Defaults Plague Little-Known Big Lender

"This is somewhat of a different animal," said Peter Shimkus, a Fitch analyst. His report said that because the cooperative's primary goal is "to provide competitive funding for its members," it "will not compare favorably to banks and finance companies."

An April 20 report by Standard & Poor's gave the CFC an A rating but flagged some weaknesses. It said that the "CFC is adequately capitalized on a risk-adjusted basis, but we would not like to see leverage increase substantially above current levels due to concerns about the company's limited ability to raise equity."

Big Loans, Big Trouble

The CFC was created in April 1969 to supplement loans provided by the Agriculture Department's Rural Utilities Service -- in Petersen's words, to "function as a bridge between electrical co-ops and financial markets."

In 1987, it formed the Rural Telephone Finance Cooperative, to provide the same service to rural telephone companies. The RTFC was a member of the CFC co-op and its management and most of the board were the same, though it did not have the CFC's tax-exempt status. In the late 1990s, the RTFC's portfolio grew fivefold, to more than $5 billion, by making some very large and, in retrospect, risky loans. So did the CFC.

The CFC's biggest customer was Denton County Electric Cooperative, which borrowed more than $1 billion. Denton County, Tex., wasn't very rural by the late 1990s -- it was part of greater Fort Worth, one of the fastest-growing counties in the country. The co-op was renamed CoServ and branched out into telecommunications and real estate. It bought a golf course, a luxury Westin hotel in Forth Worth and part of a shopping mall.

Soon CoServ was overextended. In 2001, it went bankrupt, and it held 4.6 percent of CFC's outstanding loans. It was the CFC's biggest default. Recently CoServ and the CFC agreed on a restructuring. The final amount of the losses remains unclear.

"CoServ was an opportunity to look at different things utilities could do to cement their relationships with their members," Petersen said. "Those didn't work out very well." He conceded "that was a mistake we made."

Meanwhile, the RTFC lent $550 million to Innovative Communication Corp., run by Jeffrey J. Prosser, a Nebraska accountant who had moved to the Virgin Islands and gone into the telephone business. Prosser eventually took over the local cable TV business and the Virgin Islands Daily News. In highly leveraged transactions, he bought two-thirds of the wireless telephone operations on St. Martin, cable TV operations on Guadeloupe and Martinique and a cable TV company in France.

The RTFC financed much of this. Prosser said "the RTFC gave us a deal we couldn't match." In 2004, he bought the national phone company of Belize.

But Prosser quarreled with the RTFC, which he said wasn't giving him or other members their shares of the lending co-op's profit. In 2003, he alleged that the profits from the taxable RTFC were being shifted to the tax-exempt CFC. Prosser deducted the amount he felt he was owed from his interest payments.

A legal battle between Prosser and the CFC ensued. When Innovation Communication declared bankruptcy in 2006, Prosser blamed his fight with the CFC. The CFC's chief financial officer, Steven L. Lilly, said the CFC is not to blame and that Prosser, in an earlier settlement, waived his ability to make any charges against the CFC or RTFC.

Recently, the CFC has been shrinking the RTFC. Outstanding loans of the RTFC dropped by $830 million in fiscal 2006.

Prospects

So where does that leave the CFC? The co-op had $598 million in equity as of Nov. 30, 2006, down 23 percent from six months earlier.

The key to the CFC's financial stability is its members. They are required to buy 100-year membership certificates that earn 5 percent annually, but those unsecured CFC debts take a back seat to commercial bondholders. When members borrow money, they buy more certificates. In a pinch, the CFC could defer interest payments on those certificates without hurting commercial bondholders. Finally, in a crunch the CFC could ask its members to raise electricity rates and help.

Egan doubts the value of the member certificates and the CFC's flexibility in deferring those payments. "A debt holder is unlikely to waive its rights to the timely payment of interest simply because it also has an equity stake," his firm's report says. Standard & Poor's notes that the CFC's flexibility in raising money from members is limited in the 16 states that regulate cooperatives' rates and borrowing.

In an interview, Egan said that if CFC "ran into difficulty, then they'd have to go back to co-op members to ask for additional capital, and there's no guarantee that those co-op members are going to step up to the plate."

But some rating agencies, including Standard & Poor's, consider the certificates and subordinated debts to members to be a form of equity. And Lilly asserted that CFC's loss reserves are more than adequate to cover any bad loans.

Another key to the CFC's health has been its relationship with Congress. The CFC's access to low-interest, government-guaranteed loans, granted in the 2002 Farm Bill, came just as CoServ's loan default was rattling the CFC's rating agencies.

But Lilly said that the CFC pays a small premium to the Federal Financing Bank, part of which goes to the Treasury and part of which finances a rural development program. He said the CFC has never missed a bond payment and that the federal government loans to CFC come "at no cost to the taxpayer."