WASHINGTON (MNI) – The following is the third and final section of
excerpts from Standard & Poor’s analysis of the U.S. Farm Credit System,
published late Friday:

Market risk

Market risk tolerance is small across FCS. The management of both
interest-rate risk and credit risk across the investment portfolios is
adequate.

All financial entities are exposed to interest-rate risk. We
consider the System’s and individual banks’ approach to asset-liability
management adequate, reflecting overall conservative risk tolerance and
increasingly sophisticated risk-management practices and tools. To limit
the impact of adverse interest-rate movements, FCS also uses
plain-vanilla derivatives that minimize the structural balance-sheet
mismatches. Derivatives are not used for trading purposes or arranged
for customers.

As of June 30, 2011, a 200 basis point rate shock increase would
increase net interest income by 4.4% while decreasing the market value
of equity by 4.1%. System duration as of June 2011 was only 1.1 months,
essentially neutral. All of these values are readily within the System’s
policy limits.

The banks maintain ample liquidity in their investment portfolios.
The total System securities portfolio combined to $42.5 billion as of
June 2011. MBS comprise about 70% of the combined portfolio. About 51%
of $10 billion MBS in the portfolio that has been in a continuous
unrealized loss position for less than 12 months includes $384 million
(about 4%) of unrealized losses against them. The System has taken $250
million of cumulative OTTI charges against the securities it is holding.
This includes $22 million of credit-related OTTI in second-quarter 2011
and $13 million in first-quarter 2011. Positively, the System was able
to reverse $20 million of credit-related OTTI in first-quarter 2011 when
it sold securities that had not experienced credit losses. More than 90%
of the portfolio is categorized as available-for-sale, which allows
management the option to sell them, increasing financial flexibility,
though we recognize management’s intent to hold them indefinitely.

Funding and liquidity riskLiquidity management is prudent and
conservative. The FCS relies heavily on capital markets for its funding,
typically the issuance of its System-wide Debt Securities. The System
banks are jointly and severally responsible for the obligations issued
through the Funding Corp. As of June 30, 2011, the System also has a
$3.3 billion insurance fund (2% of risk-adjusted insured obligations),
which is directed independently by FCSIC to ensure principal and
interest payments on its obligations. The FCA may require any System
bank to make the principal or interest payments due on any other System
bank’s obligations, even in the absence of a default of the primary
obligor.

Each bank has contingent exposure to overall System-wide debt
because it is also jointly and severally liable for the debts issued by
the other System banks. Total System-wide debt outstanding was $187.3
billion as of June 30, 2011, with $67.3 billion due within one year. The
securities, as GSE debt, are favorably priced, typically at small
spreads above U.S. Treasury debt. The access to favorably priced funding
is one of the System’s major benefits and rating strengths.

The banks maintain ample liquidity in their investment portfolios.
The $42.5 billion securities portfolio had $8.5 billion (primarily
Treasuries, commercial paper, etc.) maturing within one year as of June
2011. The banks are not permitted to take deposits.

The System has to maintain a regulatory minimum liquidity standard
of 90 days continuously. This standard is calculated by comparing
maturing System-wide debt securities and other bonds with the total
amount of cash, investments, and other liquid assets maintained. As of
June 30, 2011, liquid assets for FCS represented a conservative 195 days
worth of liquidity.

In response to recent financial market turmoil and to further
ensure adequate liquidity in the future, the banks have also decided to
establish a framework under which each bank should, at all times, be
able to cover 15 days of maturing debt with cash, cash equivalents,
and/or Treasury securities with maturities of less than three years.
Furthermore, the next 30 days of liquidity would also come from
investments in excess of those that qualified under the 15-day bucket
and from investments guaranteed by the full faith and credit of the U.S.
government, from top-rated commercial paper and Fed funds that mature in
45 days or less. As of June 30, 2011, all banks were in compliance with
this framework.

Accounting: Presented Both As Bank-Only And District-WideThe System
generates and provides a financial statement of the System as a whole
which is combined and is audited annually.

The banks report their financials on both a bank-only basis and a
combined-district basis because of the financial and operational
interdependence of the bank and its affiliated associations. All
significant transactions and balances between the banks and their
respective district associations are eliminated in the combined
statements.

Profitability: Modest But Adequate

Reflecting its GSE status and wholesale-lending approach, System
profitability is modest but adequate, particularly on a risk-adjusted
basis.

The System earned $982 million for the quarter ended June 30, 2011,
an increase from $882 million in the same quarter last year. Fiscal 2010
net income had risen 33% to $1.9 billion from fiscal 2009. The System
recorded a manageable $22 million in OTTI during second-quarter 2011
compared with $13 million in first-quarter 2011. Due to housing
weakness, general economic weakness, and U.S. fiscal issues, we expect
further write-downs into 2012, but these should be manageable. Net
interest income continues to be strong in the low-rate environment as
the System is able to call and re-issue consolidated obligations at
better and better spreads. However, if the U.S. government defaults, at
least part of that benefit would likely go away in fairly short order.
Even so, there will still be an abundance of maturities that need to be
re-invested in a weak investment environment with relatively few better
alternatives. The System banks continue to generate returns on assets
approximating 1% while total System returns are about 1.5%.

The banks’ operating efficiencies are comparable with those of
commercial banks of similar size. Noninterest expense remains well
curbed below 20% of total revenues (approximately 30-35 bps of assets).
CoBank is the only System bank that pays federal income taxes by
statute. This further supplements their competitive advantage in the
marketplace.

Given the System’s charter and public mission, revenue
diversification is minimal and noninterest income is a small part of
revenues at about 15%. In fact, in the first half of 2011, noninterest
income fell to about 8% because of the dearth of lending opportunities
and, therefore, lower fees.

We expect crop prices to remain high into 2012, which can pressure
profitability and cash flows for livestock segments (especially poultry
and dairy). We also expect the timber segment to remain weak due to weak
housing during the next 12-18 months.

Capital: Strong For The Risk Level

Capital levels are strong, particularly on a risk-adjusted basis,
reflecting the overall moderate risk profile. The
regulator–FCA–promulgates minimum regulatory capital requirements for
both the banks and the district associations. The main capital indicator
used is the permanent capital ratio, which must be a minimum of 7% of
risk-adjusted assets. Permanent capital includes capital stock plus
unallocated surplus, plus perpetual preferred stock. As of June 30,
2011, the lowest permanent capital ratio of any System bank was 14%.
Regulations also require all System institutions (including
associations) to maintain certain surplus (i.e. retained earnings)
levels as a percentage of capital and risk-adjusted assets. Capital
accumulated through earnings of $28.662 billion (the surplus) is the
most significant component of capital. As of June 30, 2011, surplus as a
percentage of capital was 81.7%. Capital represented 15.2% of assets as
of June 30, 2011, up from 14.5% as of Dec. 31, 2010.

All banks must also maintain a net collateral ratio (earning assets
divided by total liabilities less subordinated debt) of at least 103% of
total liabilities. Banks that have issued preferred stock and
subordinated debt offerings have a minimum net collateral ratio of 104%.
As of June 30, 2011, the lowest net collateralization ratio was 105.5%,
well within requirements. 2011 should be a strong earning year for many
sectors of the agricultural industry to generate more organic capital.

(3 of 3)

** Market News International Washington Bureau: 202-371-2121 **

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