Federal Agricultural Mortgage Corp 10-K/A 12-31-05
As filed with the Securities and Exchange Commission on
November 9, 2006
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

FORM 10-K/A
Amendment No. 1 to Form 10-K
(Mark One)
T
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2005.
or

£
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from _____ to _____.

Commission File Number 0-17440

FEDERAL AGRICULTURAL MORTGAGE CORPORATION
(Exact name of registrant as specified in its charter)

Federally chartered instrumentality
of the United States
  
 
52-1578738
(State or other jurisdiction of
incorporation or organization)
  
(I.R.S. employer identification number)
 
1133 21st Street, N.W., Suite 600,
Washington, D.C.
  
 
 
20036
(Address of principal executive offices)
  
(Zip code)

 
(202) 872-7700
  
 
(Registrant’s telephone number, including area code)
  
 
Securities registered pursuant to Section 12(b) of the Act:

Title of Each Class
Exchange on Which Registered
Class A voting common stock
New York Stock Exchange
Class C non-voting common stock
New York Stock Exchange

Securities registered pursuant to Section 12(g) of the Act: Class B voting common stock
 

Indicate by check mark whether the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.
Yes £
No T
 
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.
Yes £
No T
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes T
No £
 
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (17 C.F.R. §229.405) is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K/A or any amendment to this Form 10-K/A.   £
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer£
Accelerated filer T
Non-accelerated filer £
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes £
No T
 
The aggregate market values of the Class A voting common stock and Class C non-voting common stock held by non-affiliates of the registrant were $16,904,792 and $214,324,765, respectively, as of June 30, 2005, based upon the closing prices for the respective classes on June 30, 2005 reported by the New York Stock Exchange. For purposes of this information, the outstanding shares of Class C non-voting common stock owned by directors and executive officers of the registrant were deemed to be held by affiliates. The aggregate market value of the Class B voting common stock is not ascertainable due to the absence of publicly available quotations or prices for the Class B voting common stock as a result of the limited market for, and infrequency of trades in, Class B voting common stock and the fact that any such trades are privately negotiated transactions.
 
As of March 1, 2006, the registrant had outstanding 1,030,780 shares of Class A voting common stock, 500,301 shares of Class B voting common stock and 9,596,336 shares of Class C non-voting common stock.
 
DOCUMENTS INCORPORATED BY REFERENCE
 
The definitive proxy statement relating to the registrant’s 2006 Annual Meeting of Stockholders (portions of which are incorporated by reference into Part II and Part III of this Annual Report on Form 10-K/A as described herein).

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FEDERAL AGRICULTURAL MORTGAGE CORPORATION
FISCAL YEAR 2005 FORM 10-K/A

EXPLANATORY NOTE

This Amendment No. 1 on Form 10-K/A (the “Amendment”) to the Annual Report on Form 10-K of the Federal Agricultural Mortgage Corporation (“Farmer Mac”) for the fiscal year ended December 31, 2005, initially filed with the Securities and Exchange Commission on March 16, 2006 (the “Original Filing”) is being filed to amend and restate financial and other information contained in Item 1 (Business—Capital Standards; General), Item 6 (Selected Financial Data), Item 7 (Management’s Discussion and Analysis of Operating Results and Financial Condition), Item 7A (Quantitative and Qualitative Disclosures About Market Risk), Item 8 (Financial Statements and Supplementary Data), Item 9A (Controls and Procedures) and Item 15 (Exhibits and Financial Statements Schedule) of the Original Filing.

This Amendment restates the Corporation’s consolidated financial statements as of December 31, 2005 and 2004, and for the years ended December 31, 2005, 2004 and 2003, and other financial information as of and for the years ended December 31, 2002 and 2001 and the quarterly unaudited data for 2005 and 2004. The Corporation is concurrently filing amendments to its Forms 10-Q for the quarters ended March 31, 2006 and June 30, 2006 to restate the quarterly unaudited interim consolidated financial statements and other financial information contained in those reports. In this regard, investors should rely on the restated financial results for the years and each of the quarters in the years 2005, 2004, 2003, 2002 and 2001 and the first and second quarters of 2006 and, as the Corporation previously reported on Form 8-K on October 6, 2006, should not rely on the Corporation’s previously issued consolidated financial statements and other financial information for these reporting periods.

