The stable outlook assumes no further deterioration in the loan portfolio. The default of another large borrower could lead Standard & Poor's Ratings Services to revise the outlook to negative. In addition, Standard & Poor's expects CFC to reduce 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 its exposure to telecom loans over time.

Standard & Poor's has some concern about the level of reserves and the recovery prospects for the loans to Vartec Telecom Inc. and to Innovative Communication Corp. (ICC). As of Aug. 31, 2004, CFC had a loan-loss allowance that totaled $574 million, representing 2.8% of total loans outstanding. About $249 million is to cover impaired loans and $325 million is for high-risk loans and the general loan portfolio. CFC had impaired loans totaling $936 million, including $612 million for Denton County Electric Cooperative Inc. (CoServ) and $324 million for VarTec. Although the Aug. 31, 2004 figures for high-risk loans are not publicly available, as of May 31, 2004, CFC had reserved $109 million against the $607 million of exposure classified as high risk.

CFC's exposure to VarTec through its affiliate RTFC is secured under a mortgage on substantially all of its assets. Standard & Poor's, however, is concerned about the lack of hard assets as collateral for both of VarTec's primary businesses, dial-around long-distance service and competitive local exchange service. CFC, based on information received from a nationally recognized independent consulting firm, determined an appropriate level of reserves for the VarTec loan. However Standard & Poor's concludes that this view may be somewhat aggressive and could lead to adjustments in the reserve over time. VarTec is experiencing significant competition in its primary businesses and this competition resulted in a significant reduction to cash flow. In addition, recent court rulings have given the incumbent local exchange carrier network owners more control of the prices they can charge to companies leasing elements of the network, which will most likely result in an increase to the cost of operating as a provider that leases network capacity.

As of Aug. 31, 2004, CFC had $324 million of nonperforming loans outstanding to VarTec. On Oct. 7, 2004, CFC affiliate RTFC and VarTec entered into an amended credit agreement and, on Oct. 8, 2004, VarTec repaid $90 million of its loans to RTFC. VarTec filed for bankruptcy on Nov. 1, 2004. As of Nov. 3, 2004, RTFC had a total of $197 million of loans outstanding to VarTec. RTFC's total exposure to VarTec could increase above $197 million if RTFC advances funds to VarTec under the $20 million proposed debtor-in-possession financing.

Uncertainty surrounding the ICC loan could lead to adjustments in the reserve over time. As of Aug. 31, 2004, CFC's loan-loss allowance totaled $574 million, of which $325 million is for high-risk loans and the general loan portfolio. As of Aug. 31, 2004, CFC, through RTFC, had about $550 million in loans outstanding to ICC. RTFC's collateral for the loans to ICC includes:

• A series of mortgages, security agreements, financing statements, pledges, and guarantees creating liens in favor of RTFC on substantially all of the assets and voting stock of ICC;
• A direct pledge of 100% of the voting stock of ICC's U.S. Virgin Islands (USVI) local exchange carrier subsidiary;
• Secured guarantees, mortgages and direct and indirect stock pledges encumbering the assets and ownership interests in substantially all of ICC's other operating subsidiaries; and
• Personal guarantee of the loans from ICC's indirect majority shareholder and chairman.

In June and July 2004, RTFC filed lawsuits against ICC for failing to comply with the ICC loan agreement terms and to demand immediate full repayment of principal outstanding under loans to ICC, plus related interest and fees. In August 2004, ICC filed counterclaims, in which it denied that it defaulted on the loan agreement, and asserted a counterclaim seeking the reformation of the loan agreement to conform to a 1989 settlement agreement among the Virgin Islands Public Services Commission, ICC's predecessor, and RTFC in a manner ICC contends would relieve it of some of the defaults alleged in the RTFC's complaint. On a positive note, as of Aug. 31, 2004, ICC was current on all its scheduled monthly payments to RTFC per a stipulation agreement, and all loans are currently on accrual status regarding the recognition of interest income.

In September 2004, RTFC sued on behalf of ICC and Vitelco shareholders and as a creditor of ICC against ICC and Vitelco directors and executive officers for breaching their fiduciary duty by authorizing a 10% preferred stock issuance in violation of USVI law and loan agreements with RTFC. RTFC owns all common shares of ICC and Vitelco as a result of the pledge of those shares as security for RTFC's loans to ICC. In October 2004, ICC and Vitelco answered the complaint, denied the allegations, and filed counterclaims against RTFC alleging that RTFC has acted in bad faith and tortiously interfered with ICC and Vitelco contractual relations. ICC further alleges that RTFC was negligent regarding testimony given by an RTFC employee in litigation between ICC and its shareholders (Greenlight litigation), resulting in an increase in the damages awarded against ICC. ICC and Vitelco seek compensatory and punitive damages in an unspecified amount, as well as injunctive relief.

A significant amount of CFC's derivative financial instruments do not qualify for hedge accounting, and ratios based purely on GAAP can be misleading. 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. 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

At Aug. 31, 2004, CFC was party to interest-rate exchange agreements of $14.8 billion. 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.

The cross-currency interest-rate exchange agreements are used to synthetically change CFC's 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. dollar-denominated debt or from a variable rate on the foreign-denominated debt to a different variable rate. 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 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.