%
 

Debt-to-equity ratio(10)
 
 
 
 
 
 
 
15.49

 
16.72

 
(123)
Adjusted debt-to-equity ratio(3)
 
 
 
 
 
 
 
6.15

 
6.18

 
(3)
____________________________ 
** 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 income.
(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 annualized net interest income for the period divided by average interest-earning assets for the period.
(6)Calculated based on annualized adjusted net interest income for the period divided by average interest-earning assets for the period.
(7)Consists of the outstanding principal balance of member loans plus unamortized deferred loan origination costs, which totaled $11 million as of both November 30, 2018 and May 31, 2018.
(8)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 11—Guarantees” for additional information.  
(9)Calculated based on the allowance for loan losses at period end divided by total outstanding loans at period end.
(10)Calculated based on total liabilities at period end divided by total equity at period end.

4



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.

Financial Performance

Reported Results

We reported net income of $120 million and a TIER of 1.59 for the quarter ended November 30, 2018 (“current quarter”), compared with net income of $179 million and a TIER of 1.92 for the same prior-year quarter. We reported net income of $168 million and a TIER of 1.40 for the six months ended November 30, 2018, compared with net income of $188 million and a TIER of 1.48 for the same prior-year period. Our debt-to-equity ratio decreased to 15.49 as of November 30, 2018, from 16.72 as of May 31, 2018, primarily due to an increase in equity resulting from our reported net income of $168 million for the six months ended November 30, 2018, which was partially offset by patronage capital retirement of $48 million in August 2018.

The decrease in reported net income of $59 million in the current quarter from the same-prior year quarter was primarily due to a decrease in derivative gains of $63 million. We recognized derivative gains of $63 million in the current quarter, compared with derivative gains of $126 million in the same prior-year quarter. The derivative gains in both periods were attributable to increases in the fair value of our pay-fixed swaps as interest rates increased across the swap curve during each period. The rise in medium- and longer-term rates, however, was not as pronounced during the current quarter, which resulted in lower derivative gains relative to the same prior-year quarter. The decrease in derivative gains of $63 million was partially offset by an increase in net interest income of $6 million. The increase in net interest income resulted from the combined impact of an increase in the net interest yield of 7 basis points to 1.19% and an increase in average interest-earning assets of $766 million, or 3%.

The decrease in our reported net income of $20 million for the six months ended November 30, 2018 was primarily driven by a decrease in derivative gains of $8 million, a loss on the early extinguishment of debt of $7 million and an increase in operating expenses of $4 million. We recognized derivative gains of $71 million for the six months ended November 30, 2018, compared with derivative gains of $79 million during the comparable prior-year period. Net interest income increased slightly by $2 million, driven by an increase in average interest-earning assets of $918 million, or 4%, which was partially

5



offset by a decline in the net interest yield of 2 basis points to 1.12%. The decline in the net interest yield was largely attributable to an increase in our overall average cost of funds due to a higher average cost for our short-term and variable-rate borrowings as a result of the rise in short-term interest rates.

On July 12, 2018, we early redeemed $300 million aggregate principal amount of our 10.375% collateral trust bonds due November 1, 2018, and repaid the remaining $700 million principal amounts of these bonds at maturity. We replaced this higher-cost debt with lower cost funding, which reduced our interest expense and had a favorable impact on our average cost of funds and net interest yield for the current quarter and six months ended six months ended November 30, 2018.

Adjusted Non-GAAP Results

Our adjusted net income totaled $45 million and our adjusted TIER was 1.21 for the current quarter, compared with adjusted net income of $33 million and adjusted TIER of 1.16 for the same prior-year quarter. Our adjusted net income totaled $73 million and our adjusted TIER was 1.17 for the six months ended November 30, 2018, compared with adjusted net income of $68 million and adjusted TIER of 1.16 for the same prior-year period. Our adjusted debt-to-equity ratio decreased to 6.15 as of November 30, 2018, from 6.18 as of May 31, 2018, primarily attributable to an increase in adjusted equity due to our adjusted net income of $73 million, which was partially offset by the patronage capital retirement of $48 million.

The increase in adjusted net income of $12 million, or in the current quarter from the same prior-year quarter was primarily driven by an increase in adjusted net interest income of $14 million, which was partially offset by an increase in operating expenses of $2 million. The increase in adjusted net interest income was driven by an increase in the adjusted net interest yield of 20 basis points to 1.01% and the increase in average interest-earning assets. The increase in the adjusted net interest yield reflected the combined impact of an increase in the average yield on interest-earning assets of 11 basis points to 4.34% and a decline in our adjusted average cost of funds of 10 basis points to 3.53%.

The increase in adjusted net income of $5 million during the six months ended November 30, 2018, was primarily driven by an increase in adjusted net interest income of $17 million, which was partially offset by the loss on the early extinguishment of debt of $7 million and an increase in operating expenses of $4 million. The increase in adjusted net interest income was attributable to an increase in the adjusted net interest yield of 10 basis point to 0.93% and the increase in average interest-earning assets. The increase in the adjusted net interest yield reflected the combined impact of an increase in the average yield on interest earning assets of 6 basis points to 4.29% and a decline in our adjusted average cost of funds of 3 basis points to 3.57%.

