The ratings on National Rural Utilities Cooperative Finance Corp. (CFC; A/Stable/A-1) reflect consistent and sound financial performance, strong security provisions, historically good asset performance, and a strong financial position. In addition, CFC has demonstrated the ability to increase margins and pass through increases in funding costs to borrowers on a historical basis.

CFC's credit strength is somewhat negatively affected by credit weakness among some of its top-10 borrowers. For example, CFC through affiliate Rural Telephone Finance Cooperative (RTFC) had $340 million in exposure to VarTec Telecom (VarTec) whose loans were reclassified as nonperforming and put on nonaccrual status as of June 1, 2004. Standard & Poor's Ratings Services has always considered VarTec to be a high-risk credit among CFC's top-10 borrowers. VarTec filed for bankruptcy on Nov. 1, 2004. In addition, CFC affiliate RTFC has commenced litigation against Innovative Communication Corp. (ICC). The lawsuit alleges that U.S. Virgin Islands-based ICC has breached its loan and security agreement in various respects. RTFC's amended complaint seeks the acceleration of the $552 million outstanding at June 30, 2004. Loans and guarantees to ICC represent about 2.5% of CFC's $22 billion loan and guarantee portfolio. RTFC has stated that its exposure to ICC is fully secured.

CFC's loan portfolio continues to exhibit high credit concentration and rural telecommunication company concentration among its top-10 borrowers. The credit exposure to the top-10 borrowers constituted 21% of total loans and guarantees. Loans to rural telecommunication companies accounted for 22% of total loans as of Aug. 31, 2004, down from 27% at May 31, 2001. CFC's top-10 borrowers consist of five rural local exchange telecom companies, three generation and transmission cooperatives, and two electric distribution cooperatives. Standard & Poor's has evaluated CFC's top-10 borrowers and concluded that one half exhibit speculative-grade rating characteristics. However, CFC has only had net charge-offs of $115 million in loan principal since its inception in 1969. However, $33 million in net losses were experienced during the past three years. As of the end of its fiscal year on May 31, 2004, CFC had a loan loss allowance of$574 million of reserves, representing 2.8% of total loans outstanding. Impaired loans (primarily Denton County Electric Cooperative Inc. (CoServ) and VarTec) are covered by $233 million, $109 million was for high-risk loans, and $232 million was for the general loan portfolio. The loan loss allowance remained at $574 million as of first-quarter end Aug. 31, 2004, of which $249 million was to cover impaired loans. Yet Standard & Poor's concludes that the uncertainty surrounding the impaired and high-risk loans could lead to adjustments in the reserve over time.

Standard & Poor's concludes that CFC's leverage is high for its current rating. Standard & Poor's expected CFC to maintain its debt-to-equity ratio below 6x after meeting that goal in fiscal 2003. Although CFC took significant steps to bring leverage down in 2002 and 2003, the debt-to-equity ratio of 6.65x as of Aug. 31, 2004, is significantly higher than 5.95x, where it was at May 31, 2003. The increase in the adjusted debt to equity ratio is due to an increase in adjusted liabilities of $114 million and a decrease in adjusted equity of $27 million, largely due to the redemption of the quarterly income capital securities (QUIC).

The stable outlook assumes no further deterioration in the loan portfolio. The default of another large borrower could cause Standard & Poor's to revise the outlook to negative. In addition, Standard & Poor's expects CFC to reduce its leverage and lower its debt-to-equity ratio below 6x by year-end 2005. Failure to do so would likely result in a negative outlook. Lastly, Standard & Poor's expects CFC to continue to reduce it its exposure telecom loans over time.

CFC is owned by and makes loans and guarantees to a membership made up of rural electric utilities and telecommunications companies. CFC's 1,544 consolidated membership consists of 898 utility members, most of which are consumer-owned electric cooperatives, 507 telecommunications members, 69 service members, and 70 associate members. CFC provides primary and supplemental financing from the U.S. Department of Agriculture's Rural Utilities Service (RUS) to the rural utilities. CFC's primary goal is to provide its members with the lowest possible loan and guarantee rates while achieving prudent financial targets itself. CFC's loans are on parity with RUS loans and are more than 90% secured by a single mortgage and the system's net revenues. In its role as a lender, CFC exhibits attributes of both a finance company and a financial guarantor. Although CFC's loan portfolio is geographically diverse, with Texas the only state with more than a 10% concentration (17%), the loans are fairly concentrated among the 10-largest borrowers, which made up 21% of outstanding loans as of Aug. 31, 2004.

CFC's RTFC affiliate makes loans to rural telephone companies and their affiliates that provide telephone, cellular, cable, and related services. On Aug. 31, 2004, CFC's telecommunications loan portfolio was about $4.6 billion. Although the telecommunications portion of the total loan portfolio diversifies away from the focus on electric loans, about 22% of the telecom loans as of Aug. 31, 2004 are to entities other than rural local exchange carriers (RLEC). Rural telecom borrowers may experience a higher level of competition, compared with the rural electric cooperatives.