The Corporation, in light of SEC staff comments, has recently concluded a reassessment of its documentation and accounting treatment of financial derivative transactions under Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities (“SFAS 133”), interpretations of which have evolved. Based on the reassessment, while the transactions engaged in by the Corporation were highly effective economic hedges of interest rate risk, the Corporation has determined that it was not appropriately applying hedge accounting in accordance with SFAS 133. See “Note 15 - Restatement of Consolidated Financial Statements” in Item 8 and the discussion under the caption “Restatement of Consolidated Financial Statements” in Item 7 for further information related to the restatement with respect to the hedge accounting that had been employed and the effects of this treatment on the restated consolidated financial statements. 
 
This Amendment also addresses management’s re-evaluation of disclosure controls and procedures and management’s report on internal control over financial reporting resulting from management’s reassessment and identification of a material weakness in internal control over financial reporting relating to Farmer Mac’s accounting for derivatives under SFAS 133. See Item 9A (Controls and Procedures) for further discussion. New certifications of the principal executive officer and principal financial officer are included as exhibits to this Amendment.
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Except as described above, no attempt has been made in this Amendment to amend or update other disclosures presented in this Form 10-K/A. Therefore, this Amendment does not reflect events occurring after the filing of the Original Filing or amend or update those disclosures, or related exhibits, affected by subsequent events. Accordingly, this Amendment should be read in conjunction with Farmer Mac’s other filings with the SEC subsequent to the filing of the Original Filing.
 
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Table of Contents

7
Item 1.
7
 
General
7
 
FARMER MAC PROGRAMS
9
 
Farmer Mac I
9
 
 
Loan Eligibility
9
   
Purchases
10
   
Off-Balance Sheet Guarantees and Commitments
11
   
Underwriting and Appraisal Standards
12
   
Sellers
15
   
Servicing
16
   
Farmer Mac I Guaranteed Securities
16
   
Farmer Mac I Transactions
18
   
Funding of Guarantee and Purchase Commitment Obligations
18
   
Portfolio Diversification
19
 
Farmer Mac II
20
   
General
20
   
United States Department of Agriculture Guaranteed Loan Programs
20
   
Farmer Mac II Guaranteed Securities
21
   
Farmer Mac II Transactions
21
 
Financing
22
   
Debt Issuance
22
   
Equity Issuance
23
 
FARMER MAC’S AUTHORITY TO BORROW FROM THE U.S. TREASURY
25
 
GOVERNMENT REGULATION OF FARMER MAC
25
Item 1A.
28
Item 1B.
31
Item 2.
31
Item 3.
32
Item 4.
32
33
Item 5.
33
Item 6.
35
Item 7.
36
 
Forward-Looking Statements
36
 
Restatement of Consolidated Financial Statements
35
 
Critical Accounting Policy and Estimates
37
 
Results of Operations
41
 
Balance Sheet Review
54
 
Risk Management
56
 
Liquidity and Capital Resources
70
 
Regulatory Matters
77
 
Other Matters
77
Item 7A.
79
Item 8.
80
 
MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING (AS REVISED)
80
 
CONSOLIDATED BALANCE SHEETS (AS RESTATED)
85
 
CONSOLIDATED STATEMENTS OF OPERATIONS (AS RESTATED)
86
 
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY (AS RESTATED)
87
 
CONSOLIDATED STATEMENTS OF CASH FLOWS (AS RESTATED)
88
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (AS RESTATED)
89
Item 9.
128
Item 9A.
128
Item 9B.
128
129
Item 10.
129
Item 11.
129
Item 12.
129
Item 13.
129
Item 14.
129
130
Item 15.
130
 

PART I
Item 1.
Business

General

The Federal Agricultural Mortgage Corporation (“Farmer Mac” or the “Corporation”) was chartered by the U.S. Congress in the Agricultural Credit Act of 1987 (12 U.S.C. §§ 2279aa et seq.), which amended the Farm Credit Act of 1971 (collectively, as amended, the “Act”). Farmer Mac is a stockholder-owned instrumentality of the United States that was created to establish a secondary market for agricultural real estate and rural housing mortgage loans and to increase the availability of long-term credit at stable interest rates to American farmers, ranchers and rural homeowners. Farmer Mac conducts these activities through two programs—Farmer Mac I and Farmer Mac II. As of December 31, 2005, total volume in these two programs was $5.3 billion.

