UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Commission File Number: 1-7102

(Exact name of registrant as specified in its charter)

__________________________

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 and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted 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 and post 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.

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 ☒

INDEX OF MD&A TABLES

PART I—FINANCIAL INFORMATION

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 ratio,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” ofin our Annual Report on Form 10-K for the fiscal year ended May 31, 20172018 (“20172018 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.

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 its 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 February 28,August 31, 2018 or May 31, 2017.2018. See “Item 1. Business—Overview” ofin our 20172018 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.

Our principal operations are currently organized for management reporting purposes into three business segments: CFC, NCSC and RTFC. 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 discussing the drivers offactors 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, growth and credit quality metrics. We provide additional information on the financial performance of each of our business segments in “Note 13—Business Segments.” 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 20172018 Form 10-K and additional information contained in our 20172018 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.

Table 1 provides a summary of consolidated selected financial data for the three and nine months ended February 28,August 31, 2018 and 2017, and as of February 28,August 31, 2018 and May 31, 2017.2018. 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. 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.

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.accounting for our interest rate swaps. As a result, the mark-to-market changes in our derivativesinterest rate swaps are recorded in earnings. Based on the composition of our derivatives,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 actual derivativethe periodic cash settlement amounts.amounts of our interest rate swaps. As such, management uses our adjusted non- GAAPnon-GAAP results whichto evaluate our operating performance. Our adjusted results include realized net periodic derivative settlementsinterest rate swap settlement amounts but exclude the impact of unrealized derivative forward fair value gains and losses, to evaluate our operating performance. Because derivative forward fair value gains and losses do not impact our cash flows, liquidity or ability to service our debt costs, ourlosses. Our financial debt covenants are also based on our non-GAAP adjusted results.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.

We reported net income of $221$48 million and a TIER of 2.121.23 for the quarter ended February 28,August 31, 2018 (“current quarter”), compared with net income of $98$9 million and a TIER of 1.521.05 for the same prior-year quarter. We reported net income of $409 million and a TIER of 1.70 for the nine months ended February 28, 2018, compared with net income of $361 million and a TIER of 1.65 for the same prior-year period. Our debt-to-equity ratio decreased slightly to 17.15-to-116.71 as of February 28,August 31, 2018, from 21.94-to-116.72 as of May 31, 2017,2018, primarily due to ana decline in liabilities as equity remained relatively unchanged. In July 2018, the CFC Board of Directors authorized the allocation of patronage capital of $95 million for fiscal year 2018 and the retirement of 50% of this amount, or $48 million, which was returned to members in August 2018. The increase in equity resulting from our reported net income of $409$48 million for the nine months ended February 28, 2018, whichcurrent quarter was partially offset by patronage capitalthe retirement of $45 million in September 2017.patronage capital.

Our adjusted net income totaled $34$28 million and our adjusted TIER was 1.161.13 for the current quarter, compared with adjusted net income of $36$35 million and adjusted TIER of 1.181.16 for the same prior-year quarter. Our adjusted net income totaled $103debt-to-equity ratio increased to 6.21 as of August 31, 2018, from 6.18 as of May 31, 2018, primarily attributable to a decrease in adjusted equity due to the patronage capital retirement of $48 million, andwhich more than offset our adjusted TIER was 1.16 for the nine months ended February 28, 2018, compared with adjusted net income of $102$28 million.

The decrease in adjusted net income of $7 million and adjusted TIERin the current quarter from the comparable prior-year quarter was primarily driven by losses on the early extinguishment of 1.17 for the same prior-year period. Our adjusted debt-to-equity ratio increased to 6.21-to-1 asdebt of February 28, 2018, from 5.95-to-1 as of May 31, 2017, largely due to$7 million and an increase in debt outstanding to fund loan growth.

Loans to members totaled $25,343$25,183 million as of February 28,August 31, 2018, an increase of $976 million, or 4%,relatively unchanged from May 31, 2017. The increase was primarily due to an increase in2018. CFC distribution loans of $862 million, an increase in NCSC loans of $187 million and an increase in RTFC loans of $9increased by $87 million, which were partiallywas offset by a decreasedecreases in CFC power supply loans, NCSC loans and RTFC loans of $82 million.$76 million, $6 million and $5 million, respectively.

Long-term loan advances totaled $1,864$468 million during the nine months ended February 28, 2018,current quarter, with approximately 64%71% of those advances for capital expenditures by members and 25% for the refinancing of loans made by other lenders. CFC had long-term fixed-rate loans totaling $783$193 million that were scheduled to reprice during the nine months ended February 28, 2018.current quarter. Of this total, $646$96 million repriced to a new long-term fixed rate, $135rate; $48 million repriced to a long-term variable raterate; and $2$49 million werewas repaid in full.

OurWe 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. As total outstanding loans increased during the nine months ended February 28, 2018, our debt volume also increased. Total debt outstanding was $24,429$24,589 million as of February 28,August 31, 2018, an increase of $969 million, or 4%,relatively unchanged from May 31, 2017. The increase was primarily attributable2018, as loans to a net increasemembers also remained flat. Decreases in collateral trust bonds, dealer medium-term notes of $694 million, a net increase in thecommercial paper and Federal Agricultural Mortgage Corporation (“Farmer Mac”) notes payable of $292$296 million, a net increase$135 million, and $114 million, respectively, were largely offset by increases in dealer medium-term notes of $291 million and in member commercial

We currently expect that our net interest income, net interest yield, 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 and an increase in average outstanding loans. We havefunds. Long-term debt scheduled maturities of higher-cost debtto mature over the next 12 months including $1,830totaled $2,820 million as of August 31, 2018. Included in this amount is $880 million aggregate principal amount of higher-cost collateral trust bonds with a weighted average coupon rate of 6.98%.9.60%, scheduled to mature on November 1, 2018. On July 12, 2018, we redeemed $300 million of our 10.375% collateral trust bonds due November 1, 2018, leaving a remaining outstanding principal

amount of $700 million. We expect that we will be able to replace this higher-cost debt with lower-cost funding, which will reduce our aggregate weighted average cost of funds. We expect the amount of long-term loan advances to exceed anticipated loan repayments over the next 12 months, resulting in an increase in average outstanding loans.