The decrease in the average cost of funds in the current quarter and for the six months ended November 30, 2018 was primarily due to a reduction in adjusted interest expense from the early redemption and maturity of the $1 billion aggregate principal amount of the 10.375% collateral trust bonds and a reduction in net periodic derivative cash settlement amounts. The reduction in net periodic derivative cash settlements was attributable to the rise in short-term interest rates, which resulted in an increase in the periodic floating interest rate amounts due to us on our pay-fixed swaps, as the floating interest rate payment amounts are typically determined based on the 3-month London Interbank Offered Rate (“LIBOR”).

Lending Activity

Loans to members totaled $25,294 million as of November 30, 2018, an increase of $116 million from May 31, 2018. CFC distribution loans increased by $261 million, which was partially offset by decreases in CFC power supply loans, NCSC loans and RTFC loans of $133 million, $19 million and $8 million, respectively.

Long-term loan advances totaled $814 million during the six months ended November 30, 2018, with approximately 83% of those advances for capital expenditures by members and 14% for the refinancing of loans made by other lenders. In comparison, long-term loan advances totaled $1,127 million during the prior year six months ended November 30, 2017, with approximately 58% of those advances for capital expenditures and 31% for refinancing of loans made by other lenders. The decrease in long-term loan advances from the same prior-year period reflects weaker demand from borrowers, due in part to more limited refinancings by our members of loans made by other lenders. In addition, although growth in U.S. electricity consumption has been relatively stagnant over the last several years, many of our members had an overall more profitable year due to an increase in electricity consumption as a result of weather conditions, which reduced their need for long-term borrowings.

6



CFC had long-term fixed-rate loans totaling $439 million that were scheduled to reprice during the six months ended November 30, 2018. Of this total, $296 million repriced to a new long-term fixed rate; $88 million repriced to a long-term variable rate; and $55 million was repaid in full.

Credit Quality

The overall credit quality of our loan portfolio remained high as of November 30, 2018, as evidenced by our strong credit performance metrics. We had no delinquent or nonperforming loans as of November 30, 2018, and no loan defaults or charge-offs during the six months ended November 30, 2018. Outstanding loans to electric utility organizations represented approximately 99% of total outstanding loan portfolio as of November 30, 2018, unchanged from May 31, 2018. We historically have had limited defaults and losses on loans in our electric utility loan portfolio. We generally lend to members on a senior secured basis, which reduces the risk of loss in the event of a borrower default. Of our total loans outstanding, 93% were secured and 7% were unsecured as of both November 30, 2018 and May 31, 2018.

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. Total debt outstanding increased by $64 million to $24,697 million as of November 30, 2018, from May 31, 2018, resulting from the modest increase in loans to members. Increases in dealer medium-term notes of $272 million and in member commercial paper, select notes and daily liquidity fund notes of $433 million were largely offset by decreases in collateral trust bonds and Federal Agricultural Mortgage Corporation (“Farmer Mac”) notes payable of $553 million and $128 million, respectively. Outstanding dealer commercial paper of $1,059 million as of November 30, 2018 was below our targeted limit of $1,250 million.

On October 31, 2018, we issued $325 million aggregate principal amount of 3.90% collateral trust bonds due 2028 and $300 million aggregate principal amount of 4.40% collateral trust bonds due 2048.

On November 15, 2018, we closed on a $750 million committed loan facility (“Series N”) from the Federal Financing Bank under the Guaranteed Underwriter Program of the USDA (“Guaranteed Underwriter Program”). Pursuant to this facility, we may borrow any time before July 15, 2023. Each advance is subject to quarterly amortization and a final maturity not longer than 20 years from the advance date. With the closing of this committed loan facility, the amount available for access under the Guaranteed Underwriter Program increased to $1,875 million as of November 30, 2018.

On November 28, 2018, we amended the three-year and five-year committed bank revolving line of credit agreements to extend the maturity dates to November 28, 2021 and November 28, 2023, respectively, and to terminate certain bank commitments totaling $53 million under the three-year agreement and $57 million under the five-year agreement. The total commitment amount under the amended three-year and five-year bank revolving line of credit agreements is $1,440 million and $1,535 million, respectively, resulting in a combined total commitment amount under the two facilities of $2,975 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, adjusted net interest income, net income, adjusted net income, tier, adjusted tier, net interest yield 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 largely due to the early redemption and maturity of higher-cost debt, including the $1 billion aggregate principal amount of 10.375% collateral trust bonds due November 1, 2018. We have replaced this higher-cost debt with lower cost funding, which we expect will contribute to a continued reduction in our average cost of funds and adjusted average cost of funds.

Long-term debt scheduled to mature over the next 12 months totaled $2,318 million as of November 30, 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, committed loan facilities under the Guaranteed Underwriter Program, revolving

7



note purchase agreements with Farmer Mac 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 November 30, 2018, sources of liquidity readily available for access totaled
$7,811 million, consisting of (i) $227 million in cash and cash equivalents; (ii) up to $1,875 million available under committed loan facilities under the Guaranteed Underwriter Program; (iii) up to $2,972 million available for access under committed bank revolving line of credit agreements; (iv) up to $300 million available under a committed revolving note purchase agreement with Farmer Mac; and (v) up to $2,437 million available under a revolving note purchase agreement with Farmer Mac, subject to market conditions.

We believe we can continue to roll over outstanding member short-term debt of $3,042 million as of November 30, 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. We expect to continue accessing the dealer commercial paper market to help meet our liquidity needs. Although the intra-period amount of outstanding dealer commercial paper may fluctuate based on our liquidity requirements, we intend to manage our short-term wholesale funding risk by maintaining outstanding dealer commercial paper at an amount near or 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.