In fiscal 2003, CFC adopted a more quantitative methodology to determine the required loan loss allowance for the general portfolio. Standard & Poor's devoted significant resources to evaluating this revised methodology and concluded that the reserves set under this new method are appropriate for the rating level. The level of the loan loss allowance for the general portfolio is determined by internal risk ratings, probability of default and expected recovery levels. CFC's risk ratings for each of its borrowers are updated at least annually and are based on a variety of qualitative and quantitative factors. Standard & Poor's found a sample of the ratings to be reasonable. The probability of default is based on Standard & Poor's historic default tables according to comparable rating level and remaining maturity. Recovery rates are estimated based on historical experience of loan balance at the time of default compared with the total loss on the loan to date. Standard & Poor's reviewed the recovery estimates and found them to be reasonable. CFC aggregates the loans in the general portfolio by borrower type (distribution, generation, telecommunications, and associate member) and by internal risk rating within borrower type. CFC correlates its internal risk ratings to the ratings used in the standard default table based on a comparison of CFC's rating on borrowers that have a rating from the agencies and based on a standard matching used by banks.

In addition to the general portfolio reserve requirement, CFC maintains an additional reserve for borrowers with a total exposure in excess of 1.5% of the total CFC exposure. The additional reserve is based on the amount of exposure in excess of 1.5% of the CFC total exposure and the borrower's internal risk rating. As of May 31, 2004, CFC had a reserve of $19 million based on the additional risk related to large exposures. CFC allocates significantly higher levels of reserves for impaired and high-risk loans, which are not part of the general portfolio. The reserve for impaired loans is based on SFAS 114 and 118.

CFC funds its loans from its members' investments, debt sold to members, and debt issued in the capital markets. CFC's members are required to purchase subordinated subscription certificates as conditions of membership in CFC, borrowing from CFC, and obtaining a CFC guarantee. Standard & Poor's accords 100% equity treatment to the subordinated certificates because they are subordinate to CFC's senior debt and its subordinated convertible notes, pay deferrable interest or no interest at all, and have long maturities--as long as 100 years. In addition, members subordinate certificates differ from the type of certificates held in a mutual corporation. In CFC's case, members cannot redeem their certificates before the original maturity of their loan, and the average loan maturity is 12 years. Also, a large percent of the certificates had an initial maturity of 100 years and have a long average remaining maturity. Therefore, the chances of a membership withdrawal "death spiral" are significantly mitigated.

CFC retains considerable latitude in setting the conditions under which members purchase these securities. This is an important point in considering CFC's pricing flexibility. CFC's capital base also includes $550 million of subordinated convertible notes that are subordinate to the senior obligations, but which possess superior claim over the members' certificates. Standard & Poor's accords 65% equity treatment to these hybrid instruments. These instruments have a long maturity of up to 49 years, and interest may be deferred for 20 consecutive quarters.

A significant amount of CFC's derivative financial instruments do not qualify for hedge accounting and ratios based purely on GAAP can lead to misleading conclusions. CFC is neither a dealer nor a trader in derivative financial instruments. CFC uses interest rate, cross currency, and cross currency interest rate exchange agreements to manage its interest-rate risk and foreign-exchange risk and typically holds these instruments until maturity. Therefore, Standard & Poor's generally agrees with the adjustments that CFC makes to its ratios in its SEC filings, which includes backing out changes to the income statement and balance sheet for hedges that do not qualify as hedges under SFAS 133.

In accordance with SFAS 133, CFC records derivative instruments on the consolidated balance sheet as either an asset or liability measured at fair value. Changes in the fair value of derivative instruments are recognized in the derivative forward-value line item of the consolidated statement of operations unless specific hedge accounting criteria are met. The change to the fair value is recorded to other comprehensive income if the hedge accounting criteria are met. In the case of certain foreign currency exchange agreements that meet hedge accounting criteria, the change in fair value is recorded to other comprehensive income and then reclassified to offset the related change in the dollar value of foreign denominated debt in the consolidated statement of operations. CFC formally documents, designates, and assesses the effectiveness of transactions that receive hedge accounting. Net settlements that CFC pays and receives for derivative instruments that qualify for hedge accounting are recorded in the cost of funds. CFC records net settlements related to derivative instruments that do not qualify for hedge accounting as derivative cash settlements

As of Aug. 31, 2004, CFC was party to interest-rate exchange agreements of $14.8 billion. Generally, CFC's interest-rate exchange agreements do not qualify for hedge accounting under SFAS 133. The majority of CFC's interest-rate exchange agreements use a 30-day composite commercial paper index as either the pay or receive leg. The 30-day composite commercial paper index is the best match for the CFC commercial paper that is the underlying debt and is also used as the cost basis in the CFC variable interest rates. However, the correlation between movement in the 30-day composite commercial paper index and movement in CFC's commercial paper rates is not consistently high enough to qualify for hedge accounting. When CFC uses its commercial paper as the underlying debt, the receive leg of the interest-rate exchange agreement is based on the 30-day composite commercial paper index. CFC's commercial paper rates are not indexed to the 30-day composite commercial paper index and CFC does not solely issue its commercial paper with 30-day maturities. CFC uses the 30-day composite commercial paper index as the pay leg in these interest rate exchange agreements because it is the market index that best correlates with its own commercial paper.

