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

CFC's credit strength is somewhat negatively affected by credit weakness among some of its consolidated top 10 borrowers. For example, through affiliate Rural Telephone Finance Cooperative (RTFC), CFC had $84 million in exposure to VarTec Telecom, whose loans were reclassified as nonperforming and put in nonaccrual status in June 2004. Standard & Poor's Ratings Services has always considered VarTec a high-risk credit among CFC's top exposures. VarTec filed for bankruptcy on Nov. 1, 2004. In addition, RTFC commenced litigation against Innovative Communication Corp. (ICC), alleging that U.S. Virgin Islands-based firm breached its loan and security agreement in various respects. RTFC continues to seek the acceleration of the $475 million outstanding as of Aug. 31, 2005. Loans and guarantees to ICC represent about 2.5% of CFC's $19 billion loan and guarantee portfolio. RTFC has stated that its exposure to ICC is fully secured.

Although CFC's loan portfolio continues to exhibit high credit concentration among its top 10 borrowers, the portion was reduced from 21.3% as of May 31, 2004, to 18% as of Aug. 31, 2005. In addition, loans to higher-risk rural telecommunication companies have decreased materially, and as of Aug. 31, 2005, accounted for 12% of total loans, compared with 27% as of May 31, 2001. CFC's top borrowers are four distribution systems, four power supply systems, and two telecommunications systems. Standard & Poor's has evaluated these and concluded that some exhibit speculative-grade rating characteristics. However, CFC's net charge-offs have totaled only $115 million in loan principal since its inception in 1969. It experienced about $35 million in net losses over the past five years. As of Aug. 31, 2005, CFC had a loan loss allowance of $590 million of reserves, representing 3.2% of total loans outstanding. Reserves for impaired loans came to $421 million. Impaired loans totaled $1.15 billion, and nonperforming loans included those to Denton County Electric Cooperative Inc. ($587 million), VarTec ($84 million), and ICC ($475 million). Standard & Poor's concludes that the uncertainty surrounding the impaired and high-risk loans could lead to adjustments in the reserve over time.

CFC brought its debt-to-equity ratio down to 5.96x on Aug. 31, 2005, from 6.65x on Aug. 31, 2004. Standard & Poor's expects CFC to maintain a ratio of less than 6x.

The stable outlook on CFC 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, CFC is expected to maintain its adjusted debt-to-equity ratio at or below 6x. Failure to do so could result in a negative outlook. Lastly, Standard & Poor's expects CFC to either maintain or lower its current exposure to telecom loans over time. A change to a positive outlook, unlikely in the near term, would require a favorable resolution to the ICC loans, lower leverage, and lower telecom exposure.

CFC is owned by and makes loans and guarantees to a membership made up of rural electric utilities and telecommunications companies. As of Aug. 31, 2005, CFC comprised 900 electric utility members--most of which were consumer-owned cooperatives--512 telecommunications members, 69 service members, and 69 associate members. CFC provides both primary and supplemental funding to its members, and supplemental financing from the U.S. Department of Agriculture's RUS complements borrowings by rural utilities. CFC's primary goal is to provide its members with the lowest possible loan and guarantee rates. CFC's loans are on parity with RUS loans, and are more than 90% secured by a single mortgage and the net revenues of the system. 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 being the only state with more than a 10% concentration (15% as of May 31, 2005), the loans are fairly concentrated among the 10 largest borrowers, which accounted for 18% of outstanding loans and guarantees as of Aug. 31, 2005.

CFC's Rural Telephone Finance Cooperative (RTFC) affiliate makes loans to rural telephone companies and their affiliates that provide telephone, cellular, cable, and related services. CFC's telecommunications loan portfolio stood at about $2.3 billion as of Aug. 31, 2005, compared with $4.6 billion as of Aug. 31, 2004. While the telecommunications portion of the total loan portfolio diversifies away from the focus on electric loans, about 18% of the telecom loans as of Aug. 31, 2005, are to entities other than rural local exchange carriers (LEC), and may experience a higher level of competition than with the rural electric cooperatives.

About 92% of CFC's loans to borrowers were secured as of Aug. 31, 2005. However, Standard & Poor's will continue to monitor CFC's level of unsecured financings because CFC has begun syndicating interim unsecured financing for Generation & Transmission (G&T) Coops. CFC's first major effort was the recent syndication of the $650 million, five-year revolving credit facility for East Kentucky Power Cooperative (EKPC) in June 2005. EKPC plans to use the revolver to construct generating plants and for general corporate purposes. Over time, EKPC and other G&Ts expect to refinance with long-term financing from the RUS. However, Standard & Poor's is concerned that future failed syndications or a delay in the G&T's refinancing of the unsecured revolvers could cause an increase in CFC's unsecured debt.

Asset performance has generally been good. Net cumulative loan losses since 1970 total $115 million. However, CFC experienced $35 million in net losses during the last five years, the largest occurring in the year ended May 31, 2002, when CFC wrote off a net $25 million. In the year ended May 31, 2005, CFC wrote off $1 million in loans and recovered $1 million that was previously written off.