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 6.15 as of November 30, 2018, above our targeted threshold. Based on our forecast of loan advances and adjusted equity over the next 12 months, we anticipate that our adjusted debt-to-equity ratio will remain above the target and near the current ratio.
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” in our 2018 Form 10-K.

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. There were no material changes in the key inputs and assumptions used in our critical accounting policies during the six months ended November 30, 2018. Management has discussed significant judgments and assumptions in applying our critical accounting policies with the Audit Committee of our board of directors. We provide additional information on our critical accounting policies and estimates under “MD&A—Critical Accounting Policies and Estimates” in our 2018 Form 10-K. See “Item 1A. Risk Factors” in our 2018 Form 10-K for a discussion of the risks associated with management’s judgments and estimates in applying our accounting policies and methods.
RECENT ACCOUNTING CHANGES AND OTHER DEVELOPMENTS

See “Note 1—Summary of Significant Accounting Policies” for information on accounting standards adopted during the current quarter, as well as recently issued accounting standards not yet required to be adopted 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.

8



CONSOLIDATED RESULTS OF OPERATIONS

The section below provides a comparative discussion of our condensed consolidated results of operations between the three months ended November 30, 2018 and 2017 and the six months ended November 30, 2018 and 2017. Following this section, we provide a comparative analysis of our condensed consolidated balance sheets as of November 30, 2018 and May 31, 2018. 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 2 presents average balances for the three and six months ended November 30, 2018 and 2017, 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 2 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.”


9



Table 2: Average Balances, Interest Income/Interest Expense and Average Yield/Cost
 
 
Three Months Ended November 30,
(Dollars in thousands)
 
2018
 
2017
Assets:
 
Average Balance
 
Interest Income/Expense
 
Average Yield/Cost
 
Average Balance
 
Interest Income/Expense
 
Average Yield/Cost
Long-term fixed-rate loans(1)
 
$
22,688,250

 
$
253,340

 
4.48
%
 
$
22,458,429

 
$
248,926

 
4.45
%
Long-term variable-rate loans
 
1,096,965

 
10,066

 
3.68

 
886,257

 
6,097

 
2.76

Line of credit loans
 
1,351,917

 
11,752

 
3.49

 
1,330,776

 
8,588

 
2.59

TDR loans(2)
 
12,184

 
211

 
6.95

 
12,929

 
222

 
6.89

Other income, net(3)
 

 
(251
)
 

 

 
(306
)
 

Total loans
 
25,149,316

 
275,118

 
4.39

 
24,688,391

 
263,527

 
4.28

Cash, time deposits and investment securities
 
833,165

 
6,135

 
2.95

 
528,158

 
2,296

 
1.74

Total interest-earning assets
 
$
25,982,481

 
$
281,253

 
4.34
%
 
$
25,216,549

 
$
265,823

 
4.23
%
Other assets, less allowance for loan losses
 
1,090,619

 
 
 
 
 
526,627

 
 
 
 
Total assets
 
$
27,073,100

 
 
 
 
 
$
25,743,176

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Liabilities:
 
 
 
 
 
 
 
 
 
 
 
 
Short-term borrowings
 
$
3,816,429

 
$
22,619

 
2.38
%
 
$
2,998,298

 
$
10,116

 
1.35
%
Medium-term notes
 
3,910,610

 
33,816

 
3.47

 
3,375,389

 
27,544

 
3.27

Collateral trust bonds
 
7,265,598

 
68,934

 
3.81

 
7,637,919

 
85,321

 
4.48

Guaranteed Underwriter Program notes payable
 
4,835,203

 
35,014

 
2.90

 
5,066,574

 
35,688

 
2.83

Farmer Mac notes payable
 
2,556,991

 
19,697

 
3.09

 
2,496,587

 
11,947

 
1.92

Other notes payable
 
29,923

 
322

 
4.32

 
35,295

 
391

 
4.44

Subordinated deferrable debt
 
742,456


9,417

 
5.09

 
742,319


9,417

 
5.09

Subordinated certificates
 
1,377,089

 
14,347

 
4.18

 
1,415,352

 
14,746

 
4.18

Total interest-bearing liabilities
 
$
24,534,299

 
$
204,166

 
3.34
%
 
$
23,767,733

 
$
195,170

 
3.29
%
Other liabilities
 
976,113

 
 
 
 
 
842,246

 
 
 
 
Total liabilities
 
25,510,412

 
 
 
 
 
24,609,979

 
 
 
 
Total equity
 
1,562,688

 
 
 
 
 
1,133,197

 
 
 
 
Total liabilities and equity
 
$
27,073,100

 
 
 
 
 
$
25,743,176

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Net interest spread(4)
 
 
 
 
 
1.00
%
 
 
 
 
 
0.94
%
Impact of non-interest bearing funding(5)
 
 
 
 
 
0.19

 
 
 
 
 
0.18

Net interest income/net interest yield(6)
 
 
 
$
77,087

 
1.19
%
 
 
 
$
70,653

 
1.12
%
 
 
 
 
 
 
 
 
 
 
 
 
 
Adjusted net interest income/adjusted net interest yield:
 
 
 
 
 
 
 
 
 
 
 
 
Interest income
 
 
 
$
281,253

 
4.34
%
 
 
 
$
265,823

 
4.23
%
Interest expense
 
 
 
204,166

 
3.34

 
 
 
195,170

 
3.29

Add: Net accrued periodic derivative cash settlements(7)
 
 
 
11,805

 
0.43

 
 
 
19,635

 
0.72

Adjusted interest expense/adjusted average cost(8)
 
