Every now and then we go through the list of IG11 companies looking for something that just looks out of place. This time around our attention was caught by a financial company, whose CDS was trading at a level which we initially thought had to be a mistake. The company in question is Herndon, Virginia based National Rural Utilities Cooperative Finance Corporation (corporate ticker NRUC), and the initial reason why we were intrigued by it is that not only was it trading about 800 points tighter than comparable (and since NRUC is rated A1/A, better rated) financial companies including GECC, HSBC Financial and American Express, but on February 19, NRUC actually traded tighter compared to the United States of America itself.



So we dig deeper... Low profile NRUC (no public equity) is a non-profit, tax-exempt financial institution exclusively serving rural electric, service and telecommunication utilities, which was organized in 1969 by rural electric cooperatives (RECs) as an "economically alternative" source to federally subsidized funds from the Rural Utilities Services (RUS) of the U.S. Department of Agriculture. A cursory Google search for the company reveals that despite its lack of media exposure it did briefly make waves on July 16 2007 when Barron's picked up on a credit downgrade not by the SEC-recognized rating agencies (responsible for such recent events as, hmm, the Second Great Depression) but by small and often ridiculed Egan Jones (noted for having the best independent credit research department with a hit-miss ratio of 96% over the past 7 years, and being an early predictor of the Enron and WorldCom disasters) which cut the company to a whopping B+: smack in the middle of junk bond territory. The reason why a credit downgrade could be critical and potentially deadly to NRUC is that much like AIG and GE, its entire business model is based on its access to cheap capital, which it subsequently lends out to its member firms at slightly higher rates, thereby generating profits on the margin. A downgrade would doom the company as it would only be able to raise capital at much higher, and therefore loss generating, rates. Additionally the company also has rating-based collateral thresholds, which if crossed could trigger over $9 billion notional in interest-rate exchange agreements (more on this later). The Barron's article so incensed the company that the very next day CEO Sheldon Petersen issued a statement and a letter refuting Egan Jones' allegations, essentially claiming that E-J is a dwarf when compared to such intellectual giants as S&P and Moody's, whose "leading ratings analysts will tell you, CFC's credit fundamentals are strong and our financial underpinnings are rock solid."

"Despite the fact that CFC’s secured debt has received an A or higher rating from all three SEC-recognized rating agencies since 1972 (and currently has an A+/A1/A+ rating from Standard and Poor’s, Moody’s and Fitch, respectively), the article gives undue credence to a deeply flawed report authored by Egan-Jones, an organization that is not designated by the SEC as a nationally recognized statistical rating organization."

The story subsequently died down and any potential problems at NRUC were buried deep under the carpet... Until late Friday when Egan Jones came back with a bang, downgrading NRUC yet another notch to B. Could they be on to something?

A little background

A glance at the NRUC's most recent balance sheet gives a very good indication of the company's business model. Its main asset (aside from $473 million in cash) is $19 billion (or 93% of total assets) in loans to cooperative member firms. The liabilities are also pretty straightforward: the company finances these loans with $17.6 billion in short and long-term debt, $1.5 billion in hybrid debt/equity instruments (labeled as members' subordinated certificates) which could be interpreted as subordinated debt depending on how one looks at them, and a rapidly declining cushion of book equity which most recently amounted to $364 million.

A more detailed overview of the company can be gleaned by reading the Moody's report which NRUC has conveniently posted on its website (not surprisingly Egan Jones' report is nowhere to be found on http://www.nrucfc.org/). Looking at the asset side, NRUC provides loans to its member cooperative companies, which for the most part are RECs (89%) of total loans, and Rural Telephone Finance Cooperatives (RTFCs), accounting for 9% of loans.



The Moody's report can barely contain itself in extolling the virtues of the electric distribution cooperative segment, which amounts to the vast majority of all REC loans made by NRUC:

"Moody’s considers (the distribution cooperative) segment to be among the lowest risk segment across all electric utilities due to the highly predictable nature of the cooperative’s cash flow, the monopoly status of this group, the pass-through mechanisms that typically exists at these entities, and the relatively predictable and steady capital investment requirements which often mirror service territory growth. NRUC is the dominant private lender in the US to this particular segment of the electric cooperative sector."

In terms of credit quality, 90% of NRUC's total loan portfolio is secured, usually pari passu with other secured lenders (primarily RUS according to Moody's).



Moody's again chimes in:

"This strong collateral position has helped to provide high recovery values for NRUC in past problem loan debt restructurings and often enables NRUC to receive the payment of interest and principal while a borrower is operating in bankruptcy."

Surprisingly at a time when the LCDX index is trading at around 72, implying roughly comparable recoveries for a broad-based index of loans, Moody's (in December) was expecting virtually no portfolio losses, even in the event of default, due to expectations for "high recovery values." While it is still early to determine just how impacted the electrical utility space (and its distribution subspace in particular) will be by the ongoing Great Recession, it is likely safe to assume that it too will not be spared from the "tsunami of defaults" despite its inherent position of strength, as revenue streams decline and member's loan servicing capacities become constrained, even considering the semi-monopolistic nature of the business. This is already becoming more and more manifest in NRUC's own operations, as it is currently classifying over $1 billion in loans as "impaired pursuant to SFAS 114", the bulk of which is concentrated among two problem lenders - bankrupt CoServ Electric, a Denton, Texas distribution coop, which owes NRUC $505 million, and Innovative Communications Corporation (ICC) which has $485 million in outstanding loans with NRUC.

The risks

Just by looking at the trading level of the company's CDS, one would imagine the company is essentially backstopped by the U.S. government (which, at least implicitly, tends to happen after the U.S. nationalizes or "puts into conservatorship" entities such as the GSEs or AIG, and even the latter has CDS trading north of a 1,000 bps). Curiously, the company, in its Barron's article refutation make its thoughts quite clear on this matter:

Besides the significant points that CFC highlighted in its Letter to the Editor, Barron’s also made a number of factual errors in their story. Among these are the following:

"Although created by the Agriculture Department in 1969, the cooperative does not carry any ‘implied’ government guarantee….”
CFC was NOT created by the U.S. Department of Agriculture. CFC was created by its member cooperative utilities (under the leadership of the National Rural Electric Cooperative Association) to supplement the loans made by the USDA.

NRUC basically acknowledges its role as middleman between the capital markets and the U.S. government and cooperatives, however without any particular reason to believe that the U.S. considers NRUC in the "too large to fail" category.

Assuming NRUC should not be in the same category as Citi and other TBTF institutions, a good starting to point to evaluate corporate risk is the updated report that started it all.