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FEDERAL AGRICULTURAL MORTGAGE CORP - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) Financial information included in this report is consolidated to include the accounts of Farmer Mac and its subsidiaries, Farmer Mac Mortgage Securities Corporation and Farmer Mac II LLC. Farmer Mac II LLC was formed as a Delaware limited liability company in December 2009 to operate substantially all of the business related to the Farmer Mac II program - primarily the acquisition of USDA-guaranteed portions. The business operations of Farmer Mac II LLC began in January 2010. Since then, Farmer Mac has operated only that part of the Farmer Mac II program that involves the issuance of Farmer Mac II Guaranteed Securities to investors other than Farmer Mac or Farmer Mac II LLC. This discussion and analysis of financial condition and results of operations should be read together with: (1) the interim unaudited consolidated financial statements and the related notes that appear elsewhere in this report; and (2) Farmer Mac's Annual Report on Form 10 K for the fiscal year ended December 31, 2011 filed with the SEC on March 15, 2012. The discussion below is not necessarily indicative of future results. Forward-Looking Statements Some statements made in this report are "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995 pertaining to management's current expectations as to Farmer Mac's future financial results, business prospects and business developments. Forward-looking statements include, without limitation, any statement that may predict, forecast, indicate or imply future results, performance or achievements, and typically are accompanied by, and identified with, such terms as "anticipates," "believes," "expects," "intends," "should" and similar phrases. The following management's discussion and analysis includes forward-looking statements addressing Farmer Mac's: • prospects for earnings; • prospects for growth in loan purchase, guarantee, securitization, and LTSPC volume; • trends in net interest income and net effective spread; • trends in portfolio credit quality, delinquencies, and provisions for losses; • trends in expenses; • trends in investment securities; • prospects for asset impairments and allowance for losses; • changes in capital position; and • other business and financial matters. 55-------------------------------------------------------------------------------- Table of Contents Management's expectations for Farmer Mac's future necessarily involve a number of assumptions and estimates and the evaluation of risks and uncertainties. Various factors or events could cause Farmer Mac's actual results to differ materially from the expectations as expressed or implied by the forward-looking statements, including the factors discussed under "Risk Factors" in Part I, Item 1A of Farmer Mac's Annual Report on Form 10-K for the year ended December 31, 2011 filed with the SEC on March 15, 2012, as well as uncertainties regarding: • the availability to Farmer Mac and Farmer Mac II LLC of debt financing and, if available, the reasonableness of rates and terms; • legislative or regulatory developments that could affect Farmer Mac, including but not limited to developments in relation to agricultural policies and programs contained in the 2008 Farm Bill, many of which expired this year; • fluctuations in the fair value of assets held by Farmer Mac and Farmer Mac II LLC; • the rate and direction of development of the secondary market for agricultural mortgage and rural utilities loans, including lender interest in Farmer Mac credit products and the Farmer Mac secondary market; • the general rate of growth in agricultural mortgage and rural utilities indebtedness; • the impact of economic conditions, including the effects of drought and other weather-related conditions and fluctuations in agricultural real estate values, on agricultural mortgage lending and borrower repayment capacity; • developments in the financial markets, including possible investor, analyst and rating agency reactions to events involving GSEs, including Farmer Mac; • financial market volatility, including the future level and direction of interest rates; and • volatility in commodity prices and/or export demand for U.S. agricultural products. In light of these potential risks and uncertainties, no undue reliance should be placed on any forward-looking statements expressed in this report. Furthermore, Farmer Mac undertakes no obligation to release publicly the results of revisions to any forward-looking statements that may be made to reflect new information or any future events or circumstances, except as otherwise mandated by the SEC. 56-------------------------------------------------------------------------------- Table of Contents Overview Farmer Mac added $841.5 million of new program volume during third quarter 2012, which raised the aggregate outstanding amount of program volume to a record level $12.5 billion as of September 30, 2012. Farmer Mac's GAAP net income attributable to common stockholders for third quarter 2012 was $16.4 million, compared to net losses of $4.3 million and $23.0 million for second quarter 2012 and third quarter 2011, respectively. The increase in Farmer Mac's GAAP net income compared to the previous quarter and prior year quarter was almost entirely attributable to the effects of fair value changes of its financial derivatives. Because Farmer Mac's financial derivatives were not designated in hedge relationships for accounting purposes prior to third quarter 2012, changes in the fair values of these instruments were recorded in earnings, without offsetting fair value adjustments on the corresponding hedged items. As a result, movements in long-term interest rates have historically created significant volatility in Farmer Mac's periodic GAAP earnings due to changes in the fair values of financial derivatives. Beginning in third quarter 2012, Farmer Mac designated $950.0 million notional amount of interest rate swaps in fair value hedge relationships. Accordingly, Farmer Mac recorded in earnings offsetting fair value adjustments on the hedged items attributable to the risk being hedged. For third quarter 2012, Farmer Mac recorded unrealized fair value gains of $5.3 million on its financial derivatives and hedging activities. This compares to unrealized fair value losses of $21.6 million for second quarter 2012 and $55.2 million for third quarter 2011. Because Farmer Mac expects its fair value hedge relationships to remain highly effective through maturity, a substantial portion of the volatility caused from changes in the fair values of financial derivatives is expected to be eliminated in future periods. Farmer Mac's non-GAAP core earnings for third quarter 2012 were $13.4 million, up from $12.9 million in second quarter 2012 and $11.2 million in third quarter 2011. Core earnings for third quarter 2012 benefited from higher net effective spread of $27.3 million (95 basis points), compared to $27.2 million (99 basis points) in second quarter 2012 and $22.8 million (93 basis points) in third quarter 2011. This higher net effective spread was partially offset by net provisions to the allowance for losses of $0.1 million and $0.2 million in third quarter 2012 and second quarter 2012, respectively, compared to net releases of $0.8 million for third quarter 2011. Farmer Mac uses core earnings to measure corporate economic performance and develop financial plans because, in management's view, core earnings is a useful alternative measure in understanding Farmer Mac's economic performance, transaction economics and business trends. Core earnings differs from GAAP net income by excluding the effects of fair value accounting guidance, which are not expected to have a permanent effect on capital. Core earnings also differs from GAAP net income by excluding specified infrequent or unusual transactions that Farmer Mac believes are not indicative of future operating results and that may not reflect the trends and economic financial performance of the Corporation's core business. This non-GAAP financial measure may not be comparable to similarly labeled non-GAAP financial measures disclosed by other companies. Farmer Mac's disclosure of this non-GAAP measure is not intended to replace GAAP information but, rather, to supplement it. Further discussion of Farmer Mac's financial results and a reconciliation of Farmer Mac's GAAP net income/(loss) attributable to common stockholders to core earnings is presented in "-Results of Operations." Farmer Mac's agricultural and rural utilities portfolios continued to perform well during third quarter 2012. Historically, from quarter to quarter, Farmer Mac's 90 day delinquencies have fluctuated, both in dollars and as a percentage of the outstanding portfolio, with higher levels likely at the end of the first and 57-------------------------------------------------------------------------------- Table of Contents third quarters of each year corresponding to the annual (January 1st) and semi-annual (January 1st and July 1st) payment characteristics of most Farmer Mac I loans. As of September 30, 2012, Farmer Mac's 90-day delinquencies were $40.8 million (0.93 percent of the non-AgVantage Farmer Mac I portfolio), uncharacteristically lower than $47.0 million (1.07 percent) as of June 30, 2012, and down from $44.8 million (1.02 percent) as of September 30, 2011. This year's drought conditions in the Midwest and Great Plains have caused significant deterioration in the yields of feed grains and the quality and availability of adequate grazing land. The reduced size of the crop has resulted in prices well beyond what was forecast early in the year and at levels that in many cases compensate for the yield shortfall in terms of overall farm receipts. However, higher feed grain prices are expected to affect the profitability of agricultural industries that rely on these commodities as an input to production, including