Under the Farmer Mac I program, Farmer Mac creates a secondary market for agricultural mortgage loans and accomplishes its congressional mission of providing liquidity and lending capacity to agricultural mortgage lenders by:
 
 
·
purchasing newly originated and pre-existing (“seasoned”) eligible mortgage loans directly from lenders;
 
·
guaranteeing mortgage-backed securities backed by eligible mortgage loans, which are referred to as “Farmer Mac I Guaranteed Securities”;
 
·
exchanging newly issued Farmer Mac I Guaranteed Securities for eligible mortgage loans that back those securities in “swap” transactions; and
 
·
issuing long-term standby purchase commitments (“LTSPCs”) for newly originated and seasoned eligible mortgage loans.

To be eligible for the Farmer Mac I program, loans must meet Farmer Mac’s credit underwriting, collateral appraisal, documentation and other standards that are discussed in “Business—Farmer Mac Programs—Farmer Mac I.” Farmer Mac may retain Farmer Mac I Guaranteed Securities in its portfolio or sell them to third parties. As of December 31, 2005, outstanding loans held by Farmer Mac and loans that either back Farmer Mac I Guaranteed Securities or are subject to LTSPCs totaled $4.4 billion.

Under the Farmer Mac II program, Farmer Mac purchases the portions of loans guaranteed by the United States Department of Agriculture (the “USDA-guaranteed portions”) pursuant to the Consolidated Farm and Rural Development Act (7 U.S.C. §§ 1921 et seq.) and guarantees securities backed by those USDA-guaranteed portions (“Farmer Mac II Guaranteed Securities”). Farmer Mac I Guaranteed Securities and Farmer Mac II Guaranteed Securities are sometimes collectively referred to as “Farmer Mac Guaranteed Securities.” As of December 31, 2005, outstanding Farmer Mac II Guaranteed Securities totaled $835.7 million.

Farmer Mac’s two principal sources of revenue are:
 
 
·
fees received in connection with outstanding Farmer Mac Guaranteed Securities and LTSPCs; and
 
·
net interest income earned on its portfolio of Farmer Mac Guaranteed Securities, mortgage loans and investments.


Farmer Mac funds its purchases of Farmer Mac Guaranteed Securities, mortgage loans and investments primarily by issuing debt obligations of various maturities. As of December 31, 2005, Farmer Mac had $2.3 billion of discount notes and $1.7 billion of medium-term notes outstanding. During 2005, the Corporation continued its strategy of regularly issuing debt to increase its presence in the capital markets in order to reduce the rates it pays on its debt, which allows Farmer Mac to accept lower rates on mortgages to farmers, ranchers and rural homeowners that it purchases from lenders. To the extent the proceeds of the debt issuances exceed Farmer Mac’s need to fund program assets, those proceeds are invested in high quality non-program liquid assets.

For more information about Farmer Mac’s program assets, its financial performance and sources of capital and liquidity, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

Farmer Mac is an institution of the Farm Credit System (the “FCS”), but is not liable for any debt or obligation of any other institution of the FCS. Likewise, neither the FCS nor any other individual institution of the FCS is liable for any debt or obligation of Farmer Mac.

The Farm Credit Administration (“FCA”), acting through its Office of Secondary Market Oversight, has general regulatory and enforcement authority over Farmer Mac, including the authority to promulgate rules and regulations governing the activities of Farmer Mac and to apply FCA’s general enforcement powers to Farmer Mac and its activities. For a discussion of Farmer Mac’s statutory and regulatory capital requirements and its actual capital levels, and particularly FCA’s role in the establishment and maintenance of those requirements and levels, see “Business—Government Regulation of Farmer Mac—Regulation—Capital Standards” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Balance Sheet Review—Capital” and “—Liquidity and Capital Resources—Capital Requirements.” For a discussion of a pending proposed regulation that would affect Farmer Mac if promulgated in its current form, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Regulatory Matters.”

