Defaults Plague Little-Known Big Lender
CFC, Created to Support Rural Utilities, Ran Into Trouble When Member-Borrowers Branched Out

By Steven Mufson
Washington Post Staff Writer
Monday, April 30, 2007

The National Rural Utilities Cooperative Finance Corp., located in a sleek office building off the Dulles Toll Road, is one of the Washington area's biggest lending businesses. It has a $17.8 billion loan portfolio -- bigger than any bank based in the area -- and a chief executive who pulls down a salary of more than $800,000 a year.

It's also one of the least-known big businesses around. But a nasty legal fight with a borrower and a critical report by a bond analyst have focused attention on the unusual -- and unregulated -- lending institution's struggle over the past five years to keep itself on an even keel despite loan losses, rising interest rates and razor-thin margins.

The CFC occupies what sounds like an obscure business niche: It lends money to cooperatives that generate electricity and deliver it to rural America.

Chief executive Sheldon C. Petersen says it can deliver the "best loans to our members." As a nonprofit (and thus tax-exempt) cooperative, the CFC faces no pressure to produce stock returns or big dividends; any profit belongs to the member-customers. High marks from three rating agencies smooth the way for the CFC to borrow money cheaply on bond markets.

It also has powerful friends in Congress -- made friendlier with the lobbying support of the National Rural Cooperative Association, which has dished out $1.4 million in campaign contributions in each of the past two election cycles. The 2002 Farm Bill gave the CFC permission to borrow at even lower rates from the Federal Financing Bank, an arm of the Treasury Department. So far, the CFC has drawn $2 billion of the $4 billion credit available. The Agriculture Department's Rural Utilities Service guarantees that the money will be repaid.

Yet the CFC has had problems. It reported an operating loss of $40 million in the first nine months of its fiscal year (ended Feb. 28). In the preceding year, the tiny difference between the income from the relatively low interest paid by its members and its average cost of borrowing wasn't enough to cover the firm's administrative overhead.

Meanwhile, the CFC is working its way through some major defaults -- including two on giant loans to borrowers who had diversified into activities far beyond rural electricity, such as golf courses, newspapers and shopping centers. The defaults, plus changes in interest rates and loan structures, have cut the fair market value of the CFC's portfolio by $2.7 billion from book value, according to filings with the Securities and Exchange Commission.

Three months ago, Egan-Jones Ratings downgraded the CFC's bonds to junk status, asserting that it had "inadequate capitalization."

"The only way the co-op has been profitable has been through asset sale gains and some derivative items," said Sean Egan, managing director of Egan-Jones, noting that the CFC had sold its headquarters building in Herndon. "That doesn't give us comfort that they have the cushion you'd ordinarily expect for an investment grade."

Though Egan-Jones is not one of the rating agencies recognized by the SEC, the firm gained renown by lowering its ratings on Enron, WorldCom and Global Crossing before other agencies did. Egan-Jones also boasts that, unlike other ratings agencies, it does not collect fees from the companies it evaluates.

At the moment, Egan's is a lone voice on the CFC. On Feb. 23, Fitch Ratings raised the CFC's outlook to "positive" and affirmed its A rating after concluding that the impact of some of the bad loans would be minimal. Three weeks later, a consortium of 19 banks agreed to extend $2.25 billion in revolving credit to the CFC. In the past two weeks, the CFC has sold $1.12 billion in new bonds at rates substantially lower than expiring notes.

"We're unique," Petersen said early this month. "It doesn't fit into the standard MBA business model, but it works." He said that the fair market value of the loans doesn't matter because the CFC isn't selling them. The CFC sold its building because the Sept. 11, 2001, attacks made Petersen want to move to a more secure location, he said.

"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."