UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

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FORM 10-Q

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Commission File Number: 1-7102

NATIONAL RURAL UTILITIES COOPERATIVE FINANCE CORPORATION

(Exact name of registrant as specified in its charter)

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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 x     No ¨

The Registrant does not issue capital stock because it is a tax-exempt cooperative.

INDEX OF MD&A TABLES

PART I—FINANCIAL INFORMATION

This Quarterly Report on Form 10-Q contains forward-looking statements defined by the Securities Act of 1933, as amended, and the Exchange Act of 1934, as amended. Forward-looking statements, which are based on certain assumptions and describe our future plans, strategies and expectations, are generally identified by our use of words such as “intend,” “plan,” “may,” “should,” “will,” “project,” “estimate,” “anticipate,” “believe,” “expect,” “continue,” “potential,” “opportunity” and similar expressions, whether in the negative or affirmative. All statements about future expectations or projections, including statements about loan volume, the adequacy of the loan loss allowance, 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 could materially differ. Factors that could cause future results to vary from current expectations 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, regulatory and economic conditions in the rural electric industry, nonperformance of counterparties to our derivative agreements and the costs and effects of legal or governmental proceedings involving National Rural Utilities Cooperative Finance Corporation (“CFC”) or its members. Some of these and other factors are discussed in our annual and quarterly reports previously filed with the U.S. Securities and Exchange Commission (“SEC”). 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.

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, transmission 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. As a member-owned cooperative, CFC has no publicly held equity securities outstanding. CFC funds its activities primarily through a combination of publicly and privately held debt securities and member investments. As a member-owned cooperative, CFC's objective is not to maximize profit, but rather to offer its members cost-based financial products and services consistent with sound financial management. CFC annually allocates its net earnings, which consist of net income excluding the effect of certain non-cash accounting entries, to (i) a cooperative educational fund, (ii) a members’ capital reserve, (iii) a general reserve, if necessary, and (iv) members based on each member’s patronage of CFC’s loan programs during the year.

ForOur financial statement purposes, CFC’s resultsstatements include the consolidated accounts of operations and financial condition are consolidated with and includeCFC, Rural Telephone Finance Cooperative (“RTFC”) and, National Cooperative Services Corporation (“NCSC”). Unless stated otherwise, references to “we,” “our” or “us” relate to the consolidation of CFC, RTFC, NCSC and certain entities created and controlled by CFC to hold foreclosed assets and to accommodate loan securitization transactions. RTFC was established to provide private financing for the rural telecommunications industry. NCSC was established to provide financing to members of CFC and the for-profit and nonprofit entities that are owned, operated or controlled by, or provide significant benefits to Class A, B and C members of CFC. The entities controlled by CFC that hold foreclosed assets include Caribbean Asset Holdings, LLC (“CAH”) and Denton Realty Partners, LP (“DRP”). CAH is a holding company for various U.S. Virgin Islands, British Virgin Islands and St. Maarten-based telecommunications operating entities that provide local, long-distance and wireless telephone, cable television and internet services to residential and commercial customers. DRP holds assets primarily consisting of a land development loan and limited partnership interests in certain real estate developments and related receivables, developed lots and retail land. Unless stated otherwise, references to “we,” “our” or “us” relate to CFC and its consolidated entities.

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 results of operations, financial condition and liquidity by focusing on changes from period to period in certain key measures used by management to evaluate performance, such as leverage ratios, growth and credit quality metrics. MD&A 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, the more detailed information contained in our Annual Report on Form 10-K for the fiscal year ended May 31, 2014 ("(“2014 Form 10-K"),10-K” ), including the risk factors discussed

Table 1 provides a summary of selected financial data for the three and six months ended August 31,November 30, 2014 and 2013, and as of August 31,November 30, 2014 and May 31, 2014. 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, which we refer to as “adjusted” measures. Our key non-GAAP metrics consist of adjusted times interest earned ratio (“TIER”) and adjusted debt-to-equity ratio. The most comparable GAAP measures are 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 the RUS, subordinated deferrable debt and members’ subordinated certificates; and (iv) adjusting total equity to include subordinated deferrable debt and members’ subordinated certificates. See "Non-GAAP“Non-GAAP Financial Measures"Measures” for a detailed reconciliation of these adjusted measures to the most comparable GAAP measures. We believe our adjusted non-GAAP metrics, 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 the financial covenants in our revolving credit agreements and debt indentures are based on these adjusted metrics.