Farmer Mac has three classes of common stock outstanding—Class A voting, Class B voting and Class C non-voting. See “Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities” for information regarding Farmer Mac’s common stock. Farmer Mac has one class of preferred stock outstanding. See “Business—Farmer Mac Programs—Financing—Equity Issuance” for information regarding Farmer Mac’s preferred stock.

As of December 31, 2005, Farmer Mac employed 46 people, located primarily at its principal executive offices at 1133 Twenty-First Street, N.W., Washington, D.C. 20036. Farmer Mac’s main telephone number is (202) 872-7700.

Farmer Mac makes available free of charge, through the “Investors” section of its internet website at www.farmermac.com, copies of materials it files with, or furnishes to, the U.S. Securities and Exchange Commission (“SEC”), including Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and amendments to those reports, as soon as reasonably practicable after electronically filing such materials with, or furnishing such materials to, the SEC. Please note that all references to www.farmermac.com in this report are inactive textual references only and that the information contained on Farmer Mac’s website is not incorporated by reference into this Form 10-K/A.

 
FARMER MAC PROGRAMS

Farmer Mac I

Loan Eligibility

Under the Farmer Mac I program, Farmer Mac purchases, or commits to purchase, eligible mortgage loans and guarantees the timely payment of principal and interest on securities backed by, or representing interests in, eligible mortgage loans. A loan is eligible for the Farmer Mac I program if it is:
 
 
·
secured by a fee simple mortgage or a long-term leasehold mortgage, with status as a first lien on agricultural real estate or rural housing (as defined below) located within the United States;
 
·
an obligation of a citizen or national of the United States, an alien lawfully admitted for permanent residence in the United States or a private corporation or partnership that is majority-owned by U.S. citizens, nationals or legal resident aliens;
 
·
an obligation of a person, corporation or partnership having training or farming experience that is sufficient to ensure a reasonable likelihood that the loan will be repaid according to its terms; and
 
·
in conformance with the Farmer Mac I underwriting, appraisal, documentation and other standards. See “—Underwriting and Appraisal Standards” and “—Sellers” for a description of these standards.

For purposes of the Farmer Mac I program, agricultural real estate is one or more parcels of land, which may be improved by permanently affixed buildings or other structures, that:
 
 
·
is used for the production of one or more agricultural commodities or products; and
 
·
either consists of a minimum of five acres or generates minimum annual receipts of $5,000.
 
Although the Act does not prescribe a maximum loan size for a Farmer Mac I eligible agricultural mortgage loan secured by 1,000 acres or less of agricultural real estate, Farmer Mac limits the size of these loans to 10 percent of Farmer Mac’s core capital, resulting in a current maximum loan size of approximately $24.4 million for those loans. For a description of core capital, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Balance Sheet Review—Capital” and “—Liquidity and Capital Resources—Capital Requirements.” For a Farmer Mac I eligible agricultural mortgage loan secured by more than 1,000 acres of agricultural real estate, the Act authorizes a maximum loan size of $6.3 million (adjusted annually for inflation), but Farmer Mac currently limits the maximum loan size to $5.0 million for those loans.

For purposes of the Farmer Mac I program, rural housing is a one- to four-family, owner-occupied, moderately priced principal residence located in a community with a population of 2,500 or less. The current maximum purchase price or current appraised value for a dwelling, excluding the land to which the dwelling is affixed, that secures a rural housing loan is $247,184. That limit is adjusted annually for inflation each November. In addition to the dwelling itself, an eligible rural housing loan can be secured by land associated with the dwelling having an appraised value of no more than 50 percent of the total appraised value of the combined property. As of December 31, 2005, rural housing loans did not represent a significant part of Farmer Mac’s business.