As of Aug. 31, 2004 and May 31, 2004, CFC was party to $434 million of cross-currency interest-rate exchange agreements under which CFC receives euros and pays U.S. dollars, and $282 million, under which CFC receives Australian dollars and pays U.S. dollars. The cross-currency interest-rate exchange agreements are used to synthetically change the foreign-denominated debt to U.S. dollar-denominated debt. In addition, the agreements synthetically change the interest rate from the fixed rate on the foreign denominated debt to variable-rate U.S. denominated debt or from a variable rate on the foreign denominated debt to a different variable rate. These cross-currency interest-rate exchange agreements do not qualify for hedge accounting. Because the agreements synthetically change the interest rate and the currency-exchange rate in one agreement, the criteria to qualify for effectiveness specifies that the change in fair value of the debt when divided by the change in the fair value of the derivative must be in a range of 80% to 125%, which is more difficult to obtain than matching the critical terms. Therefore, all changes in fair value are recorded in the consolidated statements of operations. The effect on earnings for the three months ended Aug. 31, 2004 and 2003 due to the change in fair value of these cross-currency interest-rate exchange agreements was a loss of $2 million and $109 million, respectively, recorded in CFC's derivative forward value. The amounts that CFC paid and received related to its cross-currency interest-rate exchange agreements that did not qualify for hedge accounting were income of $6 million for the three months ended Aug. 31, 2004 and 2003, respectively, and were included in CFC's derivative cash settlements.

CFC entered into these exchange agreements to sell the amount of foreign currency received from the investor for U.S. dollars on the issuance date and to buy the amount of foreign currency required to repay the investor principal and interest due through or on the maturity date. By locking in the exchange rates at the time of issuance, CFC has eliminated the possibility of any currency gain or loss (except in the case of CFC or a counterparty default or unwind of the transaction), which might otherwise have been produced by the foreign-currency borrowing. On foreign currency-denominated medium-term notes with maturities longer than one year, interest is paid annually and, on medium-term notes with maturities of less than one year, interest is paid at maturity.

Standard & Poor's concludes that CFC's leverage is high for its current rating. Standard & Poor's expected CFC to maintain its debt-to-equity ratio below 6x, after meeting that goal in fiscal 2003. Although CFC took significant steps to bring leverage down in 2002 and 2003, the debt-to-equity ratio of 6.65x as of Aug. 31, 2004, is significantly higher than 5.97x, where it was as of May 31, 2003. The increase in the adjusted debt to equity ratio is due to an increase in adjusted liabilities of $114 million and a decrease in adjusted equity of $27 million due largely to the redemption of QUICs. CFC has at its disposal several programs to reduce its debt-to-equity ratio. Already mentioned are the conditions under which members purchase subordinate subscriptions as a requirement of obtaining loans and guarantees. CFC also has some pricing flexibility in the adders it uses for loan pricing. Finally, CFC has discretion on the rate it allocates and retires patronage capital back to members. Currently, it retires 70% of the allocated net margin from the previous year in the succeeding year and retains the remaining 30%.

CFC's financial performance has been stable. CFC's goal of achieving a 1.1x adjusted TIER has been attained each year since 1983 and has been at least 1.12x in each of the last 10 fiscal years. CFC uses an interest coverage ratio instead of the dollar amount of gross or net margin as its primary performance indicator because CFC's net margin in dollar terms is subject to fluctuation as interest rates change. In addition, as CFC is a not-for-profit, member-owned finance cooperative, its objective is not to maximize its net margins, but to offer its members low-cost financial services. Management has established a 1.1x adjusted TIER as its minimum operating objective. TIER is a measure of CFC's ability to cover the interest expense on its debt obligations. TIER is calculated by dividing the cost of funds and the net margin before the cumulative effect of change in accounting principle by the cost of funds. CFC's TIER for the three months ended Aug. 31, 2004 was 1.39x. CFC also calculates an adjusted TIER to exclude the derivative forward value and foreign-currency adjustments from net margin, to add back minority interest to net margin and to include the derivative cash settlements in the cost of funds. Adjusted TIER for the three months ended Aug. 31, 2004 was 1.15x. CFC adjusts its TIER calculation to exclude the noncash effect of derivatives required by SFAS 133 and foreign-currency adjustments required by SFAS 52.