ethanol, dairy, and livestock producers. Although the drought has had no measurable impact on the credit quality of Farmer Mac's portfolio as of September 30, 2012, Farmer Mac will continue to monitor closely the effects of the drought. Farmer Mac believes that it generally remains well collateralized on its exposures in drought areas and that there are no additional probable losses inherent in the portfolio as of September 30, 2012 due to the drought conditions. See "-Outlook" for further discussion about the expected effects of the drought on Farmer Mac's portfolio. When analyzing the overall risk profile of its program business, Farmer Mac takes into account more than the Farmer Mac I agricultural loan delinquency percentages. The total program business includes AgVantage securities and rural utilities loans, neither of which had any delinquencies as of September 30, 2012, and the USDA Guaranteed Securities and USDA-guaranteed portions underlying Farmer Mac II Guaranteed Securities, which are backed by the full faith and credit of the United States. Across Farmer Mac's entire program business, 90-day delinquencies represented 0.33 percent of the total program business as of September 30, 2012, compared to 0.38 percent as of June 30, 2012 and September 30, 2011. Farmer Mac remains well-positioned to meet the needs of future business opportunities. As of September 30, 2012, Farmer Mac's core capital of $508.5 million exceeded its minimum capital requirement of $368.4 million by $140.1 million. See "-Outlook" for further discussion about the opportunities that Farmer Mac foresees for future business growth. Critical Accounting Policies and Estimates The preparation of Farmer Mac's consolidated financial statements in conformity with GAAP requires the use of estimates and assumptions that affect the amounts reported in the consolidated financial statements and related notes for the periods presented. Actual results could differ from those estimates. The critical accounting policies that are both important to the portrayal of Farmer Mac's financial condition and results of operations and require complex, subjective judgments are the accounting policies for: (1) the allowance for losses, (2) fair value measurement, and (3) other-than-temporary impairment. For a discussion of these critical accounting policies and the related use of estimates and assumptions, see "Management's Discussion and Analysis of Financial Condition and Results of Operations-Critical Accounting Policies and Estimates" in the Corporation's Annual Report on Form 10-K for the year ended December 31, 2011 filed with the SEC on March 15, 2012. 58-------------------------------------------------------------------------------- Table of Contents Results of Operations Farmer Mac's GAAP net income attributable to common stockholders for third quarter 2012 was $16.4 million or $1.49 per diluted common share, compared to a net loss of $23.0 million or $2.22 per diluted common share for third quarter 2011. For the nine months ended September 30, 2012, Farmer Mac's GAAP net income attributable to common stockholders was $34.3 million or $3.12 per diluted common share, compared to $0.5 million or $0.04 per diluted common share for the nine months ended September 30, 2011. Farmer Mac's non-GAAP core earnings were $13.4 million or $1.22 per diluted common share in third quarter 2012, compared to $11.2 million or $1.04 per diluted common share in third quarter 2011. For the nine months ended September 30, 2012 and 2011, Farmer Mac's non-GAAP core earnings were $38.0 million or $3.47 per diluted share and $30.3 million or $2.83 per diluted share, respectively. The adjustments required to reconcile from GAAP net income/(loss) attributable to common stockholders to Farmer Mac's core earnings are related principally to the effects of fair value accounting guidance that cause volatility in periodic GAAP earnings but are not expected to have a cumulative net impact on GAAP earnings if the financial instruments are held to maturity, as is generally expected. Adjustments are also made to exclude specified infrequent or unusual transactions that Farmer Mac believes are not indicative of future operating results and that may not reflect the trends and economic financial performance of the Corporation's core business. 59-------------------------------------------------------------------------------- Table of Contents A reconciliation of Farmer Mac's GAAP net income/(loss) attributable to common stockholders to core earnings is presented in the following table, and the adjustments are described in more detail below the table: Reconciliation of GAAP Net Income/(Loss) Attributable to Common Stockholders to Core Earnings For the Three Months Ended September 30, 2012 September 30, 2011 (in thousands, except per share amounts) GAAP net income/(loss) attributable to common stockholders $ 16,381 $ (23,032 ) Less the after-tax effects of: Unrealized gains/(losses) on financial derivatives and hedging activities 3,456 (35,857 ) Unrealized losses on trading assets (286 ) (2,361 ) Amortization of premiums and deferred gains on assets consolidated at fair value (873 ) (1,154 ) Net effects of settlements on agency forward contracts 699 (1,291 ) Lower of cost or fair value adjustment on loans held for sale - 6,403 Sub-total 2,996 (34,260 ) Core earnings $ 13,385 $ 11,228 Core earnings per share: Basic $ 1.28 $ 1.08 Diluted 1.22 1.04 Weighted-average shares: Basic 10,492 10,354 Diluted 10,996 10,760 For the Nine Months Ended September 30, 2012 September 30, 2011 (in thousands, except per share amounts) GAAP net income attributable to common stockholders $ 34,293 $ 461 Less the after-tax effects of: Unrealized losses on financial derivatives and hedging activities (394 ) (31,316 ) Unrealized losses on trading assets (1,578 ) (230 ) Amortization of premiums and deferred gains on assets consolidated at fair value (2,732 ) (1,817 ) Net effects of settlements on agency forward contracts 958 (2,283 ) Lower of cost or fair value adjustment on loans held for sale - 5,776 Sub-total (3,746 ) (29,870 ) Core earnings $ 38,039 $ 30,331 Core earnings per share: Basic $ 3.64 $ 2.94 Diluted 3.47 2.83 Weighted-average shares: Basic 10,442 10,328 Diluted 10,974 10,715 Fair value accounting guidance for financial derivatives requires all derivatives to be recognized as either assets or liabilities on the consolidated balance sheet and measured at fair value. Because Farmer Mac's financial derivatives were not designated in hedge relationships for accounting purposes prior to third quarter 2012, changes in the fair value of these instruments were recorded in earnings as they occurred, 60-------------------------------------------------------------------------------- Table of Contents with no fair value adjustments on the corresponding hedged items. In an effort to mitigate volatility in GAAP earnings caused from these fair value changes, Farmer Mac previously elected the fair value option for certain investment securities and Farmer Mac Guaranteed Securities that were funded or hedged principally with financial derivatives. Farmer Mac classifies these assets as trading and measures them at fair value, with changes in fair value recorded in earnings as they occur. Effective July 1, 2012, Farmer Mac designated $950.0 million notional amount of interest rate swaps in fair value hedge relationships. Beginning in third quarter 2012, Farmer Mac recorded in earnings offsetting fair value adjustments on the hedged items attributable to the risk being hedged. Any differences arising from fair value changes that are not offset result in hedge ineffectiveness and affect GAAP earnings. Farmer Mac excludes the after-tax effect of unrealized gains and losses resulting from changes in the fair values of financial derivatives and hedging activities from core earnings. Farmer Mac recorded unrealized gains of $5.3 million ($3.5 million after-tax) and unrealized losses of $0.6 million ($0.4 million after-tax), respectively, for fair value changes on its financial derivatives and hedging activities for the three and nine months ended September 30, 2012, compared to unrealized losses of $55.2 million ($35.9 million after-tax) and $48.2 million ($31.3 million after-tax), respectively, for the same periods in 2011. Fair value losses on trading assets totaled $0.4 million ($0.3 million after-tax) and $2.4 million ($1.6 million after-tax), respectively, for the three and nine months ended September 30, 2012, compared to fair value losses of $3.6 million ($2.4 million after-tax) and $0.4 million ($0.2 million after-tax), respectively, for the same periods in 2011. Changes in the fair values of financial derivatives and trading assets have historically contributed significant volatility to Farmer Mac's periodic GAAP earnings. Because Farmer Mac expects its fair value hedge relationships to remain highly effective through maturity, a substantial portion of the volatility caused from changes in the fair values of financial derivatives is expected to be eliminated in future periods. As of September 30, 2012, the cumulative fair value of after-tax losses recorded on financial derivatives was $83.7 million. Over time, Farmer Mac will realize in earnings the net effect of the cash settlements on its interest rate swap contracts, which will on its own produce either income or expense, but is expected to generate positive net effective spread when combined with the interest received and paid on the assets and liabilities Farmer Mac holds on its balance sheet. Any positive net effective spread would continue to build retained earnings and capital over time. In 2010, Farmer Mac consolidated certain variable interest entities ("VIEs") where Farmer Mac held beneficial interests in trusts used as vehicles for securitization. Prior to consolidation, Farmer Mac classified these assets as trading Farmer Mac Guaranteed Securities because of a fair value option election made previously. As such, these assets were measured at fair value and the unrealized gains and losses resulting from changes in fair value were excluded from Farmer Mac's core earnings. Upon consolidation, these assets were transferred to loans held for investment in consolidated trusts at their fair value, which resulted in an unamortized premium of $42.7 million. This premium is being amortized into interest income over the contractual lives of the underlying assets. Also in 2010, Farmer Mac contributed substantially all of the assets, in excess of $1.1 billion, comprising the Farmer Mac II program to a subsidiary, Farmer Mac II LLC. The contributed assets included Farmer Mac II Guaranteed Securities and USDA Guaranteed Securities that were designated as either available-for-sale or trading, depending on whether a fair value option election had been made previously. Farmer Mac transferred these assets at their fair value, which resulted in an unamortized premium of $39.1 million being recorded by Farmer Mac II LLC. This premium is being amortized into interest income over the estimated remaining lives of the USDA-guaranteed portions that were transferred. 