Purchases

Loan Purchases. Farmer Mac offers credit products designed to increase the secondary market liquidity of agricultural mortgage loans and the lending capacity of financial institutions that originate agricultural mortgage loans, while permitting Farmer Mac to securitize efficiently eligible mortgage loans acquired through its secondary market activities. Farmer Mac enters into mandatory and optional delivery commitments to purchase loans and offers rates to price such commitments daily. Because the securitization process requires the grouping of loans into uniform pools, Farmer Mac emphasizes the importance of conformity to its program requirements, including interest rate, amortization, maturity and payment frequency specifications. Farmer Mac also purchases portfolios of newly originated and seasoned loans on a negotiated basis. Farmer Mac purchases fixed- and adjustable-rate loans primarily, but also may purchase other types of loans, including convertible mortgage loans. Loans purchased by Farmer Mac have a variety of maturities and often include balloon payments. While less prevalent for loans purchased in 2005, loans purchased or subject to purchase commitments may include provisions that require a yield maintenance payment or some other form of prepayment penalty in the event a borrower prepays a loan (depending upon the level of interest rates at the time of prepayment). During 2005, Farmer Mac purchased $110.1 million of loans in the Farmer Mac I program, which represented 14 percent of total program volume. Of the loans purchased during 2005, 60 percent included balloon payments and 3 percent included yield maintenance prepayment protection. By comparison, during 2004, Farmer Mac purchased $104.4 million of loans under the Farmer Mac I program. Of the loans purchased during 2004, 64 percent included balloon payments and 8 percent included yield maintenance prepayment protection.

During 2005, Farmer Mac’s top ten sellers generated 85.7 percent of the total Farmer Mac I loan purchase volume (12.2 percent of total program volume), of which Zions First National Bank, Farmer Mac’s largest combined Class A and Class C stockholder, accounted for 22.3 percent of loan purchase volume (3.2 percent of total program volume). The top ten sellers in 2004 generated 82.5 percent of the total Farmer Mac I loan purchase volume (15.6 percent of total program volume), of which Zions First National Bank accounted for 33.0 percent (5.1 percent of total program volume). For more information regarding loan volume, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Results of Operations—Business Volume.” For more information regarding Farmer Mac’s business with related parties, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Results of Operations—Related Party Transactions” and Note 3 to the consolidated financial statements.

Collateralized Mortgage Obligation Purchases. AgVantage transactions in the Farmer Mac I program include Farmer Mac’s purchase and guarantee of instruments that are a form of Farmer Mac I Guaranteed Securities. Those securities are collateralized by eligible mortgage loans, issued by institutions approved by Farmer Mac and guaranteed by Farmer Mac as to timely payment of principal and interest. In approving an institution as a participant in AgVantage transactions, Farmer Mac assesses the institution’s agricultural mortgage loan performance as well as its creditworthiness. AgVantage is a registered trademark of Farmer Mac.

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Each AgVantage security is a general obligation of the issuing institution and is secured by eligible collateral in an amount ranging from 103 percent to 150 percent of the outstanding principal amount of the security. Eligible collateral may consist of:
 
 
·
loans that meet the same loan eligibility criteria applied by Farmer Mac in its Farmer Mac I loan purchases and commitments;
 
·
limited amounts of cash;
 
·
securities issued by the U.S. Treasury or guaranteed by an agency or instrumentality of the United States; or
 
·
other highly-rated securities.
 
During 2005, Farmer Mac purchased ten AgVantage securities for $15.7 million with maturities ranging from one to ten years from three institutions. During 2004, Farmer Mac purchased fourteen AgVantage securities for $32.5 million with maturities ranging from one month to ten years from four institutions. As of December 31, 2005 and 2004, the outstanding principal amount of AgVantage securities held by Farmer Mac was $28.6 million and $24.3 million, respectively. As of December 31, 2005, Farmer Mac had experienced no losses, nor had it been called upon to make a guarantee payment, on any of its AgVantage securities. In January 2006, Farmer Mac guaranteed $500.0 million principal amount of AgVantage securities supported by a five-year mortgage-backed obligation of Metropolitan Life Insurance Company that is backed by eligible agricultural mortgage loans.

Off-Balance Sheet Guarantees and Commitments

Swap Transactions and LTSPCs. Farmer Mac offers two Farmer Mac I credit enhancement alternatives that allow approved agricultural and rural residential mortgage lenders both to retain the cash flow benefits of their loans and increase their liquidity and lending capacity:
 
 
·
a swap transaction, in which Farmer Mac acquires eligible loans from sellers in exchange for Farmer Mac I Guaranteed Securities backed by those loans. As consideration for its assumption of the credit risk on loans underlying the Farmer Mac I Guaranteed Securities, Farmer Mac receives guarantee fees payable in arrears out of periodic loan interest payments and based on the outstanding balance of the related Farmer Mac I Guaranteed Securities; and
 
·
an LTSPC, which is not a guarantee of loans or securities, is a Farmer Mac commitment to purchase eligible mortgage loans from a segregated pool of loans on one or more undetermined future dates. As consideration for its assumption of the credit risk on loans underlying an LTSPC, Farmer Mac receives commitment fees payable monthly in arrears in an amount approximating what would have been the guarantee fees if the transaction were structured as a swap transaction.
 
