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,“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 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 August 31, 20172018 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 months ended August 31, 20172018 and 2016,2017, and as of August 31, 20172018 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 includeare 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 and adjusted leverage ratio. The adjusted leverage ratio is a non-GAAP measure included as a covenant in our committed bank revolving line of credit agreements. The most comparable GAAP measures are net income, net interest income, interest expense, net interest yield, TIER debt-to-equity ratio and leveragedebt-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 thecertain financial covenants in our committed bank revolving line of credit agreements and debt indentures are based on adjusted TIER and adjusted leverage ratios.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 $48 million and a TIER of 1.23 for the quarter ended August 31, 2018 (“current quarter”), compared with net income of $9 million and a TIER of 1.05 for the quarter ended August 31, 2017 (“current quarter”), compared with a net loss of $132 million and a TIER of 0.27 for the same prior-year quarter. Our debt-to-equity ratio increaseddecreased slightly to 23.00-to-116.71 as of August 31, 2017,2018, from 21.94-to-116.72 as of May 31, 2017,2018, primarily due to an increasea decline in debt outstanding to fund loan growth and a decrease inliabilities as equity resulting fromremained relatively unchanged. In July 2018, the CFC Board of Directors authorizationauthorized 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 from our reported net income of $48 million for the current quarter to retirewas offset by the retirement of patronage capital of $45 million.capital.

The variance of $141$39 million between our reported net income of $9$48 million for the current quarter and our net lossincome of $132$9 million for the same prior-year quarter was primarily driven primarily by a favorable shift in the mark-to-market changes in the fair value of our derivatives. We recognized derivative lossesgains of $46$7 million in the current quarter which were largelydue to a net increase in the fair value of our pay-fixed swaps resulting from a slight rise in medium- and long-term interest rates. In contrast, we recognized derivative losses of $46 million during the comparable prior-year quarter, mainly due to a modest flattening of the yieldswap curve as interest rates on the shorter end of the curve rose while mediummedium- and longer-termlong-term interest rates declined slightly. In comparison we recognized derivative lossesThe favorable shift of $188$53 million in the same prior-year quarter, attributable to more pronounced flatteningfair value of our derivatives was offset in part by the yield curve duringrecognition of losses of $7 million on the period. In addition, we experiencedearly extinguishment of debt, a decrease in net interest income of $3$5 million and an increase in operating expenses of $1 million,$2 million. The decrease in net interest income resulted from compression in the net interest yield, which were largelywas partially offset by a favorable shiftan increase in the provision for loan losses of $2 million and a decrease in charges related to foreclosedaverage interest-earning assets of $1 million.

AdjustedOur adjusted net income totaled $35$28 million and our adjusted TIER was 1.161.13 for the current quarter, compared with adjusted net income of $33$35 million and adjusted TIER of 1.16 for the same prior-year quarter. Our adjusted debt-to-equity ratio increased to 6.05-to-16.21 as of August 31, 2017,2018, from 5.95-to-16.18 as of May 31, 2017,2018, primarily attributable to a decrease in adjusted equity due to the combined impactpatronage capital retirement of the increase in debt outstanding to fund loan growth and the decrease in equity resulting from the CFC Board$48 million, which more than offset our adjusted net income of Directors authorization in the current quarter to retire patronage capital.$28 million.

The increase of $2 milliondecrease in adjusted net income of $7 million in the current quarter from the samecomparable prior-year quarter was primarily driven by losses on the favorable shift in the provision for loan lossesearly extinguishment of $2debt of $7 million and decrease in charges related to foreclosed assets of $1 million, which were partially offset by thean increase in operating expenses of $1$2 million, offset in part by an increase in adjusted net interest income of $2 million. The increase in adjusted net interest income was attributable to the increase in average interest-earning assets $1,068 million and a slight increase in the adjusted interest yield of 1 basis point to 0.85%.

Loans to members totaled $24,642$25,183 million as of August 31, 2017, an increase of $275 million, or 1%,2018, relatively unchanged from May 31, 2017. The increase was primarily due an increase in2018. CFC distribution loans of $244 million and an increase in NCSC loans of $45increased by $87 million, which were partiallywas offset by a decreasedecreases in CFC power supply loans, NCSC loans and RTFC loans of $14 million. The net increase in loans outstanding was largely attributable to member$76 million, $6 million and $5 million, respectively.

Long-term loan advances totaled $468 million during the current quarter, with approximately 71% of those advances for capital investmentsexpenditures by members and members25% for the refinancing with usof loans made by other lenders.

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 current quarter, our debt volume also increased. Total debt outstanding was $23,664$24,589 million as of August 31, 2017, an increase of $204 million, or 1%,2018, 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 commercial paper and Federal Agricultural Mortgage Corporation (“Farmer Mac”) notes payable of $296 million, $135 million, and $114 million, respectively, were largely offset by increases in dealer medium-term notes of $396 million, a net increase in our member investments of $217$291 million and a net increase in member commercial paper, select notes payable to the Federal Financing Bank under the Guaranteed Underwriter Programand daily liquidity fund notes of the USDA (“Guaranteed Underwriter Program”) of $88$238 million. These increases were partially offset by a net decrease inOutstanding dealer commercial paper outstanding of $490 million.

