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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.
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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.
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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
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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.
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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.
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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,
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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.
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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.
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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.
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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.
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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
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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.
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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.
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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.
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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.
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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
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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.
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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
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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.
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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.
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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
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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.
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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.
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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
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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:
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