61-------------------------------------------------------------------------------- Table of Contents At the time of transfer, Farmer Mac had after-tax unrealized gains of $7.0 million recorded in accumulated other comprehensive income related to changes in the fair value of the contributed securities designated as available-for-sale. These gains are being amortized into other income based on the estimated remaining lives of the related USDA-guaranteed portions. On a consolidated basis, the amortization of these gains will offset the premium amortization on the contributed securities designated as available-for-sale. The after-tax net effect of the amortization of the premiums and deferred gains described above are shown as amortization of premiums and deferred gains on assets consolidated at fair value in the table above. Farmer Mac excludes these items from core earnings because they are not expected to have an economic effect on Farmer Mac's financial performance if the assets are held to maturity, as is generally expected. As of September 30, 2012, $53.9 million of these premiums were still outstanding and $2.9 million of after-tax gains remained deferred in accumulated other comprehensive income. Farmer Mac routinely enters into forward sales contracts on the debt of other GSEs to reduce its interest rate exposure on forecasted future debt issuances. In its calculation of core earnings, Farmer Mac reverses the gains or losses resulting from the net settlement of these contracts in the period of settlement and amortizes them over the estimated lives of the associated debt issuances. The after-tax net effect of these items is shown as net effect of settlements on agency forward contracts in the table above. Changes in the fair values of these contracts prior to net settlement are excluded from Farmer Mac's core earnings and are captured in unrealized gains/(losses) on financial derivatives and hedging activities in the table above. Farmer Mac's portfolio of loans held for sale is reported at the lower of cost or fair value and is subject to fair value adjustments in certain periods. These periodic unrealized gains and losses recorded to adjust the carrying value of loans held for sale to the lower of cost or fair value are excluded from Farmer Mac's core earnings. The following sections provide more detail regarding specific components of Farmer Mac's results of operations. Net Interest Income. Net interest income for the three and nine months ended September 30, 2012 was $30.4 million and $99.2 million, respectively, compared to $31.7 million and $87.9 million, respectively, for the same periods during 2011. The increase in net interest income in the first nine months of 2012 was primarily attributable to purchases of AgVantage securities throughout 2011 and 2012 that Farmer Mac held on balance sheet. The overall net interest yield was 114 basis points for the nine months ended September 30, 2012, compared to 120 basis points for the nine months ended September 30, 2011. 62-------------------------------------------------------------------------------- Table of Contents The following table provides information regarding interest-earning assets and funding for the nine months ended September 30, 2012 and 2011. The balance of non-accruing loans is included in the average balance of loans, Farmer Mac Guaranteed Securities and USDA Guaranteed Securities presented, though the related income is accounted for on a cash basis. Therefore, as the balance of non-accruing loans and the income received increases or decreases, the net interest yield will fluctuate accordingly. The balance of consolidated loans with beneficial interests owned by third parties is disclosed in the net effect of consolidated trusts and is not included in the average balances of interest-earning assets and interest-bearing liabilities. The interest income and expense associated with these trusts are shown in the net effect of consolidated trusts. The average rate earned on cash and investments reflects lower short-term market rates during the first nine months of 2012 compared to the first nine months of 2011. The lower average rate on loans, Farmer Mac Guaranteed Securities and USDA Guaranteed Securities during the first nine months of 2012 reflects the decline in market rates reflected in the rates on loans acquired or reset during the past year. The lower average rate on Farmer Mac's notes payable due within one year is consistent with general trends in average short-term rates during the periods presented. The downward trend in the average rate on notes payable due after one year reflects the retirement of older debt and the issuance of new debt at lower market rates. For the Nine Months Ended September 30, 2012 September 30, 2011 Average Income/ Average Average Income/ Average Balance Expense Rate Balance Expense Rate (dollars in thousands) Interest-earning assets: Cash and investments $ 2,997,130 $ 18,693 0.83 % $ 2,447,032 $ 21,100 1.15 % Loans, Farmer Mac Guaranteed Securities and USDA Guaranteed Securities (1) 8,099,888 173,900 2.86 % 6,569,953 152,599 3.10 % Total interest-earning assets 11,097,018 192,593 2.31 % 9,016,985 173,699 2.57 % Funding: Notes payable due within one year 5,220,955 7,068 0.18 % 4,019,952 6,962 0.23 % Notes payable due after one year (2) 5,403,647 87,801 2.17 % 4,529,535 81,292 2.39 % Total interest-bearing liabilities (3) 10,624,602 94,869 1.19 % 8,549,487 88,254 1.38 % Net non-interest-bearing funding 472,416 - 467,498 - Total funding 11,097,018 94,869 1.14 % 9,016,985 88,254 1.31 % Net interest income/yield prior to consolidation of certain trusts 11,097,018 97,724 1.17 % 9,016,985 85,445 1.26 % Net effect of consolidated trusts (4) 468,825 1,463 0.42 % 760,581 2,495 0.44 % Adjusted net interest income/yield $ 11,565,843 $ 99,187 1.14 % $ 9,777,566 $ 87,940 1.20 % (1) Excludes interest income of $15.9 million and $28.3 million in 2012 and 2011, respectively, related to consolidated trusts with beneficial interests owned by third parties. (2) Includes current portion of long-term notes. (3) Excludes interest expense of $14.4 million and $25.8 million in 2012 and 2011, respectively, related to consolidated trusts with beneficial interests owned by third parties. (4) Includes the effect of consolidated trusts with beneficial interests owned by third party investors. 63-------------------------------------------------------------------------------- Table of Contents The following table sets forth information regarding the changes in the components of Farmer Mac's net interest income for the periods indicated. For each category, information is provided on changes attributable to changes in volume (change in volume multiplied by old rate) and changes in rate (change in rate multiplied by old volume). Combined rate/volume variances, the third element of the calculation, are allocated based on their relative size. The decreases in income due to changes in rate reflect the reset of variable rate investments and adjustable rate mortgages to lower rates and the acquisition of new lower-yielding investments, loans, Farmer Mac Guaranteed Securities and USDA Guaranteed Securities, as described above. The decreases in expense reflect the decreased cost of funding due to lower interest rates in the debt markets. The increases due to changes in volume reflect the increase in on-balance sheet assets during the first nine months of 2012 compared to the first nine months of 2011. For the Nine Months Ended September 30, 2012 Compared to Same Period 2011 Increase/(Decrease) Due to Rate Volume Total (in thousands) Income from interest-earning assets: Cash and investments $ (6,561 ) $ 4,154 $ (2,407 ) Loans, Farmer Mac Guaranteed Securities and USDA Guaranteed Securities (12,205 ) 33,506 21,301 Total (18,766 ) 37,660 18,894 Expense from interest-bearing liabilities (12,947 ) 19,562 6,615 Change in net interest income prior to consolidation of certain trusts (1) $ (5,819 ) $ 18,098 $ 12,279 (1) Excludes the effect of consolidated trusts with beneficial interests owned by third parties. The net interest yield includes yield maintenance payments received upon the early payoff of certain borrowers' loans and the amortization of premiums on assets consolidated at fair value and excludes the accrual of income and expense related to the contractual amounts due on financial derivatives that are not designated in hedging relationships. The following paragraphs describe the effects of these items on the net interest yield and the table below presents them as adjustments to reconcile to the net effective spread Farmer Mac earns on the difference between its interest-earning assets and its net funding costs, including payments for income and expense related to financial derivatives. Farmer Mac uses interest rate swap contracts to manage its interest rate risk exposure by modifying the interest rate reset or maturity characteristics of certain assets and liabilities. Farmer Mac historically accounted for its financial derivatives as undesignated financial derivatives, however, beginning in third quarter 2012, Farmer Mac designated $950.0 million notional amount of financial derivatives in fair value hedge relationships. The Corporation presents the income or expense related to the contractual amounts due on undesignated financial derivatives in "Gains/(losses) on financial derivatives and hedging activities" on the consolidated statements of operations. For derivatives designated in fair value hedge relationships, the income or expense related to the contractual amounts due on the financial derivatives is included as an adjustment to the yield of the hedged item and is included in interest income. Farmer Mac includes the accrual of the contractual amounts due for undesignated financial derivatives in its calculation of net effective spread. For the three months ended September 30, 2012, expenses related to undesignated financial derivatives were $4.1 million (14 basis points), compared to $10.4 million (42 basis points) for the three months ended September 30, 2011. For the nine months ended September 30, 2012, expenses related to undesignated financial derivatives were $22.2 million (27 basis points), compared to $28.7 million (42 basis points) for the nine months ended September 30, 2011. 