 
 
$
215,971

 
3.53
%
 
 
 
$
214,805

 
3.63
%
 
 
 
 
 
 
 
 
 
 
 
 
 
Adjusted net interest spread(4)
 
 
 
 
 
0.81
%
 
 
 
 
 
0.60
%
Impact of non-interest bearing funding(5)
 
 
 
 
 
0.20

 
 
 
 
 
0.21

Adjusted net interest income/adjusted net interest yield(9)
 
 
 
$
65,282

 
1.01
%
 
 
 
$
51,018

 
0.81
%
 
 
 
 
 
 
 
 
 
 
 
 
 

10



 
 
Six Months Ended November 30,
(Dollars in thousands)
 
2018
 
2017
Assets:
 
Average Balance
 
Interest Income/Expense
 
Average Yield/Cost
 
Average Balance
 
Interest Income/Expense
 
Average Yield/Cost
Long-term fixed-rate loans(1)
 
$
22,691,903

 
$
505,141

 
4.44
%
 
$
22,414,622

 
$
498,290

 
4.43
%
Long-term variable-rate loans
 
1,084,188

 
19,447

 
3.58

 
864,494

 
11,960

 
2.76

Line of credit loans
 
1,387,579

 
23,385

 
3.36

 
1,342,124

 
17,295

 
2.57

TDR loans(2)
 
12,369

 
429

 
6.92

 
13,026

 
448

 
6.86

Other income, net(3)
 

 
(576
)
 

 

 
(538
)
 

Total loans
 
25,176,039

 
547,826

 
4.34

 
24,634,266

 
527,455

 
4.27

Cash, time deposits and investment securities
 
821,222

 
11,918

 
2.89

 
445,452

 
4,283

 
1.92

Total interest-earning assets
 
$
25,997,261

 
$
559,744

 
4.29
%
 
$
25,079,718

 
$
531,738

 
4.23
%
Other assets, less allowance for loan losses
 
907,444

 
 
 
 
 
543,490

 
 
 
 
Total assets
 
$
26,904,705

 


 
 
 
$
25,623,208

 


 


 
 
 
 
 
 
 
 
 
 
 
 
 
Liabilities:
 
 
 


 


 


 


 


Short-term borrowings
 
$
3,667,402

 
$
42,038

 
2.29
%
 
$
3,111,502

 
$
20,655

 
1.32
%
Medium-term notes
 
3,833,484

 
66,226

 
3.45

 
3,192,063

 
52,660

 
3.29

Collateral trust bonds
 
7,370,550

 
146,639

 
3.97

 
7,636,669

 
170,598

 
4.46

Guaranteed Underwriter Program notes payable
 
4,841,855

 
70,348

 
2.90

 
5,030,955

 
71,290

 
2.83

Farmer Mac notes payable
 
2,674,397

 
40,808

 
3.04

 
2,502,096

 
23,437

 
1.87

Other notes payable
 
29,900

 
644

 
4.30

 
35,269

 
781

 
4.42

Subordinated deferrable debt
 
742,439

 
18,834

 
5.06

 
742,302

 
18,833

 
5.06

Subordinated certificates
 
1,377,524

 
28,860

 
4.18

 
1,416,619

 
29,647

 
4.17

Total interest-bearing liabilities
 
$
24,537,551

 
$
414,397

 
3.37
%
 
$
23,667,475

 
$
387,901

 
3.27
%
Other liabilities
 
836,273

 
 
 

 
847,751

 

 
 
Total liabilities
 
25,373,824

 
 
 

 
24,515,226

 

 
 
Total equity
 
1,530,881

 
 
 
 
 
1,107,982

 

 
 
Total liabilities and equity
 
$
26,904,705

 


 
 
 
$
25,623,208

 


 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Net interest spread(4)
 
 
 


 
0.92
%
 


 


 
0.96
%
Impact of non-interest bearing funding(5)
 
 
 
 
 
0.20

 
 
 
 
 
0.18

Net interest income/net interest yield(6)
 
 
 
$
145,347

 
1.12
%
 
 
 
$
143,837

 
1.14
%
 
 
 
 
 
 
 
 
 
 
 
 
 
Adjusted net interest income/adjusted net interest yield:
 
 
 
 
 


 
 
 
 
 
 
Interest income
 
 
 
$
559,744

 
4.29
%
 
 
 
$
531,738

 
4.23
%
Interest expense
 
 
 
414,397

 
3.37

 
 
 
387,901

 
3.27

Add: Net accrued periodic derivative cash settlements(7)
 
 
 
24,634

 
0.45

 
 
 
39,857

 
0.74

Adjusted interest expense/adjusted average cost(8)
 
 
 
$
439,031

 
3.57
%
 


 
$
427,758

 
3.60
%
 
 
 
 
 
 
 
 
 
 
 
 
 
Adjusted net interest spread(4)
 
 
 
 
 
0.72
%
 

 
 
 
0.63
%
Impact of non-interest bearing funding(5)
 
 
 
 
 
0.21

 
 
 
 
 
0.20

Adjusted net interest income/adjusted net interest yield(9)
 
 
 
$
120,713

 
0.93
%
 

 
$
103,980


0.83
%
____________________________ 
(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.