Our primary objective as a member-owned cooperative lender is to provide cost-based financial products to our rural electric and telecommunications members, while maintaining sound financial results 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 achieve and maintain an adjusted debt-to-equity ratio below 6.00-to-1.

Total loans outstanding, were $20,475which consists of the unpaid principal balance and excludes deferred loan origination costs, was $20,773 million as of August 31,November 30, 2014, a slightan increase of $8$306 million, less thanor 1%, from May 31, 2014. The change reflected an increase of $164 millionwas primarily due to the increase in CFC distribution loans and an increase of $48 million in CFC power supply loans of $351 million and $139 million, respectively, which was almost entirelypartially offset by a decrease of $189 million in NCSC loans of $158 million and a decrease of $13 million in RTFC loans.loans of $21 million. The increase in CFC distribution and power supply loans was attributable to members refinancing with us loans issued by other lenders and member advances for capital investments.

Total debt outstanding was $20,539$21,010 million as of August 31,November 30, 2014, a decreasean increase of $85$385 million, or less than 1%2%, from May 31, 2014. The decrease in debt outstandingincrease was primarily due to the issuance of $300 million aggregate principal amount of collateral trust bonds in November 2014. Other significant funding-related developments are discussed below.

On November 18, 2014, we closed on a $250 million committed loan facility (“Series H”) from the U.S. Treasury Department’s Federal Financing Bank (“FFB”) guaranteed by the United States of America, acting through the Rural Utilities Service (“RUS”) as part of the Guaranteed Underwriter Program. Under the Series H facility, we are able to borrow any time before October 15, 2017, with each advance having a final maturity not longer than 20 years from the advance date. This commitment increases total funding available to us under committed loan facilities from the FFB to $874 million.

debt credit rating; our corporate and short-term credit ratings remained unchanged. On November 24, 2014, Moody’s Investor Services (“Moody’s”). reaffirmed CFC’s existing senior secured debt, senior unsecured debt, subordinated debt and short-term credit ratings with a stable outlook. There have been no changes of CFC’s ratings by Moody’s since November 24, 2014.

We expect the amount of new long-term loan advances to exceed scheduled loan repayments over the next 12 months. We anticipate an increase to earnings from our core lending operations over the next 12 months due to the expectedbased on our expectations of an increase in long-term loans outstanding and the reduction in our funding costs from the debt exchange completed in May 2014 and the decrease in our funding costs resulting from the call of our 7.5% member capital securities.

During fiscal year 2014, the CFC Board of Directors authorized management to execute the call of the outstanding $387 million of 7.5% member capital securities and offer members the option to invest in a new series of member capital securities that currently have a 5% interest rate. As of August 31,November 30, 2014, $326$349 million of the 7.5% member capital securities had been redeemed, and we had outstanding call notices, with call dates through November 2014,January 2015, for an additional $23 million. Over the next 12 months, we expect to provide notice to members for the early call of the remaining $38 million of the 7.5% member capital securities, with call dates through January 2015.million. Members had invested $186$208 million in the new series of member capital securities as of August 31,November 30, 2014.

We have $1,020As of November 30, 2014, we had $1,941 million of long-term debt scheduled to mature over the next 12 months. We believe that we have sufficient liquidity from the combination of existing cash and time deposits, member loan repayments, committed loan facilities and our ability to issue debt in the capital markets, to our members and in private placements, to satisfymeet the demand for member loan advances and meetsatisfy our needobligations to fundrepay long-term debt maturing over the next 12 months. As of August 31,November 30, 2014, we had $973$1,008 million in cash investments, and time deposits, up to $624$874 million available under committed loan facilities from the Federal Financing Bank, $3,224$3,418 million available under committed revolving lines of credit with a syndicate of banks and, subject to market conditions, up to $2,445$2,372 million available under a revolving note purchase agreement with Farmer Mac. On September 22, 2014, we received a commitment from RUS to guarantee a loan from the Federal Financing Bank of the USDA (the "Guaranteed Underwriter Program") for additional funding of $250 million as part of the Guaranteed Underwriter Program. Upon closing ofJanuary 8, 2015, the commitment we will have an additional $250amount under the Farmer Mac note purchase agreement was increased by $600 million available under Federal Financing Bank loan facilities with a 20-year maturity repaymentto $4,500 million, and the draw period for advances made during the three-year period following the date of closing.was extended by four years to January 11, 2020. We also have the ability to issue collateral trust bonds and medium-term notes in the capital markets and medium-term notes to members.