64-------------------------------------------------------------------------------- Table of Contents Net interest income and net interest yields for the three months ended September 30, 2012 and 2011 include the benefits of yield maintenance payments of $0.5 million (2 basis points) and $0.1 million (less than one basis point), respectively. Net interest income and net interest yields for the nine months ended September 30, 2012 and 2011 include the benefits of yield maintenance payments of $0.8 million (1 basis point) and $0.7 million (1 basis point), respectively. Yield maintenance payments represent the present value of expected future interest income streams and accelerate the recognition of interest income from the related loans. Because the timing and size of these payments vary greatly, variations do not necessarily indicate positive or negative trends to gauge future financial results. Farmer Mac's net interest income and net interest yield for the three months ended September 30, 2012 and 2011 also include expenses of $1.7 million (6 basis points) and $2.3 million (9 basis points), respectively, related to the amortization of premiums on assets consolidated at fair value. Farmer Mac's net interest income and net interest yield for the nine months ended September 30, 2012 and 2011 also include expenses of $5.3 million (6 basis points) and $7.3 million (11 basis points), respectively, related to the amortization of premiums on assets consolidated at fair value. These premiums are being amortized into interest income over the contractual or estimated remaining lives of the underlying assets. The following table presents the net effective spread between Farmer Mac's interest-earning assets and its net funding costs. This spread is measured by including income or expense related to undesignated financial derivatives and excluding yield maintenance payments and the amortization of premiums on assets consolidated at fair value. New on-balance sheet program volume added during the first nine months of 2012 and throughout 2011 increased Farmer Mac's net effective spread for the three and nine months ended September 30, 2012 to $27.3 million and $80.1 million, respectively, up from $22.8 million and $63.4 million, respectively, for the same periods in 2011. The net effective spreads have remained relatively stable at 0.95 percent and 0.96 percent for the three and nine months ended September 30, 2012, respectively, compared to 0.93 percent and 0.94 percent, respectively, for the same periods in 2011. See Note 9 to the consolidated financial statements for more information regarding net effective spread for Farmer Mac's individual business segments. For the Three Months Ended For the Nine Months Ended September 30, 2012 September 30, 2011 September 30, 2012 September 30, 2011 Dollars Yield Dollars Yield Dollars Yield Dollars Yield (dollars in thousands) Net interest income/yield prior to consolidation of certain trusts $ 30,172 1.05 % $ 30,927 1.26 % $ 97,724 1.18 % $ 85,445 1.26 % Expense related to undesignated financial derivatives (4,130 ) (0.14 )% (10,375 ) (0.42 )% (22,163 ) (0.27 )% (28,695 ) (0.42 )% Yield maintenance payments (473 ) (0.02 )% (77 ) - % (784 ) (0.01 )% (699 ) (0.01 )% Amortization of premiums on assets consolidated at fair value 1,687 0.06 % 2,290 0.09 % 5,320 0.06 % 7,346 0.11 % Net effective spread $ 27,256 0.95 % $ 22,765 0.93 % $ 80,097 0.96 % $ 63,397 0.94 % Provision for and Release of Loan Losses. During the three months ended ended September 30, 2012, Farmer Mac recorded provisions to its allowance for loan losses of $0.1 million and charge-offs of $0.4 million, respectively, compared to releases of $0.3 million and charge-offs of $5,000, respectively, for the same periods in 2011. During the nine months ended September 30, 2012, Farmer Mac recorded releases of $0.7 million and charge-offs of $0.4 million, respectively, compared to provisions of $1.1 million and charge-offs of $0.2 million, respectively, for the same periods in 2011. The releases 65-------------------------------------------------------------------------------- Table of Contents recorded during the first nine months of 2012 were driven primarily by reductions in specific allowances for certain loans due to principal payments received and updated appraisal information and the reclassification of approximately $0.3 million from the allowance for loan losses to the reserve for losses due to the deconsolidation of certain VIEs resulting from a change in related party status. In the first nine months of 2011, Farmer Mac purchased two defaulted loans pursuant to the terms of an LTSPC agreement. This resulted in a reclassification of $1.8 million of specific allowance, which had been recorded in 2010, from the reserve for losses to the allowance for loan losses. This reclassification was partially offset by a decline in Farmer Mac's general loan loss allowance related to its exposure to the ethanol industry. As of September 30, 2012, Farmer Mac's total allowance for loan losses was $9.1 million, compared to $10.2 million as of December 31, 2011. See "-Risk Management-Credit Risk - Loans." Release of and Provision for Losses. During the three and nine months ended September 30, 2012, Farmer Mac recorded releases of losses of $43,000 and provisions for losses of $1.4 million, respectively, compared to releases of $0.5 million and $3.3 million, respectively, for the same periods in 2011. The provision for losses recorded during the first nine months of 2012 resulted primarily from an increase in a specific allowance on an ethanol loan and the reclassification of approximately $0.3 million described above. The release of losses recorded in the first nine months of 2011 primarily resulted from the reclassification of the $1.8 million specific allowance described above. As of September 30, 2012, Farmer Mac's reserve for losses was $8.7 million, compared to $7.4 million as of December 31, 2011. See "-Risk Management-Credit Risk - Loans." Guarantee and Commitment Fees. Guarantee and commitment fees, which compensate Farmer Mac for assuming the credit risk on loans underlying Farmer Mac Guaranteed Securities and LTSPCs, were $6.4 million and $18.4 million, respectively, for the three and nine months ended September 30, 2012, compared to $6.1 million and $18.9 million, respectively, for the same periods in 2011. The decrease in guarantee and commitment fees in 2012 was primarily attributable to the maturity of a $475.0 million AgVantage security during 2011. Gains and Losses on Financial Derivatives and Hedging Activities. Effective July 1, 2012, Farmer Mac designated $950.0 million notional amount of interest rate swaps in fair value hedge relationships. Prior to third quarter 2012, Farmer Mac did not designate its financial derivatives in hedging relationships for accounting purposes. The net effect of unrealized and realized gains and losses on Farmer Mac's financial derivatives and hedging activities for the three and nine months ended September 30, 2012 was a net gain of $1.6 million and a net loss of $23.3 million, respectively, compared to a net loss of $68.6 million and $82.4 million, respectively, for the three and nine months ended September 30, 2011. 