11



(4)Net interest spread represents the difference between the average yield on total average interest-earning assets and the average cost of total average interest-bearing liabilities. Adjusted net interest spread represents the difference between the average yield on total average interest-earning assets and the adjusted average cost of total average interest-bearing liabilities.
(5)Includes other liabilities and equity.
(6)Net interest yield is calculated based on annualized 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. This amount is added to interest expense to derive non-GAAP adjusted interest expense. The average (benefit)/cost associated with derivatives is calculated based on annualized 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 $11,123 million and $10,902 million for the three months ended November 30, 2018 and 2017, respectively. The average outstanding notional amount of interest rate swaps was $11,039 million and $10,791 million for the six months ended November 30, 2018 and 2017, respectively.
(8)Adjusted interest expense represents interest expense plus net accrued periodic interest rate swap cash settlements during the period. Net accrued periodic derivative cash settlements are reported on our consolidated statements of income as a component of derivative gains (losses). Adjusted average cost is calculated based on annualized 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 annualized adjusted net interest income for the period divided by total average interest-earning assets for the period.


Table 3 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. 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.
 

12



Table 3: Rate/Volume Analysis of Changes in Interest Income/Interest Expense
 
 
Three Months Ended November 30,
 
Six Months Ended November 30,
 
 
2018 versus 2017
 
2018 versus 2017
 
 
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
 
$
4,414

 
$
2,547

 
$
1,867

 
$
6,851

 
$
6,164

 
$
687

Long-term variable-rate loans
 
3,969

 
1,450

 
2,519

 
7,487

 
3,039

 
4,448

Line of credit loans
 
3,164

 
136

 
3,028

 
6,090

 
586

 
5,504

Restructured loans
 
(11
)
 
(13
)
 
2

 
(19
)
 
(23
)
 
4

Other income, net
 
55

 

 
55

 
(38
)
 

 
(38
)
Total loans
 
11,591

 
4,120

 
7,471

 
20,371

 
9,766

 
10,605

Cash, time deposits and investment securities
 
3,839

 
1,326

 
2,513

 
7,635

 
3,613

 
4,022

Interest income
 
15,430

 
5,446

 
9,984

 
28,006

 
13,379

 
14,627

 
 
 
 
 
 
 
 
 
 
 
 
 
Interest expense:
 
 
 
 
 
 
 
 
 
 
 
 
Short-term borrowings
 
12,503

 
2,760

 
9,743

 
21,383

 
3,690

 
17,693

Medium-term notes
 
6,272

 
4,368

 
1,904

 
13,566

 
10,582

 
2,984

Collateral trust bonds
 
(16,387
)
 
(4,159
)
 
(12,228
)
 
(23,959
)
 
(5,945
)
 
(18,014
)
Guaranteed Underwriter Program notes payable
 
(674
)
 
(1,630
)
 
956

 
(942
)
 
(2,680
)
 
1,738

Farmer Mac notes payable
 
7,750

 
289

 
7,461

 
17,371

 
1,614

 
15,757

Other notes payable
 
(69
)
 
(60
)
 
(9
)
 
(137
)
 
(119
)
 
(18
)
Subordinated deferrable debt
 

 
2

 
(2
)
 
1

 
3

 
(2
)
Subordinated certificates
 
(399
)
 
(399
)
 

 
(787
)
 
(818
)
 
31

Interest expense
 
8,996

 
1,171

 
7,825

 
26,496

 
6,327

 
20,169

Net interest income
 
$
6,434

 
$
4,275

 
$
2,159

 
$
1,510

 
$
7,052

 
$
(5,542
)
 
 
 
 
 
 
 
 
 
 
 
 
 
Adjusted net interest income:
 
 
 
 
 
 
 
 
 
 
 
 
Interest income
 
$
15,430

 
$
5,446

 
$
9,984

 
$
28,006

 
$
13,379

 
$
14,627

Interest expense
 
8,996

 
1,171

 
7,825

 
26,496

 
6,327

 
20,169

Net accrued periodic derivative cash settlements(2)
 
(7,830
)
 
399

 
(8,229
)
 
(15,223
)
 
913

 
(16,136
)
Adjusted interest expense(3)
 
1,166

 
1,570

 
(404
)
 
11,273

 
7,240

 
4,033

Adjusted net interest income
 
$
14,264

 
$
3,876

 
$
10,388

 
$
16,733

 
$
6,139

 
$
10,594

____________________________ 
(1)The changes for each category of interest income and interest expense are divided between the portion of change attributable to the variance in volume and the portion of change attributable to the variance in rate for that category. The amount attributable to the combined impact of volume and rate has been allocated to each category based on the proportionate absolute dollar amount of change for that category.
(2)For net accrued periodic derivative cash settlements, the variance due to average volume represents the change in derivative cash settlements resulting from the change in the average notional amount of derivative contracts outstanding. The variance due to average rate represents the change in derivative cash settlements resulting from the net difference between the average rate paid and the average rate received for interest rate swaps during the period.
(3) See “Non-GAAP Financial Measures” for additional information on our adjusted non-GAAP measures.

Reported Net Interest Income
Reported net interest income of $77 million for the current quarter reflected an increase of $6 million, or 9%, from the comparable prior-year quarter, driven by an increase in net interest yield of 6% (7 basis points) to 1.19% and an increase in average interest-earning assets of 3%.

13



Net Interest Yield: The increase of 7 basis points in the net interest yield for the current quarter reflected the combined impact of an increase in the average yield on interest-earning assets of 11 basis points to 4.34%, which was partially offset by an increase in the average cost of funds of 5 basis points to 3.34% due to a higher average cost for our short-term and variable-rate borrowings as a result of the rise in short-term interest rates. The increase in the average cost of funds was somewhat mitigated by the benefit from the early redemption in July 2018 of $300 million aggregate principal amount of our $1 billion 10.375% collateral trust bonds due November 1, 2018, and the repayment of the remaining $700 million of these bonds at maturity.