We believe we can continue to roll over the $4,173 million ofmember outstanding short-term debt of $2,142 million as of November 30, 2014 based on our expectation that our members will continue to reinvest their excess cash in our commercial paper. As part of our strategy to help restore our ratings outlook by S&P to stable, we intend to manage our short-term wholesale funding risk by reducing our non-member outstanding short-term debt, which primarily consists of dealer commercial paper, of $2,080 million as weof November 30, 2014 to an approximate range between $1,000 million and $1,250 million in the third quarter of fiscal year 2015 and maintain our dealer commercial paper within that range for the foreseeable future. We expect to continue to maximize the utilization of these short-term funding options. We expect to be in compliance with the covenants under our revolving credit agreements; therefore,agreements, which will allow us to mitigate our roll-over risk as we couldcan draw on these facilities to reduce the level of dealer commercial paper and repay dealer or member commercial paper that cannot be rolled over due to potential adverse changes in the event of market disruptions.conditions.

We expect to be ableOur goal is to maintain the adjusted debt-to-equity ratio at or below 6.00-to-1. However, because of the expected increase in long-term loans during the remainder of the fiscal year, we anticipate additional borrowings to support our loan growth. As a result, our adjusted debt-to-equity ratio will likely be higher than 6.00-to-1 overin the next 12 months.near term.

The preparation of financial statements in accordance with GAAP requires management to make a number of judgments, estimates and assumptions that affect the reported amount of assets, liabilities, income and expenses in the consolidated financial statements. Understanding our accounting policies and the extent to which we use management 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—General Information and Accounting Policies” in our 2014 Form 10-K.

We have identified the allowance for loan losses and the determination of fair value of certain items on our balance sheet as our most critical accounting policies because they require 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 reported results of operations or financial condition. We evaluate our critical accounting estimates and judgments on an ongoing basis and update them, as necessary, based on changing conditions. We did not make any significant changes in the methodologies and assumptions used in estimating the allowance for loan losses or fair value during the first quarter of fiscal year 2015. Management has discussed our critical accounting policies and estimates with the Audit Committee of the Board of Directors. We provide additional information on the methodologies and key assumptions used in our critical accounting

The section below provides a comparative discussion of our condensed consolidated results of operations for the three and six months ended August 31,November 30, 2014 and 2013. Following this section, we provide a comparative analysis of our condensed consolidated balance sheets as of August 31,November 30, 2014 and May 31, 2014. You should read these sections together with our “Executive Summary—Outlook for the Next 12 Months"Months” where we discuss trends and other factors that we expect will affect our future results of operations.

Net interest income represents the difference between the interest income and applicable fees earned on our interest-earning assets, which include 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.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 funding large aggregated amounts of loans.

Table 2 presents our average balance sheets for the three and six months ended August 31,November 30, 2014 and 2013, 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 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“Non-GAAP Financial Measures."”

 

Net interest income of $81$77 million for the three months ended August 31, 2014current quarter increased by $7$3 million, or 10%4%, from the same prior year period,quarter, driven by a 1% increase in average interest-earning assets and a 9% (12 basis points)an increase in the net interest yield of 5% (7 basis points) to 1.51%.

Adjusted net interest income of $61$55 million for the three months ended August 31, 2014current quarter increased by $4$1 million, or 7%1%, from the same prior year period,quarter, driven by the 1% increase in average interest-earning assets and a 6% (6 basis points)an increase in the adjusted net interest yield of 2% (2 basis points) to 1.13%1.04%, which was partially offset by a 1% decrease in average interest-earning assets. Adjusted net interest income of $116 million for the six months ended November 30, 2014 increased by $5 million, or 4%, from the same prior-year period, driven by an increase in the adjusted net interest yield of 4% (4 basis points) to 1.08%.