66-------------------------------------------------------------------------------- Table of Contents The components of gains and losses on financial derivatives and hedging activities for the three and nine months ended September 30, 2012 and 2011 are summarized in the following table: For the Three Months Ended For the Nine Months Ended September 30, September 30, September 30, September 30, 2012 2011 2012 2011 (in thousands) Fair value hedges: Unrealized (losses)/gains due to fair value changes: Financial derivatives $ (5,142 ) $ - $ (5,142 ) $ - Hedged items 8,378 - 8,378 - Gains on hedging activities 3,236 - 3,236 - No hedge designation: Unrealized gains/(losses) due to fair value changes 2,081 (55,204 ) (3,842 ) (48,184 ) Realized: Expense related to financial derivatives (4,130 ) (10,375 ) (22,164 ) (28,695 ) Gains/(losses) due to terminations or net settlements 371 (2,988 ) (564 ) (5,489 ) Losses on financial derivatives not designated in hedging relationships (1,678 ) (68,567 ) (26,570 ) (82,368 ) Gains/(losses) on financial derivatives and hedging activities $ 1,558 $ (68,567 ) $ (23,334 ) $ (82,368 ) Changes in the fair values of Farmer Mac's open derivative positions for both designated and undesignated hedges are captured in unrealized (losses)/gains due to fair value changes in the table above and are primarily the result of fluctuations in long-term interest rates. For financial derivatives designated as fair value hedges, changes in the fair values of the hedged items attributable to the hedged risk are also included in unrealized (losses)/gains due to fair value changes above. The accrual of periodic cash settlements for interest paid or received from Farmer Mac's interest rate swap contracts that are not designated in hedging relationships is shown as expense related to financial derivatives. Payments or receipts to terminate derivative positions or net cash settle forward sales contracts on the debt of other GSEs and U.S. Treasury futures that are not designated in hedging relationships are included in losses due to terminations or net settlements. For the three and nine months ended September 30, 2012 and 2011, Farmer Mac was a party to interest rate swap contracts with one related party, Zions First National Bank. Farmer Mac realized expenses of $0.2 million and $0.8 million for the three and nine months ended September 30, 2012, respectively, related to these interest rate swap contracts, compared to realized expenses of $0.5 million and $1.4 million, respectively, for the same periods in 2011. Losses on Trading Assets. During the three and nine months ended September 30, 2012, Farmer Mac recorded unrealized losses on trading assets of $0.4 million and $2.4 million, respectively, compared to unrealized losses of $3.6 million and $0.4 million, respectively, for the same periods in 2011. Of the total unrealized losses recognized on trading assets during the three and nine months ended September 30, 2012, $0.5 million and $2.6 million, respectively, related to assets selected for the fair value option, compared to $3.3 million and $1.4 million for the same periods in 2011. Farmer Mac made no fair value option elections during the three and nine months ended September 30, 2012 and 2011. 67-------------------------------------------------------------------------------- Table of Contents The unrealized trading losses recorded in the first nine months of 2012 resulted primarily from the reversal of previously recorded unrealized fair value gains upon payoff or refinancing of certain fixed rate USDA Guaranteed Securities given the low interest rate environment and decreases in the fair values of USDA Guaranteed Securities due to wider spreads on mortgage securities. Gains on Sale of Available-for-Sale Investment Securities. During the three months ended September 30, 2012, Farmer Mac did not sell any securities from its available-for-sale investment portfolio. During the nine months ended September 30, 2012, Farmer Mac realized net gains of $28,000 from the sale of securities from its available-for-sale investment portfolio, compared to net gains of $0.1 million and $0.3 million, for the three and nine months ended September 30, 2011, respectively. Losses and Gains on Sale of Real Estate Owned ("REO"). During the three and nine months ended September 30, 2012, Farmer Mac realized losses of $13,000 and gains of $0.2 million upon the sale of REO properties. This compares to losses of $4,000 and gains of $0.7 million, respectively, for the same periods in 2011. Lower of Cost or Fair Value Adjustment on Loans Held for Sale. During the three and nine months ended September 30, 2012, Farmer Mac did not record any fair value adjustments on loans held for sale, compared to unrealized gains of $9.9 million and $8.9 million, for the three and nine months ended September 30, 2011, respectively. The unrealized gains recorded during 2011 resulted from the reversal of previously recognized unrealized losses as the fair value of these loans increased above their cost amounts. Other Income. Other income totaled $1.0 million and $2.5 million for the three and nine months ended September 30, 2012, respectively, compared to $0.7 million and $5.7 million, respectively, for the same periods in 2011. Other income for the first nine months of 2012 and 2011 included the recognition of $1.1 million and $4.6 million, respectively, of gains previously deferred in accumulated other comprehensive income related to fair value changes of certain Farmer Mac II Guaranteed Securities and USDA Guaranteed Securities contributed to Farmer Mac II LLC in 2010. Compensation and Employee Benefits. Compensation and employee benefits were $4.4 million and $13.4 million, respectively, for the three and nine months ended September 30, 2012, compared to $4.8 million and $14.0 million, respectively, for the same periods in 2011. The decreased level of expenses in 2012 was primarily attributable to lower employee health insurance costs resulting from a change in the type of health insurance plan offered to employees in 2012. Farmer Mac expects employee heath insurance costs to increase in 2013. General and Administrative Expenses. General and administrative expenses, including legal, audit and consulting fees, were $2.8 million and $8.2 million for the three and nine months ended September 30, 2012, compared to $2.5 million and $7.4 million for the same periods in 2011. The increased level of expenses during the first nine months of 2012 was primarily related to higher costs for consulting and information technology services associated with general corporate activities. 68-------------------------------------------------------------------------------- Table of Contents Regulatory Fees. Regulatory fees for the three and nine months ended September 30, 2012 and 2011 were $0.6 million and $1.7 million, respectively. FCA has advised Farmer Mac that its estimated fees for the federal fiscal year ending September 30, 2013 will be $2.4 million, compared to $2.3 million for the federal fiscal year ended September 30, 2012. After the end of a federal government fiscal year, FCA may revise its prior year estimated assessments to reflect actual costs incurred, and has issued both additional assessments and refunds in the past. REO Operating Costs. Farmer Mac recorded $0.1 million of REO operating costs for both the three and nine months ended September 30, 2012. During the three and nine months ended September 30, 2011, Farmer Mac recorded REO operating costs of $0.1 million and $0.7 million, respectively, primarily to adjust the carrying value of REO properties to net realizable value (fair value less estimated costs to sell). Other Expense. During first quarter 2011, Farmer Mac recorded $0.9 million of expense related to the termination of an agreement with a third party that previously provided services related to loan and security administration for certain Farmer Mac I assets. Farmer Mac is currently performing those services internally and expects to continue to do so in the future. Since then, Farmer Mac incurred no comparable termination charges. Income Tax Benefit/Expense. For the three and nine months ended September 30, 2012, Farmer Mac recorded an income tax expense of $8.3 million and $17.3 million, respectively, compared to income tax benefit of $14.1 million and $2.1 million, respectively, for the same periods in 2011. The income tax benefits recorded in 2011 were primarily due to a pre-tax book loss for third quarter 2011 resulting from fair value adjustments on the Corporation's financial derivatives combined with the consolidated tax benefit of the dividends declared on the Farmer Mac II LLC Preferred Stock, which is presented as "Net income attributable to non-controlling interest - preferred stock dividends" on the consolidated statements of operations on a pre-tax basis. Because of this non-controlling interest, Farmer Mac's effective tax rate varies from the statutory federal rate of 35 percent. 69-------------------------------------------------------------------------------- Table of Contents Business Volume. During third quarter 2012, Farmer Mac added $841.5 million of new program volume. Specifically, Farmer Mac: • purchased $132.9 million of newly originated Farmer Mac I eligible loans; • added $115.8 million of Farmer Mac I eligible loans under LTSPCs; • purchased $201.0 million of Farmer Mac I AgVantage securities; • purchased $26.8 million of loans under the Rural Utilities program; • purchased $250.0 million of Rural Utilities AgVantage securities; and • purchased $115.0 million of Farmer Mac II USDA-guaranteed portions. Farmer Mac's outstanding program volume was $12.5 billion as of September 30, 2012, an increase of $554.8 million from December 31, 2011, as new volume exceeded maturities and principal paydowns on existing program assets. The new program volume in the first nine months of 2012 included $600.0 million of AgVantage securities with maturities between two and five years purchased from Rabo Agrifinance Inc., and $250.0 million of Rural Utilities AgVantage securities with an original term-to-maturity of 13 months purchased from CFC. Principal paydowns and maturities in the first nine months of 2012 included $495.7 million related to Rural Utilities AgVantage securities. The following table sets forth Farmer Mac I, Farmer Mac II and Rural Utilities loan purchase, LTSPC and guarantee activities for newly originated and current seasoned loans during the periods indicated: Farmer Mac Loan Purchases, Guarantees and LTSPCs For the Three Months Ended For the Nine Months Ended September 30, September 30, September 30, September 30, 2012 2011 2012 2011 (in thousands) Farmer Mac I: Loans $ 132,882 $ 68,201 $ 388,791 $ 397,030 LTSPCs 115,757 266,906 365,852 374,306 Farmer Mac Guaranteed Securities - AgVantage 201,000 1,001,500 601,000 1,801,500 Farmer Mac II: USDA Guaranteed Securities 114,974 85,787 376,985 300,311 Farmer Mac Guaranteed Securities - 1,264 5,327 3,268 Rural Utilities: Loans 26,843 32,387 109,479 148,782 Farmer Mac Guaranteed Securities - AgVantage 250,000 - 250,000 2,796 Total purchases, guarantees and commitments $ 841,456 $ 1,456,045 $ 2,097,434 $ 3,027,993 70-------------------------------------------------------------------------------- Table of Contents The following table presents