Average Interest-Earning Assets: The increase in average interest-earning assets of 3% for the current quarter was attributable to growth in average total loans of $461 million, or 2%, and an increase in our investment securities portfolio.
Reported net interest income of $145 million for the six months ended November 30, 2018 reflected an increase of $2 million, or 1%, from the comparable prior-year period, driven by an increase in average interest-earning assets of 4%, which was partially offset by a decrease in net interest yield of 2% (2 basis points) to 1.12%.

Net Interest Yield: The decrease of 2 basis points in the net interest yield was attributable to a 10 basis points increase in the average cost of funds to 3.37%, which was partially offset by a 6 basis point increase in the average yield on interest-earning assets to 4.29%, largely due to interest rate increases on variable rate loans. The increase in the average yield on interest-earning assets and the increase in the average cost of funds were both largely due to an increase in rates on short-term and variable-rate loans and borrowings as a result of the continued rise in short-term interest rates. The 3-month London Interbank Offered Rate (“LIBOR”) was 2.74% as of November 30, 2018, an increase of 125 basis points from November 30, 2017, while the federal funds target rate was 2.25% as of November 30, 2018, up 100 basis points from November 30, 2017. The benefit from the early redemption and repayment of our $1 billion 10.375% collateral trust bonds due November 1, 2018, partially offset the increase in the average cost of short-term and variable-rate borrowings.

Average Interest-Earning Assets: The increase in average interest-earning assets of 4% for the six months ended November 30, 2018 was attributable to growth in average total loans of $542 million, or 2%, and an expansion of our investment securities portfolio.

Adjusted Net Interest Income

Adjusted net interest income of $65 million for the current quarter increased by $14 million, or 28%, from the comparable prior-year quarter, driven by an increase in the adjusted net interest yield of 25% (20 basis points) to 1.01% and the increase in average interest-earning assets of 3%. The increase in the adjusted net interest yield reflected the combined impact of an increase in the average yield on interest-earning assets of 11 basis points to 4.34% and a decline in our adjusted average cost of funds of 10 basis points to 3.53%.

Adjusted net interest income of $121 million for the six months ended November 30, 2018 increased by $17 million, or 16%, from the comparable prior-year period, driven by an increase in the adjusted net interest yield of 12% (10 basis points) to 0.93% and the increase in average interest-earning assets of 4%. The increase in the adjusted net interest yield reflected the combined impact of an increase in the average yield on interest earning assets of 6 basis points to 4.29% and a decline in our adjusted average cost of funds of 3 basis points to 3.57%.

The decrease in the average cost of funds in the current quarter and for the six months ended November 30, 2018 was primarily due to a reduction in adjusted interest expense from the early redemption and maturity of the $1 billion aggregate principal amount of the 10.375% collateral trust bonds and a reduction in net periodic derivative cash settlement amounts. The reduction in net periodic derivative cash settlements was attributable to the rise in short-term interest rates, which resulted in an increase in the periodic floating interest rate amounts due to us on our pay-fixed swaps, as the floating interest rate payment amounts are typically determined based on the 3-month LIBOR.

We recorded net periodic derivative cash settlement expense of $12 million and $20 million for the three months ended November 30, 2018 and 2017, respectively, and $25 million and $40 million for the six months ended November 30, 2018 and 2017, respectively. We include net accrued periodic derivative cash settlements during the period in the calculation of our adjusted average cost of funds, which, as a result, also impacts the calculation of adjusted net interest income and

14



adjusted net interest yield. See “Non-GAAP Financial Measures” for additional information on our adjusted measures, including a reconciliation of these measures to the most comparable GAAP measures.

Provision for Loan Losses

Our provision for loan losses in each period is primarily driven by the level of allowance that we determine is necessary for probable incurred loan losses inherent in our loan portfolio as of each balance sheet date.

We recorded a benefit for loan losses of $2 million for both the three and six months ended November 30, 2018. In comparison, we recorded a benefit for loan losses of less than $1 million for the same prior-year periods. The credit quality and performance statistics of our loan portfolio continued to remain strong. We had no payment defaults or charge-offs during the six months ended November 30, 2018, and no delinquent loans or nonperforming loans in our loan portfolio as of November 30, 2018 or May 31, 2018.

We provide additional information on our allowance for loan losses under “Credit Risk—Allowance for Loan Losses” and “Note 5—Allowance for Loan Losses” of this report. For additional information on our allowance methodology, see “MD&A—Critical Accounting Policies and Estimates” and “Note 1—Summary of Significant Accounting Policies” in our 2018 Form 10-K.

Non-Interest Income

Non-interest income consists of fee and other income, gains and losses on derivatives not accounted for in hedge accounting relationships and results of operations of foreclosed assets.
 
Table 4 presents the components of non-interest income recorded in results of operations for the three and six months ended November 30, 2018 and 2017.

Table 4: Non-Interest Income
 
 
Three Months Ended November 30,
 
Six Months Ended November 30,
(Dollars in thousands)
 
2018
 
2017
 
2018

2017
Non-interest income:
 
 
 
 
 
 
 
 
Fee and other income
 
$
4,321

 
$
5,542

 
$
7,506

 
$
9,487

Derivative gains
 
63,343

 
125,593

 
70,526

 
79,395

Results of operations of foreclosed assets
 

 
(10
)
 

 
(34
)
Total non-interest income
 
$
67,664

 
$
131,125

 
$
78,032

 
$
88,848


The significant variances in non-interest income between periods were primarily attributable to changes in net derivative gains recognized in our consolidated statements of income.

