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.
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. Late Friday afternoon, as mentioned, Egan Jones, came out with a report that built upon the concerns it had laid out in its 2007 report. We highlight the summary of Friday's report.
Needing support - although other rating firms rate NRUC's senior unsecured at A/ A2, we have difficulty finding comfort. For the Nov, 2008 quarter, net interest after provisions was ($91M); including the $139M derivative loss, the pretax loss was $238M. On the balance sheet side, the decline in total equity from $666M for May 2008 to $364M for Nov. 2008 is an issue particularly in light of the $20B of assets. Our concerns remain NRUC's tight lending margins, relatively small capital base, problems in rolling its $5.7B of Short-Term debt, violations in revolver covenants (see p. 15 of 10Q) and rating triggers on its derivatives. A core issue is whether the federal government will help.Zero Hedge decided to look a little more in depth into some of these allegations. Our independent analysis indicates that the risks brought up by Egan Jones certainly merit additional consideration.
Growing debt/equity ratio
While the Company's debt is near all time highs in order to fund a 5 year high of loans to members ($18.9 billion at November 2008 net of allowance for loan losses of $650 million), book equity declined to record low levels, at a mere $364 million for the same time period. The debt/equity ratio has kept growing progressively, hitting a staggering 48.4x late last year.
As part of this analysis we do not take into consideration the $1.5 billion in member subordinated certificates which in theory are debt (earning 5% interest) but have equity like characteristics. The Washington Post presents a good overview of some of the risks embedded in member subordinated certificates:
The key to the CFC's financial stability is its members. They are required to buy 100-year membership certificates that earn 5 percent annually, but those unsecured CFC debts take a back seat to commercial bondholders. When members borrow money, they buy more certificates. In a pinch, the CFC could defer interest payments on those certificates without hurting commercial bondholders. Finally, in a crunch the CFC could ask its members to raise electricity rates and help.
Egan doubts the value of the member certificates and the CFC's flexibility in deferring those payments. "A debt holder is unlikely to waive its rights to the timely payment of interest simply because it also has an equity stake," his firm's report says. Standard & Poor's notes that the CFC's flexibility in raising money from members is limited in the 16 states that regulate cooperatives' rates and borrowing.
In an interview, Egan said that if CFC "ran into difficulty, then they'd have to go back to co-op members to ask for additional capital, and there's no guarantee that those co-op members are going to step up to the plate."
But some rating agencies, including Standard & Poor's, consider the certificates and subordinated debts to members to be a form of equity. And [Steven Lilly, NRUC CFO] asserted that CFC's loss reserves are more than adequate to cover any bad loans.
Curiously, the member certificates, which S&P categories as "hybrid capital" seem to be losing favor with even the "big time" rating agencies. In a little noticed S&P report on February 24, the rating agency announced it was downgrading the "hybrid capital securities" of 47 financial institutions, among which was also National Rural's member certificate class, which was downgraded from BBB+ to BBB. Key criteria which forced S&P to reevaluate this security class were the following:
- The company has incurred material net losses recently and its near-term financial prospects are poor;
- The company's capital ratios are weak;
- The company is at risk of breaching performance or capital tests that would then require special regulatory approval to continue payments;
- Our CCR on the company is in jeopardy of being lowered to a level that is likely to materially affect its access to and cost of capital (for example, short-term CCR to 'A-2' from 'A-1');
- The company has substantially cut or eliminated its common dividend. Such an action means that a certain line has already been crossed as far as market perception is concerned. Also, virtually all hybrid issues contain so-called "dividend stoppers," whereby the company must continue to make hybrid payments as long as it is paying common dividends. Once the common dividend has been eliminated, the company has a freer hand to defer payments on its hybrids.
As S&P's concerns becomes shared by Moody's and Fitch, it is feasible that more and more investors become concerned about this hybrid tranche which had previously been seen as a safe equity buffer above book equity.
Insufficient allowance for Bad Loans
As mentioned by Egan Jones, some of the concern about NRUC revolves around what may be classified as underprovisioning for bad loans. Seeing how the company is already provisioning almost $1 billion in impaired loans for a mere two of its member loans (for a company that takes pride in its diversification, have just two lender bankruptcies account for 5% in terms of impaired to total loans does not seem too prudent). Yet, while the allowance for bad loans has grown on an absolute basis to an all time high of $650 million (yet still below the absolute at risk number of $1 billion based on the impaired calculation, without even giving effect for any other potential defaults or impairments), the 3.3% ratio of loss allowances to total loans seems dangerously low, as it is comparable to the 3.3% rate last seen during the booming 2006.
