Pub. 5 2010-2011 Issue 2

July/August 2010 13 Extraordinary Service for Extraordinary Members. T HE BIGGEST COMPONENT OF FCS’ higher net income was a $141 million (11 percent) increase in net interest income. A $75 million (30 percent) drop in its loan- loss provision was the other major component. Other income and ex- pense items, taken together, lowered net income by $29 million. FCS boosted its net interest income largely by pulling down its funding costs faster than the average inter- est rate on its loans and investments dropped. Comparing the first quarter of 2010 with the same quarter last year, the FCS’ yield on its earning assets dropped 28 basis points while the average cost of its interest-bearing liabilities dropped 56 basis points, to 1.73 percent from 2.29 percent. The FCS attributed this sharp drop to the FCS’ “ability to more quickly re-price [its] outstanding debt in the lower interest rate environment.” What the FCS did not acknowledge is that it increased its bet that short-term inter- est rates will stay low for a sustained period of time. non-performing assets have continued to increase. From a $259 million loss provision in the third quarter of last year, the FCS cut this provision to $192 million in the fourth quarter of last year and to $171 million in the first quarter of this year even though, according to an FCS news release, the FCS continues to experience “dete- rioration in the credit quality of loans to borrowers in certain agricultural sectors such as dairy and forestry.” While the FCS’ loan-loss allowance as a percentage of non-performing assets has crept up in recent quarters, rising from 35 percent on March 31, 2009, to 36.6 percent one year later, that percentage is still quite low given continuing problems in the sectors of the economy where the FCS takes credit risk. Why FCS Wants a Derivatives Carve-Out Clearly, the FCS is using derivatives to take a major interest-rate bet to enhance its profitability while shrink- ing its loan portfolio. As of March 31, 2010, the FCS had $48.23 billion of derivatives contracts in place, equal to 27.2 percent of its interest-bearing liabilities on that date. Those numbers are up from a year earlier when the FCS had $46.89 billion of derivatives, equal to 25.8 percent of its interest- bearing liabilities. The FCS also had shifted $4.43 billion of credit risk to third parties as of March 31, 2010. Not surprisingly, the FCS is concerned that Congress, in the pending financial regulatory reform legislation, will significantly curb its use of deriva- tives. Accordingly, on April 20, 2010, the Farm Credit Council (the FCS trade association) sent a letter to Sen. Blanche Lincoln (D-AR), chairman of the Senate Ag Committee, pleading for an exemption to any restrictions the legislation might impose on the use of derivatives by financial institutions. Specifically, the FCS seeks to be Bert Ely’s FARM CREDIT WATCH ® Shedding Light on the Farm Credit System, America’s Least Known GSE © 2010 Bert Ely The Farm Credit System’s (FCS’) first quarter 2010 net income jumped 30.4 percent, or $187 million, over the same quarter last year even though average loans rose just 1.3 percent. FCS loan volume actually dropped 1.4 percent during its most recent quarter. How FCS goosed its profits raises troubling concerns about FCS finances. The FCS placed its bet by increas- ing the average maturity or time to a loan’s re-pricing while also using interest-rate swaps and other deriva- tives to shorten the effective matu- rity of FCS debt. In effect, the FCS reduced its reliance on longer-term funding, relative to its longer-term assets, to take greater advantage of a steep yield curve. Evidence of this greater risk-taking: Over the last year, the FCS’ interest-rate sensitivity gap (earning assets minus interest-bearing liabilities adjusted for swaps and other derivatives) for the zero to six months pricing interval declined $11.1 billion. Beyond the one-year pricing interval, the FCS’ positive gap increased $16 billion. These two measures indicate the magnitude by which the FCS in- creased its exposure to higher short- term rates. As short-term rates begin to rise, the consequent flattening of the yield curve will bite the FCS, perhaps painfully so. The FCS also has enhanced its profitability in recent quarters by trim- ming its loan-loss provision even as its FCS Bets Big With Derivatives & Wins Q FCS Derivatives — continued on page 14