Derivative Gains (Losses)

Our derivative instruments are an integral part of our interest rate risk management strategy. Our principal purpose in using derivatives is to manage our aggregate interest rate risk profile within prescribed risk parameters. The derivative instruments we use primarily include interest rate swaps, which we typically hold to maturity. In addition, we may on occasion use treasury locks to manage the interest rate risk associated with debt that is scheduled to reprice in the future. The primary factors affecting the fair value of our derivatives and derivative gains (losses) recorded in our results of operations include changes in interest rates, the shape of the swap curve and the composition of our derivative portfolio. We generally do not designate our interest rate swaps, which currently account for the substantial majority of our derivatives, for hedge accounting. Accordingly, changes in the fair value of interest rate swaps are reported in our consolidated statements of income under derivative gains (losses). However, we typically designate treasury locks as cash flow hedges. We did not have any derivatives designated as accounting hedges as of November 30, 2018. During the current quarter, we terminated a treasury lock that was previously designated as a cash flow hedge.


15



We currently use two types of interest rate swap agreements: (i) we pay a fixed rate and receive a variable rate (“pay-fixed swaps”); and (ii) we pay a variable rate and receive a fixed rate (“receive-fixed swaps”). The benchmark variable rate for the substantial majority of the floating rate payments under our swap agreements is 3-month LIBOR. Table 5 displays the average notional amount outstanding, by swap agreement type, and the weighted-average interest rate paid and received for interest rate swap settlements during the three and six months ended November 30, 2018 and 2017. As indicated in Table 5, our interest rate swap portfolio currently consists of a higher proportion of pay-fixed swaps than receive-fixed swaps, with pay-fixed swaps representing approximately 67% and 65% of the outstanding notional amount of our derivative portfolio as of both November 30, 2018 and May 31, 2018, respectively. The composition of our interest rate swap portfolio, however, may change as a result of changes in market conditions and actions taken to manage our exposure to interest rate risk.

Table 5: Derivative Average Notional Amounts and Average Interest Rates
 
 
Three Months Ended November 30,
 
 
2018
 
2017
(Dollars in thousands)
 
Average
Notional
Balance
 
Weighted-
Average
Rate Paid
 
Weighted-
Average
Rate Received
 
Average
Notional
Balance
 
Weighted-
Average
Rate Paid
 
Weighted-
Average
Rate Received
Pay-fixed swaps
 
$
7,424,114

 
2.71
%
 
2.35
%
 
$
7,052,629

 
2.84
%
 
1.35
%
Receive-fixed swaps
 
3,699,000

 
3.05

 
2.52

 
3,849,001

 
1.91

 
2.63

Total
 
$
11,123,114

 
2.82
%
 
2.41
%
 
$
10,901,630

 
2.51
%
 
1.80
%
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Six Months Ended November 30,
 
 
2018
 
2017
(Dollars in thousands)
 
Average
Notional
Balance
 
Weighted-
Average
Rate Paid
 
Weighted-
Average
Rate Received
 
Average
Notional
Balance
 
Weighted-
Average
Rate Paid
 
Weighted-
Average
Rate Received
Pay-fixed swaps
 
$
7,308,859

 
2.70
%
 
2.30
%
 
$
7,003,898

 
2.84
%
 
1.31
%
Receive-fixed swaps
 
3,729,738

 
3.01

 
2.52

 
3,787,525

 
1.87

 
2.63

Total
 
$
11,038,597

 
2.80
%
 
2.37
%
 
$
10,791,423

 
2.50
%
 
1.77
%

The average remaining maturity of our pay-fixed and receive-fixed swaps was 19 years and four years, respectively, as of both November 30, 2018 and 2017.

Pay-fixed swaps generally decrease in value as interest rates decline and increase in value as interest rates rise. In contrast, receive-fixed swaps generally increase in value as interest rates decline and decrease in value as interest rates rise. Because our pay-fixed and receive-fixed swaps are referenced to different maturity terms along the swap curve, different changes in the swap curve—parallel, flattening or steepening—will result in differences in the fair value of our derivatives. The chart below provides comparative swap curves as of the end of November 30, 2018, May 31, 2018, November 30, 2017 and May 31, 2017.


16



chart-f3602d352b48571ea5c.jpg
____________________________ 
Benchmark rates obtained from Bloomberg.

Table 6 presents the components of net derivative gains (losses) recorded in results of operations for the three and six months ended November 30, 2018 and 2017. Derivative cash settlements represent the net periodic contractual interest amount for our interest-rate swaps for the reporting period. Derivative forward value gains (losses) represent the change in fair value of our interest rate swaps during the reporting period due to changes in expected future interest rates over the remaining life of our derivative contracts.

Table 6: Derivative Gains (Losses)
 
 
Three Months Ended November 30,
 
Six Months Ended November 30,
(Dollars in thousands)
 
2018
 
2017
 
2018
 
2017
Derivative gains (losses) attributable to:
 
 
 
 
 
 
 
 
Derivative cash settlements
 
$
(11,805
)
 
$
(19,635
)
 
$
(24,634
)
 
$
(39,857
)
Derivative forward value gains
 
75,148

 
145,228

 
95,160

 
119,252

Derivative gains
 
$
63,343

 
$
125,593

 
$
70,526

 
$
79,395


The net derivative gains of $63 million and $71 million for the three and six months ended November 30, 2018, were attributable to an increase in the fair value of our pay-fixed swaps resulting from an increase in interest rates across the swap yield curve, as depicted by the November 30, 2018 swap curve presented in the above chart.