We currently expect the amount of long-term loan advances to exceed anticipated loan repayments over the next 12 months. We expectthat our net interest income, and adjusted net interest income, to be relatively flat over the next 12 months, reflecting a projected slight increase in average total loans and a relatively stablenet income, adjusted net income, tier, adjusted tier, net interest yield and adjusted net interest yield.

We believe we have sufficient liquidity from the combination of existing cash and time deposits,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 satisfy our obligations to repay long-term debt maturing over the next 12 months. As of August 31, 2017, we had2018, sources of liquidity readily available for access to liquidity reserves totaling $6,483totaled $7,295 million, which consistedconsisting of (i) $396$266 million in cash and cash equivalents and time deposits,equivalents; (ii) up to $625$1,225 million available under committed loan facilities under the Guaranteed Underwriter Program,Program; (iii) up to $3,164$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 $1,998$2,422 million available under a revolving note purchase agreement with Farmer Mac, subject to market

We believe we can continue to roll over the outstanding member short-term debt of $2,565$2,864 million as of August 31, 2017,2018, 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 6.056.21 as of August 31, 2017, slightly2018, above our targeted threshold due to the combined impact of the increase in debt outstanding to fund loan growth and the decrease in adjusted equity resulting from the CFC Board of Directors authorization in the current quarter to retire patronage capital retirement of $45 million.$48 million during the quarter. We expect to maintainthat our adjusted debt-to-equity ratio at approximatelywill decrease during the remainder of the fiscal year due to an 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 were no material changes in the key inputs and assumptions used in our critical accounting policies and estimates during the current quarter. Management has discussed significant judgments and assumptions in applying our critical accounting policies with the Audit Committee of our board of directors. We provide additional information on the methodologies and key assumptions used in our critical accounting policies and estimates under “MD&A—Critical Accounting Policies and Estimates” in our 20172018 Form 10-K. See “Item 1A. Risk Factors” in our 20172018 Form 10-K for a discussion of the risks associated with management’s judgments and estimates in applying our accounting policies and methods.

 

Adjusted net interest income of $53$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 4%, which was partially offset by and a decreaseslight increase in the adjusted net interest yield of 2% (21% (1 basis points)point) to 0.84%0.85%. The decreaseincrease in the adjusted net interest yield was primarily attributable to a modestreflected the combined impact of increases in the average yield on interest-earning assets and the benefit from non-interest bearing funding, which were partially offset by an increase in ourthe adjusted average cost of funds.debt.

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 $20$13 million and $23$20 million for the three months ended August 31, 20172018 and 2016,2017, 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 benefit for loan losses of less than $1 million for both the current quarter compared with a provision for loan losses of $2 million for the sameand comparable prior-year 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 current quarter and we had no loans classified as nonperforming as ofor the end of the quarter. In comparison, we recorded a net charge-off of $2 million in the same prior yearcomparable 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 months ended August 31, 20172018 and 2016.2017.

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 hedges during the current quarter nor during the same prior-year quarter.a cash flow hedge of a forecasted transaction as of

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 months ended August 31, 20172018 and 2016.2017. 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.

The average remaining maturity of our pay-fixed and receive-fixed swaps was 19 years and four years, respectively, as of both August 31, 2017, unchanged from fiscal year end May 31,2018 and 2017. In comparison, the average remaining maturity of our pay-fixed and receive-fixed swaps was 18 years and three years, respectively, as of August 31, 2016.

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. Because

our pay-fixed and receive-fixed swaps are referenced to different maturity terms along the swap yield curve, different changes in the swap yield curve— parallel, flattening or steepening—will result in differences in the fair value of our

Table 6 presents the components of net derivative gains (losses) recorded in our condensed consolidated results of operations.operations for the three months ended August 31, 2018 and 2017. Derivative cash settlements represent the net periodic contractual interest amount for our interest-rate swaps for the reporting period. Derivative forward value gains (losses) represent 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 losses of $46 million in the currentsame prior-year quarter were due to a net decrease in the fair value of our interest rate swaps resulting from a modest flattening of the yieldswap curve, as interest rates on the shorter end of the curve rose while medium and longer-term interest rates declined slightly.

See “Note 8—9—Derivative Instruments and Hedging Activities” for additional information on our derivative instruments.

Non-interest expense consists of salaries and employee benefit expense, general and administrative expenses, losses on early extinguishment of debt and other miscellaneous expenses.

Table 7 presents the components of non-interest expense recorded in our condensed consolidated results of operations for the three months ended August 31, 20172018 and 2016.2017.

Non-interest expense of $22$31 million for the current quarter increased by $1$9 million, or 4%39%, from the samecomparable prior-year period primarilyquarter. The increase was largely due to increases in salaries and employee benefits and other operating expenses.the loss on early extinguishment of debt of $7 million, attributable to the premium paid for the early redemption of $300 million of the $1 billion collateral trust bonds, with a coupon rate of 10.375%, that mature on November 1, 2018.

Net income (loss) attributable to noncontrolling interests represents 100% of the results of operations of NCSC and RTFC, as the members of NCSC and RTFC own or control 100% of the interest in their respective companies. The fluctuations in net income (loss) attributable to noncontrolling interests are primarily due to changes in the fair value of NCSC’s derivative instruments recognized in NCSC's earnings.

We recorded net lossesincome attributable to noncontrolling interests of less than $1 million for the three months ended August 31, 2017 and 2016.current quarter. In comparison we recorded a net loss attributable to noncontrolling interests of less than $1 million for the same prior-year quarter.