If the company has indeed underprovisioned for bad loans due to undue economic optimism, this would adversely impact the company's equity ratio and also lead to a breach of the company's Minimum permitted 6 running quarters Adjusted TIER covenant which would result in a loss of access to the company's $3.65 billion credit facility, which was instrumental to the company recently when it almost had a liquidity crunch (more on both in a second). As the allowance for loan provisioning line on the balance sheet (if the case of a loan provision increase) is expensed on the income statement in the provision for loan losses line, which in turn feeds into adjusted net income, there is a danger that in an environment in which loan losses do in fact accelerate the company will be forced to recognize more and more income statement losses, which leads us to...
The TIER Ratio
The company's primary non-GAAP measure of performance is the so called TIER, or the adjusted Times Interest Earned Ratio. This "represents the interest expense adjusted to include the derivative cash settlements, plus minority interest net income, plus net income prior to the cumulative effect of change in accounting principle and dividing that by the interest expense adjusted to include the derivative cash settlements." The TIER ratio, together with the senior debt to capital ratios, are important as these form the maintenance covenants on the company's 3 revolving credit agreements which total $3.65 billion (maturing between March 13, 2009 and March 16, 2012; p.15 of 10-Q). The requirements of the company are to maintain a maximum ratio of senior debt to total equity of 10x (8.11x for the six months ended November 30), a minimum adjusted TIER at the prior fiscal year end of 1.15x (which as the name implies can at most change once a year) and a minimum average adjusted TIER over the six most recent fiscal quarters of 1.025x.
This is the risky ratio, as our own calculations imply that based on the 0.021x multiple margin of safety the company currently has, it only can afford to lose an incremental $30 million in adjusted net income going forward before it breaches the 6 running quarters TIER covenant. The $30 million loss could come from any source: whether it is due to a reduction in net interest income (a potential threat due to the recent increase in cost of debt - more on that also shortly), or an additional loan loss provision, resulting in a critical cutoff of liquidity to the company. And NRUC recently exhibited just why liquidity is so important, when it was forced to raise emergency capital at the mindboggling rate of 10.325% in October 2008!
After the Lehman bankruptcy, NRUC found itself unable to roll substantial near-term Commercial Paper maturities. This is why on October 7, the company was forced to draw down $418.5 million on its revolver to fund liquidity due to the loss of access to the CP market (p.32 of 10-Q). Luckily, NRUC was included in the government's emergency Commercial Paper Funding Facility (CPFF), which allows the government to purchase CP direct from issuers who are unable to access capital markets. By using the government as a backstop, the company was again able to roll CP and subsequently paid down the $418.5 million revolver borrowing: curiously, the Company drew down not just the revolver amount, but double that on the CPFF facility. "At November 30 the Company had issued a total of $1,017 billion of commercial paper through the CPFF program." As NRUC says in its 10-Q: "The Company believes that if accessing the credit markets continued to be difficult, the remaining amounts in the credit facility will be adequate to fund its operations in the near term." Of course, if the company is in breach on the TIER covenant, its revolver access would go up in smoke.
It gets worse. In October 2008, the Company apparently needed a whole lot more cash: so much so that it came to market with a 10 year $1 billion Collateral Trust Bonds issue which priced at a staggering 10.375% interest rate, almost double the rate it was charged for its June 2008 $900 million collateral trust bond. The CTB rate is so high that it is probably an immediate loss center for the company as it likely much higher than any rate it charges its member companies for issued loans. The scramble for additional liquidity continued as the company also raised $500 million (at a 57.5 bps over comparable treasuries) under US Treasury (specifically the Federal Financing Bank, or FBB) subsidized Rural Economic Development Loan And Grant (REDLG) in September 2008, of which it had a total outstanding balance of $3 billion at November 30, and another $230 million which was raised (at a 4.735% rate) under the Federal Agricultural Mortgage Corporation (Farmer Mac), per a revised $500 million note purchase agreement with Farmer Mac. The company has this to say about the liquidity scramble in the post-Lehman aftermath:
"The high cost of the $1 billion collateral trust bonds did not have a significant effect on funding cost for the six months ended November 30, 2008, as it was only outstanding for about a month and a half during the period and the impact was offset slightly by the lower cost on the $500 million REDLG advance in September 2008. The impact of this higher cost debt on future periods is mitigated by the fact that the $1 billion represents only 5 percent of the total debt outstanding, the lower cost REDLG and Farmer Mac debt issuance and by the fact that by November 30, 2008, the spread for LIBOR rates over the federal funds rate decreased significantly from the extremely high spreads experienced in September and October of 2008."Obviously the high interest rate will manifest itself in the company's Q3 numbers and could lead to a material drop in net interest income. What is very odd is that in this environment in which as the company acknowledges "companies experienced difficulty issuing long-term debt, and for the companies that were able to issue long-term debt, the interest rate on the debt included historically high spreads over comparable treasuries" NRUC was issuing incremental member loans, with total gross loans to members rising to $19.6 billion from $19.4 billion in the prior quarter. One could argue the prudent response would have been to reduce loan issuance activity in a capital constrained environment.