the outstanding principal balance of loans held, loans underlying LTSPCs and on- and off-balance sheet Farmer Mac Guaranteed Securities and USDA Guaranteed Securities as of September 30, 2012 and December 31, 2011: Outstanding Balance of Loans, Loans Underlying Farmer Mac Guaranteed Securities and LTSPCs, and USDA Guaranteed Securities September 30, December 31, 2012 2011 (in thousands) On-balance sheet: Farmer Mac I: Loans $ 1,382,273 $ 1,251,370 Loans held in trusts: Beneficial interests owned by Farmer Mac 40 181 Beneficial interests owned by third party investors 163,088 696,554 Farmer Mac Guaranteed Securities - AgVantage 3,339,200 2,741,000 Farmer Mac II: USDA Guaranteed Securities 1,536,974 1,435,679 Farmer Mac Guaranteed Securities 28,957 35,410 Rural Utilities: Loans 606,459 529,227 Loans held in trusts: Beneficial interests owned by Farmer Mac 368,848 386,800 Farmer Mac Guaranteed Securities - AgVantage 1,165,100 1,410,800 Total on-balance sheet $ 8,590,939 $ 8,487,021 Off-balance sheet: Farmer Mac I: Farmer Mac Guaranteed Securities - AgVantage $ 970,000 $ 970,000 LTSPCs 1,881,836 1,776,051 Farmer Mac Guaranteed Securities 975,720 621,871 Farmer Mac II: Farmer Mac Guaranteed Securities 33,295 42,088 Rural Utilities: Farmer Mac Guaranteed Securities - AgVantage 16,269 16,271 Total off-balance sheet $ 3,877,120 $ 3,426,281 Total $ 12,468,059 $ 11,913,302 Of the $12.5 billion outstanding principal balance of volume included in Farmer Mac's three programs as of September 30, 2012, $5.5 billion were Farmer Mac Guaranteed Securities structured as AgVantage securities. Each AgVantage security is a general obligation of an issuing institution approved by Farmer Mac and is secured by eligible loans in an amount at least equal to the outstanding principal amount of the security. Unlike business volume in the form of purchased loans, USDA Guaranteed Securities, and loans underlying LTSPCs and non-AgVantage Farmer Mac Guaranteed Securities, the Farmer Mac Guaranteed Securities structured as AgVantage securities do not pay down principal based on amortization schedules and instead have fixed maturity dates when the secured general obligation is due. 71-------------------------------------------------------------------------------- Table of Contents The following table summarizes by maturity date the outstanding principal amount of both on- and off-balance sheet AgVantage securities as of September 30, 2012: AgVantage Balances by Year of Maturity As of September 30, 2012 (in thousands) 2013 658,250 2014 1,060,900 2015 650,250 2016 1,252,000 2017 1,250,500 Thereafter (1) 618,669 Total $ 5,490,569 (1) Includes various maturities ranging from 2018 to 2024. The weighted-average remaining maturity of the outstanding $5.5 billion of AgVantage securities shown in the table above was 3.5 years as of September 30, 2012. As a general matter, if the issuer of a maturing AgVantage security does not issue new AgVantage securities to replace the maturing securities, and Farmer Mac does not find alternate sources of business volume, the Corporation's income could be adversely affected. However, the income effect of future maturing AgVantage securities, particularly off-balance sheet transactions, may not be material and will likely not be proportional to the amount of any resulting decrease in business volume. The Corporation's income could also be adversely affected if the net interest margin earned by Farmer Mac on new AgVantage securities that replace maturing AgVantage securities is lower than the margin earned on the maturing securities, as was the case in the CFC transaction completed in third quarter 2012. The weighted-average age of the Farmer Mac I newly originated and current seasoned loans purchased during third quarter 2012 and 2011 was two months and four months, respectively. The third quarter 2012 and 2011 purchases had a weighted-average remaining term to maturity of 16.7 years and 15.7 years, respectively. Of the Farmer Mac I newly originated and current seasoned loans purchased during third quarter 2012 and 2011, 65 percent and 79 percent, respectively, had principal amortization periods longer than the maturity date, resulting in balloon payments at maturity. As part of fulfilling its guarantee obligations for Farmer Mac I Guaranteed Securities and commitments to purchase eligible loans underlying LTSPCs, Farmer Mac purchases defaulted loans, all of which are at least 90 days delinquent or in material non-monetary default at the time of purchase, out of the loan pools underlying those securities and LTSPCs, and records the purchased loans as such on its balance sheet. The purchase price for defaulted loans purchased out of Farmer Mac I Guaranteed Securities is the current outstanding principal balance of the loan plus accrued and unpaid interest. The purchase price for defaulted loans purchased under an LTSPC is the then-current outstanding principal balance of the loan, with accrued and unpaid interest on the defaulted loans payable out of any future loan payments or liquidation proceeds as received. The purchase price of a defaulted loan is not an indicator of the expected loss on that loan; many other factors affect expected loss, if any, on loans so purchased. The weighted-average age of delinquent loans purchased out of securitized pools and LTSPCs during third quarter 2012 and 2011 was 4.7 years and 9.9 years, respectively. See "Management's Discussion and Analysis of Financial Condition and Results of Operations-Risk Management-Credit Risk - Loans" in the 72-------------------------------------------------------------------------------- Table of Contents Corporation's Annual Report on Form 10 K for the year ended December 31, 2011 filed with the SEC on March 15, 2012. The following table presents Farmer Mac's purchases of newly originated and current seasoned loans under the Farmer Mac I program and purchases of defaulted loans underlying Farmer Mac I Guaranteed Securities and LTSPCs for the periods indicated: For the Three Months Ended For the Nine Months Ended September 30, September 30, September 30, September 30, 2012 2011 2012 2011 (inthousands) Farmer Mac I newly originated and current seasoned loan purchases $ 132,882 $ 68,201 $ 388,791 $ 397,030 Defaulted loans purchased underlying Farmer Mac I Guaranteed Securities owned by third party investors 6,742 2,921 8,069 7,292 Defaulted loans purchased underlying LTSPCs 432 - 2,962 13,974 Total loan purchases $ 140,056 $ 71,122 $ 399,822 $ 418,296 Farmer Mac II LLC. In January 2010, Farmer Mac contributed substantially all of the assets comprising the Farmer Mac II program (in excess of $1.1 billion) to Farmer Mac's subsidiary, Farmer Mac II LLC. The assets that Farmer Mac contributed to Farmer Mac II LLC consisted primarily of USDA-guaranteed portions that had not been securitized by Farmer Mac but also included $35.0 million of Farmer Mac II Guaranteed Securities. Farmer Mac did not and will not guarantee the timely payment of principal and interest on the $1.1 billion of contributed USDA-guaranteed portions. The financial information presented in this report reflects the accounts of Farmer Mac and its subsidiaries on a consolidated basis. Accordingly, Farmer Mac's reportable operating segments presented in this report will differ from the stand-alone financial statements of Farmer Mac II LLC. Those separate financial statements are available on the website of Farmer Mac II LLC and are not incorporated in this report by reference. The assets of Farmer Mac II LLC will only be available to creditors of Farmer Mac after all obligations owed to creditors of and equity holders in Farmer Mac II LLC have been satisfied. As of September 30, 2012, Farmer Mac II LLC held assets with a fair value of $1.6 billion, had debt outstanding of $293.0 million, had preferred stock outstanding with a liquidation preference of $250.0 million, and had $1.0 billion of common stock outstanding held by Farmer Mac. For more information about the formation and operations of Farmer Mac II LLC and the features of the preferred stock issued by Farmer Mac II LLC in January 2010, see Notes 7 and 9 to the consolidated financial statements. 73-------------------------------------------------------------------------------- Table of Contents Outlook Farmer Mac continues to provide a source of liquidity, capital, and risk management tools to help lenders meet the borrowing needs of their customers, and continues to be well-positioned for future business opportunities. While the pace of Farmer Mac's growth will be dictated by the capital and liquidity demands of lenders and their commodity concentrations, Farmer Mac foresees opportunities for continued growth in both the agricultural and rural utilities segments of its business. Agricultural Sector: The agricultural sector includes many diverse industries that respond in different ways to changes in economic conditions. Those individual industries often are affected differently, sometimes positively and sometimes negatively, by prevailing economic and weather conditions. This results in cycles where one or more industries may be under stress at the same time that others are not. In addition, producers that rely on non-farm sources of income as a significant percentage of overall income may experience stress associated with weakness in the general economy. These industries are also affected by commodity inventories and their associated market prices, which can vary largely as a result of weather patterns and harvest conditions. The agricultural sector has remained profitable across a variety of industries through the first nine months of 2012, but the extremely high temperatures and drought that areas of the Midwest and Great Plains experienced this past summer generated concerns of substantial yield reductions in the grain crop. Although the drought has been widespread, factors such as a producer's specific location, soil makeup, and irrigation and cultural practices, including seed genetics