Both of these alternative products result in the creation of off-balance sheet obligations for Farmer Mac in the ordinary course of its business.

A swap transaction or an LTSPC may involve loans with payment, maturity and interest rate characteristics that differ from Farmer Mac’s cash purchase product offerings. Both types of transactions permit a seller to nominate from its portfolio a segregated pool of loans for participation in the Farmer Mac I program, subject to review by Farmer Mac for conformance with its underwriting, appraisal and documentation standards. Upon Farmer Mac’s acceptance of the eligible loans, whether under a swap transaction or an LTSPC, the seller effectively transfers the credit risk on those loans to Farmer Mac, thereby reducing the seller’s credit and concentration risk exposures and, consequently, its regulatory capital requirements and its loss reserve requirements. Only the LTSPC structure permits the seller to retain the segregated loan pool in its portfolio until such time, if ever, as the seller delivers some or all of the segregated loans to Farmer Mac for purchase under the LTSPC. An LTSPC commits Farmer Mac to a future purchase of loans that met Farmer Mac’s underwriting standards at the time the loans first became subject to the LTSPC and Farmer Mac assumed the credit risk on loans.


Farmer Mac generally purchases loans subject to an LTSPC at:
 
 
·
par plus accrued interest (if the loans become delinquent for at least four months);
 
·
a mark-to-market price or in exchange for Farmer Mac I Guaranteed Securities (if the loans are not delinquent and are standard cash purchase Farmer Mac loan products); or
 
·
either a mark-to-market negotiated price for all (but not some) loans in the pool, based on the sale of Farmer Mac I Guaranteed Securities in the capital markets or the funding obtained by Farmer Mac through the issuance of matching debt in the capital markets, or in exchange for Farmer Mac I Guaranteed Securities (if the loans are not four months delinquent).

In 2005, Farmer Mac entered into $461.4 million of LTSPCs, compared to $392.6 million in 2004. LTSPCs remained the preferred credit enhancement alternative for new non-cash transactions and were a significant portion of the Farmer Mac I program. As of December 31, 2005, Farmer Mac’s outstanding LTSPCs covered 11,652 mortgage loans with an aggregate principal balance of $2.3 billion and outstanding off-balance sheet Farmer Mac I Guaranteed Securities were backed by 1,587 mortgage loans having an aggregate principal balance of $804.8 million. For more information regarding guarantee and LTSPC volume, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Results of Operations—Business Volume.”

Underwriting and Appraisal Standards
 
As required by the Act, Farmer Mac has established credit underwriting and collateral appraisal standards for loans under the Farmer Mac I program that at a minimum are intended to:

 
·
provide that no agricultural mortgage loan with a loan-to-value ratio (“LTV”) in excess of 80 percent may be treated as a qualified loan;
 
·
require each borrower to demonstrate sufficient cash-flow to adequately service the agricultural mortgage loan;
 
·
protect the integrity of the appraisal process with respect to any agricultural mortgage loans; and
 
·
confirm that the borrower is or will be actively engaged in agricultural production for an agricultural mortgage loan.

Underwriting. To manage its credit risk, to mitigate the risk of loss from borrower defaults and to provide guidance concerning the management, administration and conduct of underwriting to all participating sellers and potential sellers in its programs, Farmer Mac has adopted credit underwriting standards that vary by type of loan and program product under which the loan is brought to Farmer Mac. These standards were developed based on industry norms for similar mortgage loans and are designed to assess the creditworthiness of the borrower, as well as the risk to Farmer Mac as the guarantor of mortgage-backed securities representing interests in, or obligations backed by, pools of such mortgage loans. Further, Farmer Mac requires sellers of agricultural mortgage loans to make representations and warranties regarding the conformity of eligible mortgage loans to these standards and any other requirements the Corporation may impose from time to time.