This is where the NRUC story becomes eerily reminiscent of AIG's. The company is in many ways held hostage by its current rating under both Moody's, S&P and Fitch. This is manifest in three places:
1) The company's $3 billion REDLG notes (as already mentioned) have a rating agency trigger. As page 13 of the 10-Q notes:
The $3.0 billion of notes payable to the FFB contain a rating trigger related to the Company's senior secured credit ratings from Standard & Poor's Corporation, Moody's Investors Service and Fitch Ratings. A rating trigger event exists if the Company's senior secured debt does not have at least two of the following ratings: (i) A- or higher from Standard & Poor's Corporation, (ii) A3 or higher from Moody's Investors Service, (iii) A- or higher from Fitch Ratings and (iv) an equivalent rating from a successor rating agency to any of the above rating agencies. If the Company's senior secured credit ratings fall below the levels listed above, the mortgage notes on deposit at that time, which totaled $3,811 million at November 30, 2008, would be pledged as collateral rather than held on deposit. At November 30, 2008, National Rural’s senior secured debt ratings were above the rating trigger threshold.It becomes obvious why the Rating Agencies are instrumental to the company's longevity: a 3 notch downgrade from the current senior secured rating of A/A1/A would severely limit the company to government funded liquidity in the form of the $3 billion in REDLG notes it has on the balance sheet currently.
2) As Moody's notes on page 11 of its report, NRUC has $9.2 billion notional amount in interest rate exchange agreements, which has rating triggers, this time based on the company's senior unsecured credit rating from Moody's or S&P:
"If NRUC’s rating for senior unsecured debt from either agency falls below the level specified in the agreement, the counterparty may, but is not obligated to, terminate the agreement. Upon termination, both parties would be required to make all payments that might be due to the other party. If NRUC’s senior unsecured rating from Moody’s or S&P declines to Baa1 or BBB+, respectively, the counterparty may terminate agreements with a total notional amount of $1.919 billion. If NRUC’s senior unsecured rating from Moody’s or S&P falls below Baa1 or BBB+, respectively, the counterparty may terminate the agreement on the remaining total notional amount of $7.314 billion."The prospect of having to terminate $9 billion in swap would likely have reverberations across both of NRUC's income and cash flow statements.
3) Lastly, the increasing reliance the company has on government funding in the form of CPFF borrowing, makes it critical that the company does not lose A-1/P-1/F-1 rating which is the cutoff for CPFF eligibility. As noted NRUC currently has over $1 billion in CPFF borrowings (a number that could grow by an additional $2.9 billion soon, see below) which it would have to find alternative ways to finance if two or more of the rating agencies turn hostile on the company.
While NRUC is nowhere near to having the collateral posting requirements that its higher rated cousin GECC has, the threat of downgrades should be factored when evaluating the full risk picture of the company (and as we have written recently, the rating agencies have lately been on a massive downgrade spree, especially in high yield and cross over corporate names).
$5.7 billion in Near-Term debt maturities
On page 14 of the 10-Q the company highlights its one-year debt maturities:
And while we assume that the company should have little trouble with rolling its CP maturities into the CPFF program, the balance of almost $3 billion in debt could prove to be quite a burden if the recent 10%+ note issuance is any indication of market appetite for the company's debt.
It looks like the financial whirlwind has so far spared NRUC, as even its higher rated financial peers have seen their CDS levels explode over the past couple of weeks. Egan Jones estimates that in a worst case scenario, liquidation values for the company would imply a recovery rate of approximately 42.8%, and furthermore in its March 6 report, the agency estimates the likelihood of 1 year default at 14%, which leads Egan Jones to conclude "the CDS price is cheap based on EJR's Recovery Rate". How cheap? Using JPM's recently outsourced CDSW screen and plugging in those variables (and using a flat curve), implies that CDS is is fairly priced at approximately 825 bps, implying roughly 675 bps of upside to Friday's CDS closing level of 150bps.
While there are likely numerous factors that we have omitted, both positive and negative (on which we welcome our readers' input), we question the logic of the implied risk of National Rural Utilities trading at virtually the same level as that of the United States of America. Also keeping in mind that NRUC was created, in the first place, to provide an alternative to federally funded loans, the fact that its balance sheet is becoming more and more federally capitalized, may present the question of whether it needs to exist in the first place.
A last observation is the potential negative basis opportunity that exists in NRUC, if one even takes the 10.375% notes recently issued, which closed at 117 on Friday, implying a 484 Z spread, and a potential pick up of 330bps in spread. A CRVD screen indicates that at no point on the NRUC CDS curve is there a basis that is not negative. Due to the ICE clearinghouse launch, and our firm belief that basis trades will converge substantially as a result of the clearinghouse, it would seem that NRUC is a diamond in the rough, if not for its operations, then definitely from a purely trading stand point.
Disclaimer: Zero Hedge has no holdings in any NRUC securities.Sphere: Related Content Print this post