As of Aug. 31, 2005, CFC had a loan loss allowance totaling $590 million, representing 3.24% of total loans outstanding. About $421 million will cover impaired loans, and the rest high-risk loans and the general loan portfolio. Impaired loans totaled $1.146 billion, and nonperforming loans included those to Denton County Electric Cooperative Inc. ($587 million), VarTec ($84 million), and ICC ($475 million). Standard & Poor's concludes that the uncertainty surrounding the impaired and high-risk loans could lead to adjustments in the reserve over time.

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 the methodology, and concluded that the reserves set under it 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 once a year, 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 historical default tables according to comparable rating level and remaining maturity. Recovery rates are estimated based on record 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 its rating on borrowers that have a rating from the agencies and 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 that 1.5% and on the borrower's internal risk rating. As of May 31, 2005, CFC's reserve totaled $7 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. 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 certificates, since they are subordinate to CFC's senior debt and its subordinated deferrable notes, pay deferrable interest or no interest at all, and have maturities as long as 100 years. Also, a significant number of the certificates have an initial maturity of 100 years and a long average remaining maturity. Therefore, the chances of a membership withdrawal "death spiral" are significantly mitigated.

An important factor in determining CFC's pricing flexibility is that CFC retains considerable latitude in setting the conditions under which members purchase these securities. CFC's capital base also includes $685 million of subordinated deferrable notes that are subordinate to the senior obligations but possess superior claim over the members' certificates. Standard & Poor's accords some equity treatment to these hybrid instruments, which have a maturity of up to 49 years and for which 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 result in misleading conclusions. CFC is neither a dealer nor a trader of 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 include backing out changes to the income statement and balance sheet for hedges that do not qualify as such under SFAS 133.

In accordance with SFAS 133, CFC records derivative instruments on the consolidated balance sheet as either assets or liabilities measured at fair value. It usually recognizes changes in the fair value of derivative instruments in the derivative forward value line item of the consolidated statement of operations. But if certain hedge accounting criteria are met, it records the changes to other comprehensive income. For some foreign currency exchange agreements that meet hedge accounting criteria, CFC records the change in fair value to other comprehensive income and then reclassifies it to offset the related change in the dollar value of foreign-currency-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. It records as derivative cash settlements net settlements related to derivative instruments that do not qualify for hedge accounting.

As of Aug. 31, 2005, CFC was party to interest rate exchange agreements of $14.3 billion. Generally, CFC's agreements of this type 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. This 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 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 this way, and CFC does not solely issue its commercial paper with maturities of 30 days. 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, 2005, and May 31, 2005, respectively, CFC was party to $824 million of cross-currency interest rate exchange agreements under which it receives euros and pays U.S. dollars, and $282 million under which it receives Australian dollars and pays U.S. dollars. Of these agreements, $434 million worth do not qualify for hedge accounting. The agreements are used to synthetically change the foreign-currency-denominated debt to U.S. dollar-denominated debt. In addition, they synthetically change the interest rate from the fixed rate on the foreign-currency-denominated debt to variable rate U.S. dollar-denominated debt, or they alter the variable rate on the foreign-currency-denominated debt. Since the agreements synthetically change both 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 within a range of 80-125%, which is more difficult to obtain than matching the critical terms. Therefore, all changes in fair value for the agreements that do not qualify for hedge accounting are recorded in the consolidated statements of operations. The impact on earnings for the three-month periods ended Aug. 31, 2005, and Aug. 31, 2004, due to the change in fair value of these agreements, were losses of $5 million and $2 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 $3 million and $6 million, respectively, for the three-month periods ended Aug. 31, 2005, and Aug. 31, 2004, 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 defaulting on or unwinding the transaction) that might otherwise have been produced by the foreign currency borrowing. Interest is paid annually on foreign-currency-denominated medium-term notes with maturities longer than one year, and is paid at maturity on medium-term notes with maturities of less than one year.

Standard & Poor's concludes that CFC's leverage is adequate for its current rating. CFC was expected to maintain a debt-to-equity ratio below 6x, but after it met that goal in fiscal 2003, at 5.95x, the defaults at Vartec and ICC led it to reduce its loan exposure by transferring patronage capital held for these issuers to their respective loan accounts. This reduction in equity was a significant driver behind the increase in CFC's debt-to-equity ratio to 6.65x on Aug. 31, 2004, and 5.96x on Aug. 31, 2005. However, if the subordinate deferrable notes are not given equity treatment, the debt-to-equity ratio was 7.6x as of Aug. 31, 2005. CFC has at its disposal several programs to maintain or 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 at which it reallocates 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. Every year since 1983, it has achieved its goal of attaining a 1.10x adjusted TIER, and in each of the last 10 fiscal years the TIER has been at least 1.12x. CFC uses an interest coverage ratio instead of the dollar amount of gross or net margin as its primary performance indicator, since its 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 1.10x adjusted TIER as its minimum operating objective. TIER, a measure of CFC's ability to cover the interest expense on its debt obligations, is calculated by dividing the cost of funds and the net margin prior to the cumulative effect of change in accounting principle by the cost of funds. CFC's TIER for the year ended May 31, 2005, was 1.14x, and its TIER for the three-month period ended Aug. 31, 2005, was less than 1x. 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. Standard & Poor's concludes that adjusted TIER more accurately reflects CFC's financial performance. The adjusted TIER for the three-month period ended Aug. 31, 2005, was 1.15x. CFC adjusts its TIER calculation to exclude the impact of derivatives required by SFAS 133 and foreign currency adjustments required by SFAS 52.