Our adjusted net interest income and adjusted net interest yield reflect the impact of net periodic derivative cash settlements during the period, which we include in interest expense to derive adjusted interest expense. We recorded net periodic derivative cash settlement expense of $20$22 million and $17$19 million for the three months ended August 31,November 30, 2014 and 2013, respectively, and $42 million and $36 million for the six months ended November 30, 2014 and 2013, respectively. The increase in the adjusted net interest yield was attributablein the three and six months ended November 30, 2014 reflected the benefit from strategic actions taken to a 15 basis pointreduce our funding costs, resulting in higher adjusted net interest income as the reduction in the adjustedour average debt cost of funds to 3.43% for the three months ended August 31, 2014, from 3.58% for the same prior year period, which more than offset thea decrease in the average yield on our interest-earning assets of 12 basis points. Our adjusted average cost of funds also reflected the benefit from the call and redemption of the $326 million of 7.5% member capital securities and the replacement of higher-cost debt that matured in 2014 with lower-cost debt as a result of the overall low interest rate environment.assets. See "Non-GAAP“Non-GAAP Financial Measures"Measures” for additional information on our adjusted measures.

We build our allowance for loan losses through the 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 negative provision for loan losses of $7$1 million and a negative provision of $6 million for the three and six months ended August 31,November 30, 2014, respectively, compared with a provision of loan losses of $1 million and $2 million for the same prior year period. The negativethree and six months ended November 30, 2013. Our provision for loan losses resulted from a decrease in the allowance for loan losses to $50 million as of August 31, 2014, from $56 million as of May 31, 2014, largely due tohas remained relatively stable, reflecting modest improvement in the credit quality and overall credit risk profile of our loan portfolio and relatively flat loan balances. Specifically, certain loans experienced favorable migration through our internal risk rating process. As a result, our allowance for loan losses decreased to $51 million as of November 30, 2014, from $56 million as of May 31, 2014. We provide additional information on our allowance for loan losses under "Credit“Credit Risk—Allowance for Loan Losses"Losses” and "Note“Note 3—Loans and Commitments"Commitments” of this Report. For information on our allowance methodology, see "Note“Note 1—General Information and Accounting Policies"Policies” in our 2014 Form 10-K.

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.

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, and treasury locks, which we typically hold to maturity. We consider the cost of derivatives used in our management of interest rate risk to be an inherent part of our cost of funding. The primary factors affecting the fair value of our derivatives and net derivative gains (losses), net recorded in our results of operations include changes in interest rates, yield curves and implied interest rate volatility and the composition and balance of instrument types in our derivative portfolio. We generally do not designate interest rate swaps, which represent 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 operations under derivative gains (losses), net. We did not have any derivatives designated as accounting hedges as of August 31,November 30, 2014 or May 31, 2014.

We recorded net derivative losses of $75 million and $31 million for the three months ended November 30, 2014 and 2013, respectively. We recorded net derivative losses of $124 million for the six months ended November 30, 2014, compared with net derivative gains of $76 million for the same prior-year period. Table 4 presents the components of net derivative gains (losses) recorded in our condensed consolidated results of operations for the three and six months ended August 31,November 30, 2014 and 2013. Derivative cash settlements represent net contractual interest expense accruals on interest rate swaps during the period. The derivative forward value represents 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.

The net derivative gains (losses) relate to interest rate swap agreements. We currently use two types of interest rate swap agreements: (i) we pay a fixed rate and receive a variable rate ("(“pay-fixed swaps"swaps”) and (ii) we pay a variable rate and receive a fixed rate ("(“receive-fixed swaps"swaps”). 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. The composition of our pay-fixed and receive-fixed swaps varies across the swap yield curve. As a result, the overall fair value gains and losses of our derivatives are also sensitive to flattening and steepening of the swap yield curve. See "Note“Note 12—Fair Value of Financial Instruments"Instruments” for information on how we estimate the fair value of our derivative instruments.

Table 5 displays the average notional amount outstanding, by swap agreement type, and the weighted-average interest rate paid and received for derivative cash settlements during the three and six months ended August 31,November 30, 2014 and 2013. As indicated in Table 5, our derivative portfolio is currently comprised of a higher proportion of pay-fixed swaps than receive-fixedreceive-

fixed swaps, which is subject to change based on changes in market conditions and actions taken to manage our interest rate risk.