used, have resulted in great variability in crop yields. The drought has had no measurable impact on the credit quality of Farmer Mac's portfolio as of the end of third quarter 2012. In general, Farmer Mac does not expect the drought to have a significant negative effect on grain producers because the majority use risk management strategies such as crop insurance to reduce the impact of these situations. Many grain producers also entered this period of drought in a position of financial strength after a period of high profitability and, to the extent that they have a harvestable crop, they may also benefit from the increased grain prices attributable to the reduced grain supply resulting from the drought. However, these increased grain prices may adversely affect the profitability of producers in many industries, including livestock, dairy, and ethanol producers that have already experienced stress over the past few years and face yet another period of high production costs and reduced incomes. Farmer Mac believes that it generally remains well collateralized on its exposures in drought areas, due in part to the appreciation in land values in those areas over the last several years, and will continue to monitor closely the effects of drought on its portfolio. Agricultural land values that have increased over the past several years have remained elevated. Concern over the sustainability of current land values is mitigated somewhat by the amount of cash used to make purchases and the consideration that a majority of agricultural land purchases have been made by producers rather than investors. Farmer Mac continues to closely monitor sector profitability and agricultural land value trends to tailor underwriting practices to changing conditions. For example, in response to the recent increases in land values, during third quarter 2012 Farmer Mac adopted more conservative underwriting standards for loans in designated states in the upper Midwest by decreasing the maximum loan-to-value ratio ("LTV") from 70 percent to 60 percent for those loans. Furthermore, although Farmer Mac underwrites loans with an emphasis on the borrower's repayment capacity, it is noteworthy that the weighted average original LTV (based on original appraised value that has not been indexed to provide a current market value) for non-AgVantage Farmer Mac I loans was approximately 53 percent and 52 percent as of September 30, 2012 and December 31, 2011, respectively. 74-------------------------------------------------------------------------------- Table of Contents Farmer Mac also continues to monitor the establishment and evolution of legislation and regulations that affect farmers, ranchers, and rural lenders. Many existing federal agricultural policies contained in the 2008 Farm Bill, including policies affecting crop subsidies, availability of crop insurance, and other aspects of agricultural production, expired in September of this year. These policies and others have been the subject of recent political debate within the context of proposals to replace the 2008 Farm Bill. Although various legislative initiatives have been introduced in Congress to modify or extend the policies contained in the 2008 Farm Bill, Congress has not yet passed any such legislation. Farmer Mac will continue to closely monitor these developments. Farmer Mac has recently observed increased demand for its longer-term, fixed-rate loan products in the agricultural segment of its portfolio. Farmer Mac believes that the trend toward longer-term mortgage financing by farmland owners will continue and that demand for Farmer Mac's secondary market tools will also increase as rural lenders make more loans and adapt to the changing regulatory environment, which could require more liquidity and capital. Renewable Energy Sector: Farmer Mac's support of the renewable energy sector is centered in ethanol production, an industry that continues to experience narrow or uneven profit margins in many cases due to a variety of factors. Government support for this industry in the form of an excise tax credit and an import tariff expired in 2011. In anticipation of this expiration, many ethanol blenders established large inventories of ethanol in late 2011, creating downward pressure on ethanol prices. Oversupply, combined with reduced demand for gasoline, has resulted in narrow margins for the ethanol industry this year. As a result, many ethanol plants have curtailed production or shut down to minimize operating losses. The escalation in corn prices from the drought has placed additional pressure on profit margins as operators have experienced increased input costs, and has also increased political pressure on legislators to reduce or eliminate the Renewable Fuel Standard, which currently mandates targeted use of fuel from renewable sources. While a reduction or elimination of the Renewable Fuel Standard is not expected, any such change would have an adverse effect on demand for ethanol. Variability in consumer demand for gasoline has also had periodic negative effects on the demand for ethanol as a blending agent. On the other hand, many producers have begun installing and utilizing corn oil extraction technologies in their plants in an effort to increase profitability. Nonetheless, profit margins at the ethanol production level will likely remain narrow for the foreseeable future, and it is likely that the trend of ethanol plants operating at less than full capacity will continue. Although the ethanol loans in Farmer Mac's portfolio has decreased in recent years both in dollar amount ($153.5 million as of September 30, 2012) and as a percentage of its overall portfolio volume (3.5 percent of the non-AgVantage Farmer Mac I portfolio as of September 30, 2012), Farmer Mac continues to monitor developments in the ethanol industry and evaluate their potential impact on the overall performance of Farmer Mac's portfolio. Other than $14.8 million of undisbursed commitments on existing ethanol loans, Farmer Mac does not expect to add additional ethanol loans to its portfolio. Rural Utilities Industry: The demand of the rural utilities industry for capital and financing tends to follow the state of the general economy. Continued weakness in the general economy has reduced the demand for rural electric power and, consequently, the need for rural utilities cooperatives to expand. This lower demand within the industry is the primary reason for the lack of growth in Farmer Mac's rural utilities portfolio over the past few years. However, many domestic economic indicators have improved recently, and Farmer Mac and industry sources expect that demand for rural utilities loans will increase as the economy strengthens. Farmer Mac believes that the rural utilities industry will have significant needs for financing over the course of the next decade, as capital will be needed for growth and modernization such as transmission 75-------------------------------------------------------------------------------- Table of Contents and distribution system improvements and demand-side management. In addition, the industry will also require capital to comply with any future public policy initiatives such as environmental regulations and clean energy initiatives. For example, in response to low natural gas fuel costs, many power generators are building environmentally cleaner natural gas-fired generating projects to replace their aging coal-fired plants. Any increase in rural utilities cooperatives' demand for loans could result in increased business volume for Farmer Mac in that segment of its portfolio. Balance Sheet Review Assets. Total assets as of September 30, 2012 were $12.5 billion, compared to $11.9 billion as of December 31, 2011. The increase in total assets was driven by higher levels of non-program assets held for liquidity purposes and purchases of AgVantage securities during 2012 that were retained on balance sheet, offset partially by the deconsolidation of $460.3 million unpaid principal balance of Farmer Mac Guaranteed Securities held by a third party, previously reported as loans held for investment in consolidated trusts, that was no longer a related party during second quarter 2012. As of September 30, 2012, Farmer Mac had $870.0 million of cash and cash equivalents and $2.6 billion of investment securities, compared to $817.0 million of cash and cash equivalents and $2.2 billion of investment securities as of December 31, 2011. As of September 30, 2012, Farmer Mac had, $4.6 billion of Farmer Mac Guaranteed Securities, $1.6 billion of USDA Guaranteed Securities and $2.5 billion of loans, net of allowance. This compares to, $4.3 billion of Farmer Mac Guaranteed Securities, $1.5 billion of USDA Guaranteed Securities and $2.9 billion of loans, net of allowance, as of December 31, 2011. Liabilities. Total liabilities increased to $11.9 billion as of September 30, 2012 from $11.3 billion as of December 31, 2011. The increase in liabilities was due to an increase in notes payable used to purchase program and non-program assets, offset partially by a decrease in debt securities of consolidated trusts held by a third party of $460.3 million that were deconsolidated in second quarter 2012 because the third party was no longer a related party. Equity. As of September 30, 2012, Farmer Mac had total equity of $600.3 million comprised of stockholders' equity of $358.4 million and non-controlling interest - preferred stock of $241.9 million. As of December 31, 2011 Farmer Mac had total equity of $554.5 million comprised of stockholders' equity of $312.6 million and non-controlling interest - preferred stock of $241.9 million. The increase in total equity during the first nine months of 2012 was the result of increased retained earnings and accumulated other comprehensive income driven by increases in the fair values of securities designated as available-for-sale. Regulatory Capital Compliance. Farmer Mac was in compliance with its statutory minimum capital requirement and its risk-based capital standard as of September 30, 2012. Farmer Mac is required to hold capital at the higher of its statutory minimum capital requirement and the amount required by its risk-based capital stress test. As of September 30, 2012, Farmer Mac's core capital totaled $508.5 million and exceeded its statutory minimum capital requirement of $368.4 million by $140.1 million. As of December 31, 2011, Farmer Mac's core capital totaled $475.2 million and exceeded its statutory minimum capital requirement of $348.7 million by $126.5 million. As of September 30, 2012, Farmer Mac's risk-based capital stress test generated a risk-based capital requirement of $42.0 million. Farmer Mac's regulatory capital of $526.3 million exceeded that amount by approximately $484.3 million. Accumulated other comprehensive income is not a component of Farmer Mac's core capital or regulatory capital. 