Long-term debt scheduled to mature over the next 12 months totaled $2,862 million as of February 28, 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 from the Federal Financing Bank guaranteed by RUS under the Guaranteed Underwriter Program (“Guaranteed Underwriter Program”), revolving 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 to satisfy our obligations to repay long-term debt maturing over the next 12 months. As of February 28,August 31, 2018, we hadsources of liquidity readily available for access to liquidity reserves totaling $7,254totaled $7,295 million, which consistedconsisting of (i) $251$266 million in cash and cash equivalents,equivalents; (ii) up to $1,225 million available under committed loan facilities under the Guaranteed Underwriter Program,Program; (iii) up to $3,083$3,082 million available under committed bank revolving line of credit agreements,agreements; (iv) up to $300 million available under a committed revolving note purchase agreement with Farmer Mac,Mac; and (v) up to $2,395$2,422 million available under a revolving note purchase agreement with Farmer Mac, subject to market conditions. On August 17, 2018, we executed a commitment letter for a $750 million loan facility under the Guaranteed Underwriter Program. The amount available for access under the Guaranteed Underwriter Program, based on amounts advanced to us as of August 31, 2018, will increase to $1,975 million upon closing of the facility.

We believe we can continue to roll over the outstanding member short-term debt of $2,439$2,864 million as of February 28,August 31, 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. Although we expect to continue accessing the dealer commercial paper market to help meet our liquidity needs, we intend to manage our short-term wholesale funding risk by maintaining outstanding dealer commercial paper at an amount 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 our roll-over risk, as we can draw on these facilities to repay dealer or member commercial paper that cannot be

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 6.21 as of February 28,August 31, 2018, above our targeted threshold due to the increasedecrease in debt outstanding to fund loan growth. Due to anticipated asset growth, weadjusted equity resulting from the patronage capital retirement of $48 million during the quarter. We expect that our adjusted debt-to-equity ratio will decrease during the remainder of the fiscal year due to be abovean increase in equity from earnings. As a result, we believe our adjusted debt-to equity ratio will decrease closer to our target ratio of 6.00-to-1 over the next 12 months.

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 20172018 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

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.

 

Adjusted net interest income of $54$55 million for the current quarter increased by $1$2 million, or 1%5%, from the samecomparable prior-year quarter, driven bydue to the combined impact of an increase in average interest-earning assets of 3%, which was partially offset by4% and a decreaseslight increase in the adjusted net interest yield of 1% (1 basis point) to 0.86%0.85%.

Our adjusted net interest income and adjusted net interest yield include the impact of net accrued periodic derivative cash settlements during the period. We recorded net periodic derivative cash settlement expense of $19$13 million and $20 million for both the three months ended February 28, 2018 and 2017, and $59 million and $64 million for the nine months ended February 28,August 31, 2018 and 2017, respectively. See “Non-GAAP Financial Measures” for additional information on our adjusted measures.

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 provisionbenefit for loan losses of less than $1 million for both the threecurrent quarter and nine months ended February 28, 2018, compared with a provision for loan losses of $2 million and $5 million, respectively, for the samecomparable prior-year periods.quarter. The credit quality and performance statistics of our loan portfolio continued to remain strong. We experiencedhad no payment defaults, charge-offs, delinquent loans or nonperforming loans in our loan portfolio during the three and nine months ended February 28, 2018, and we had no loans classified as nonperforming as ofcurrent quarter or the end of the period. In comparison, we recorded a net charge-off of $2 million during the nine months ended February 28, 2017.comparable prior-year quarter.

We provide additional information on our allowance for loan losses under “Credit Risk—Allowance for Loan Losses” and “Note 4—Loans and Commitments”5—Allowance for Loan Losses” of this Report.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 20172018 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.

 

Table 4 presents the components of non-interest income recorded in our condensed consolidated results of operations for the three and nine months ended February 28,August 31, 2018 and 2017.

Non-interest income of $172 million for the current quarter increased by $124 million from the same prior-year quarter. Non-interest income of $261 million for the nine months ended February 28, 2018 increased by $52 million from the same prior-year period. The significant variances in non-interest income for the three and nine months ended February 28, 2018 between the same prior-year periods were primarily attributable to changes in net derivative gains (losses) recognized in our consolidated statements of operations.income.

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 yieldswap curve and the composition of our derivative portfolio. We generally do not designate our interest rate swaps, which currently account for allthe 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 operationsincome under derivative gains (losses). However, we typically designate treasury locks as cash flow hedges. We did not have any derivativesentered into one treasury lock agreement, which was designated as accounting hedgesa cash flow hedge of a forecasted transaction as of February 28,

August 31, 2018 orand May 31, 2017.2018.

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 LIBOR. Table 5 displays the average notional amount outstanding, by swap agreement type, and the weighted-average interest rate paid and received for derivative cashinterest rate swap settlements during the three and nine months ended February 28,August 31, 2018 and 2017. As indicated in Table 5, our derivativeinterest rate swap portfolio currently consists of a higher proportion of pay-fixed swaps than receive-fixed swaps. The profile of our derivativeinterest rate swap portfolio, however, may change as a result of changes in market conditions and actions taken to manage ourexposure to interest rate risk.