The net derivative gains of $126 million and $79 million for the three and six months ended November 30, 2017, respectively, were also attributable to an increase in the fair value of our pay-fixed swaps as interest rates increased across the yield curve.

17



As discussed above, pay-fixed swaps, which represent a higher proportion of our derivative portfolio, typically increase in fair value when interest rates rise. Although interest rates rose in both the current year and prior year periods, the rise in medium- and longer-term rates was not as pronounced during the current quarter and year-to-date period. As a result, the derivative gains were lower relative to the same prior-year periods. For example, the 5-year swap rate increased by 11 basis points and 17 basis points during the three and six months ended November 30, 2018, respectively, while the 10-year swap rate increased by 13 basis points and 17 basis points, respectively. In comparison, the 5-year swap rate increased by 44 basis points and 37 basis points during the three and six months ended November 30, 2017, respectively, while the 10-year swap rate increased by 34 basis points and 26 basis points, respectively.

See “Note 9—Derivative Instruments and Hedging Activities” for additional information on our derivative instruments.

Non-Interest Expense

Non-interest expense consists of salaries and employee benefit expense, general and administrative expenses, losses on early extinguishment of debt and other miscellaneous expenses.

Table 7 presents the components of non-interest expense recorded in results of operations for the three and six months ended November 30, 2018 and 2017.

Table 7: Non-Interest Expense
 
 
Three Months Ended November 30,
 
Six Months Ended November 30,
(Dollars in thousands)
 
2018
 
2017
 
2018
 
2017
Non-interest expense:
 
 
 
 
 
 
 
 
Salaries and employee benefits
 
$
(12,392
)
 
$
(12,009
)
 
$
(25,074
)
 
$
(23,832
)
Other general and administrative expenses
 
(11,478
)
 
(9,905
)
 
(22,001
)
 
(19,718
)
Losses on early extinguishment of debt
 

 

 
(7,100
)
 

Other non-interest expense
 
(2,700
)
 
(618
)
 
(3,094
)
 
(1,140
)
Total non-interest expense
 
$
(26,570
)
 
$
(22,532
)
 
$
(57,269
)
 
$
(44,690
)

Non-interest expense of $27 million for the current quarter increased by $4 million, or 18%, from the comparable prior-year quarter, primarily due to increases in general and administrative expenses and other non-interest expense.

Non-interest expense of $57 million for the six months ended November 30, 2018 increased by $13 million, or 28%, from the comparable prior-year quarter. The increase was largely due to the loss on early extinguishment of debt of $7 million, attributable to the premium paid for the early redemption of $300 million of the $1 billion collateral trust bonds, with a coupon rate of 10.375%, that matured on November 1, 2018.

Net Income (Loss) Attributable to Noncontrolling Interests

Net income (loss) attributable to noncontrolling interests represents 100% of the results of operations of NCSC and RTFC, as the members of NCSC and RTFC own or control 100% of the interest in their respective companies. The fluctuations in net income (loss) attributable to noncontrolling interests are primarily due to changes in the fair value of NCSC’s derivative instruments recognized in NCSC's earnings.

We recorded net income attributable to noncontrolling interests of less than $1 million for both the three and six months ended November 30, 2018. We recorded net income attributable to noncontrolling interests of $1 million for both the three and six months ended November 30, 2017.

18



CONSOLIDATED BALANCE SHEET ANALYSIS

Total assets of $26,830 million as of November 30, 2018 increased by $139 million from May 31, 2018. Total liabilities of $25,203 million as of November 30, 2018 increased by $18 million from May 31, 2018. Total equity increased by $121 million to $1,627 million as of November 30, 2018, attributable to our reported net income of $168 million during the six months ended November 30, 2018, which was partially offset by patronage capital retirement of $48 million in August 2018.

Following is a discussion of changes in the major components of our assets and liabilities during the six months ended November 30, 2018. Period-end balance sheet amounts may vary from average balance sheet amounts due to liquidity and balance sheet management activities that are intended to manage liquidity requirements for the company and our customers and our market risk exposure in accordance with our risk appetite.

Loan Portfolio

We offer long-term fixed- and variable-rate loans and line of credit variable-rate loans. The substantial majority of loans in our portfolio represent advances under secured long-term facilities with terms up to 35 years. Borrowers have the option of selecting a fixed or variable interest rate for each advance for periods ranging from one year to the final maturity of the facility. Line of credit loans are typically revolving facilities and are generally unsecured.
 
Loans Outstanding

Table 8 summarizes loans to members, by loan type and by member class, as of November 30, 2018 and May 31, 2018. As indicated in Table 8, long-term fixed-rate loans accounted for 90% of loans to members as of both November 30, 2018 and May 31, 2018.

Table 8: Loans Outstanding by Type and Member Class
 
 
November 30, 2018
 
May 31, 2018
 

(Dollars in thousands)
 
Amount
 
% of Total
 
Amount
 
% of Total
 
Change
Loans by type:
 
 
 
 
 
 
 
 
 
 
Long-term loans:
 
 
 
 
 
 
 
 
 
 
Fixed-rate
 
$
22,713,588

 
90
%
 
$
22,696,185

 
90
%
 
$
17,403

Variable-rate
 
1,077,971