76-------------------------------------------------------------------------------- Table of Contents Off-Balance Sheet Arrangements Farmer Mac offers approved lenders two credit enhancement alternatives to increase their liquidity or lending capacity while retaining the cash flow benefits of their loans: (1) LTSPCs, which are available only through the Farmer Mac I and Rural Utilities programs; and (2) Farmer Mac Guaranteed Securities, which are available through each of the Farmer Mac I, Farmer Mac II and Rural Utilities programs. For securitization trusts where Farmer Mac is the primary beneficiary, the trust assets and liabilities are included on Farmer Mac's consolidated balance sheet. For the remainder of these transactions, and in the event of deconsolidation, both of these alternatives result in the creation of off-balance sheet obligations for Farmer Mac. See Notes 1(f) and 6 to the consolidated financial statements for further information regarding consolidation and Farmer Mac's off-balance sheet program activities. Risk Management Credit Risk - Loans. Farmer Mac is exposed to credit risk resulting from the inability of borrowers to repay their loans in conjunction with a deficiency in the value of the collateral relative to the outstanding balance of the loan and the costs of liquidation. Farmer Mac is exposed to credit risk on: • loans held; • loans underlying Farmer Mac Guaranteed Securities; and • loans underlying LTSPCs. Farmer Mac generally assumes 100 percent of the credit risk on loans held and loans underlying Farmer Mac I Guaranteed Securities, LTSPCs and Farmer Mac Guaranteed Securities - Rural Utilities. Farmer Mac has direct credit exposure to loans in non-AgVantage transactions and indirect credit exposure to loans that secure AgVantage transactions, which involve a general obligation of a lender secured by qualified loans. The credit exposure of Farmer Mac and Farmer Mac II LLC on USDA-guaranteed portions is covered by the full faith and credit of the United States. Farmer Mac believes that the Corporation and Farmer Mac II LLC have little or no credit risk exposure to USDA-guaranteed portions because of the USDA guarantee. As of September 30, 2012, neither Farmer Mac nor Farmer Mac II LLC had experienced any credit losses on any business under the Farmer Mac II program and does not expect that the Corporation or Farmer Mac II LLC will incur any such losses in the future. 77-------------------------------------------------------------------------------- Table of Contents Farmer Mac has established underwriting, collateral valuation and documentation standards (including interest rate shock tests for adjustable rate mortgages with initial reset periods of less than five years) for agricultural real estate mortgage loans and rural utilities loans. Farmer Mac believes that these standards mitigate the risk of loss from borrower defaults and provide guidance about the management, administration, and conduct of underwriting and appraisals to all participating sellers and potential sellers in its programs. These standards were developed on the basis of industry norms for agricultural real estate mortgage loans and rural utilities loans and are designed to assess the creditworthiness of the borrower, as well as the value of the collateral securing the loan. Farmer Mac evaluates and adjusts these standards on an ongoing basis based on current and anticipated market conditions. For example, in mid-August 2012 Farmer Mac refined its non-AgVantage Farmer Mac I loan underwriting standards to: • increase the minimum ratio of current assets to current liabilities (current ratio) from 1.0 to 1.25; • decrease the maximum LTV from 70 percent to 60 percent for loans secured by agricultural real estate located in designated states in the upper Midwest; and • focus on a borrower's total debt coverage ratio for purposes of analyzing loan repayment capacity (rather than considering total debt coverage ratio in conjunction with property debt coverage ratio). These changes were in response to economic conditions affecting agricultural producers, including volatility in revenues and concern over the sustainability of current land values in certain areas, that Farmer Mac believes may have an effect on overall borrower repayment capability. Farmer Mac believes that these refinements to its underwriting standards are consistent with practices undertaken within the agricultural credit industry in general, and does not expect these changes to have a significant impact on Farmer Mac's business volume. Farmer Mac requires sellers to make representations and warranties regarding the conformity of eligible mortgage and rural utilities loans to these standards, the accuracy of loan data provided to Farmer Mac and other requirements related to the loans. Sellers are responsible to Farmer Mac for breaches of those representations and warranties, and Farmer Mac has the ability to require a seller to cure, replace or repurchase a loan sold or transferred to Farmer Mac if any breach of a representation or warranty is discovered that was material to Farmer Mac's decision to purchase the loan or that directly or indirectly causes a default or potential loss on a loan sold or transferred by the seller to Farmer Mac. Pursuant to contracts with Farmer Mac and in consideration for servicing fees, Farmer Mac-approved central servicers service mortgage loans in accordance with Farmer Mac requirements. Central servicers are responsible to Farmer Mac for serious errors in the servicing of those mortgage loans. Detailed information regarding Farmer Mac's underwriting and collateral valuation standards and seller eligibility requirements are presented in "Business-Farmer Mac Programs-Farmer Mac I-Underwriting and Collateral Valuation (Appraisal) Standards," "Business-Farmer Mac Programs-Farmer Mac I-Sellers" and "Business-Farmer Mac Programs-Rural Utilities" in the Corporation's Annual Report on Form 10-K for the year ended December 31, 2011 filed with the SEC on March 15, 2012. Farmer Mac AgVantage securities are general obligations of institutions approved by Farmer Mac and are secured by eligible loans in an amount at least equal to the outstanding principal amount of the security. Farmer Mac excludes the loans that secure AgVantage securities from the credit risk metrics it discloses because of the credit quality of the issuing institutions, the collateralization level for the securities, and because delinquent loans are required to be removed from the pool of pledged loans and replaced with current eligible loans. As such, all AgVantage securities are secured by current loans representing at least 100 percent of the outstanding amount of the security. As of September 30, 2012, Farmer Mac had not experienced any credit losses on any AgVantage securities and does not expect to 78-------------------------------------------------------------------------------- Table of Contents incur any such losses in the future. See "-Credit Risk-Institutional" for more information about Farmer Mac's credit risk on AgVantage securities. Farmer Mac has developed different underwriting standards for rural utilities loans that depend on whether direct or indirect credit exposure is assumed on a loan and whether the borrower is an electric distribution cooperative or a generation and transmission ("G&T") cooperative. As of September 30, 2012, there were no delinquencies in Farmer Mac's portfolio of rural utilities loans, which includes rural utilities loans held and rural utilities loans underlying or securing Farmer Mac Guaranteed Securities - Rural Utilities. Farmer Mac's direct credit exposure to rural utilities loans as of September 30, 2012 was $975.3 million, of which $950.4 million were loans to electric distribution cooperatives and $24.9 million were loans to G&T cooperatives. Farmer Mac also had indirect credit exposure to the rural utilities loans securing Farmer Mac Guaranteed Securities - Rural Utilities structured as AgVantage securities, some of which were secured by loans to G&T cooperatives. For more information, see "-Credit Risk-Institutional." Farmer Mac maintains an allowance for losses to cover estimated probable losses on loans held and loans underlying LTSPCs and Farmer Mac Guaranteed Securities. The methodology that Farmer Mac uses to determine the level of its allowance for losses is described in "Management's Discussion and Analysis of Financial Condition and Results of Operations-Critical Accounting Policies and Estimates-Allowance for Losses" in Farmer Mac's Annual Report on Form 10-K for the year ended December 31, 2011 filed with the SEC on March 15, 2012. Management believes that this methodology produces a reasonable estimate of probable losses, as of the balance sheet date, for all loans held and loans underlying Farmer Mac Guaranteed Securities and LTSPCs, in accordance with accounting guidance related to contingencies and measuring impairment of individual loans. The following table summarizes the components of Farmer Mac's allowance for losses as of September 30, 2012 and December 31, 2011: |