In fourth quarter 2005, Farmer Mac began accepting into its programs agricultural mortgage loans that meet the minimum underwriting requirements in the Act set forth above and are either: (1) highly-rated loans; or (2) loans collateralizing AgVantage securities issued by highly-rated financial institutions. Highly-rated loans are loans rated 5 or better under the 14-point Uniform Classification System used by FCS institutions and other financial institutions, or loans evidencing comparable credit quality that are originated or held by financial institutions.

For all other loans, Farmer Mac I credit underwriting standards require that the LTV of any loan not exceed 70 percent, except that a loan secured by a livestock facility and supported by a contract with an integrator may have an LTV of up to 75 percent, a part-time farm loan supported by private mortgage insurance may have an LTV of up to 85 percent and a rural housing loan supported by private mortgage insurance may have an LTV of up to 97 percent. Farmer Mac may require that a loan have a lower LTV when it determines that such lower LTV is appropriate.

In the case of newly originated farm loans that are not highly-rated loans described above, particularly loans secured by agricultural real estate with building improvements contributing more than 60 percent of the appraised value of the property (referred to by Farmer Mac as facility loans), borrowers on the loans must, among other criteria set forth in Farmer Mac’s credit underwriting standards, meet the following standard underwriting ratios on a pro forma basis (i.e., giving effect to the new loan):
 
 
·
total debt service coverage ratio, including farm and non-farm income, of not less than 1.25:1;
 
·
debt-to-asset ratio of 50 percent or less;
 
·
ratio of current assets to current liabilities of not less than 1:1; and
 
·
cash flow debt service coverage ratio on the mortgaged property of not less than 1:1.
 
Farmer Mac also accepts loans that are secured by eligible collateral with low LTVs and made to borrowers with high credit scores. For those loans, processing has been simplified and documentation of the underwriting ratios described above may not be necessary. Small farm, part-time farm and rural housing loans are underwritten to standards customary in the residential lending industry, including a borrower’s credit score.

Farmer Mac’s underwriting standards provide for acceptance of loans that do not conform to one or more of the standard underwriting ratios when those loans:

 
·
exceed minimum requirements for one or more of the underwriting standards to a degree that compensates for noncompliance with one or more other standards, referred to as compensating strengths; and
 
·
are made to producers of particular agricultural commodities or products in a segment of agriculture in which such compensating strengths are typical of the financial condition of sound borrowers in that segment.

 
Farmer Mac’s use of compensating strengths is not intended to provide a basis for waiving or lessening the requirement that eligible mortgage loans under the Farmer Mac I program be of consistently high quality. In fact, loans approved on the basis of compensating strengths have not demonstrated a significantly different rate of default than loans that were approved on the basis of conformance with all of the standard underwriting ratios. As of December 31, 2005, a total of $1.6 billion (36.7 percent) of the outstanding balance of loans held and loans underlying LTSPCs and Farmer Mac I Guaranteed Securities issued after the enactment of the Farm Credit System Reform Act of 1996 (the “1996 Act”) were approved based upon compensating strengths ($49.2 million of which had original LTVs of greater than 70 percent). The original LTV of a loan is calculated by dividing the loan’s principal balance at the time of guarantee, purchase or commitment by the appraised value at the date of loan origination or, when available, updated appraised value at the time of guarantee, purchase or commitment. During 2005, $111.2 million (19.5 percent) of the loans purchased or added under LTSPCs were approved based upon compensating strengths ($2.6 million of which had original LTVs of greater than 70 percent), as compared to 2004 when $169.3 million (34 percent) of the loans purchased or added under LTSPCs were approved based upon compensating strengths ($1.5 million of which had original LTVs of greater than 70 percent).

In the case of a seasoned loan, other than the highly-rated loans described above, Farmer Mac considers sustained historical performance to be a reliable alternative indicator of a borrower’s ability to pay the loan according to its terms. A seasoned loan generally will be deemed an eligible loan if:

 
·
it has been outstanding for at least five years and has an LTV of 60 percent or less;
 
·
there have been no payments more than 30 days past due during the previous three years; and
 
·
there have been no material restructurings or modifications for credit reasons during the previous five years.

A seasoned loan that has been outstanding for more than one year but less than five years must substantially comply with the applicable underwriting standards for newly originated loans as of the date the loan was originated by the lender. The loan must also have a payment history that shows no payment more than 30 days past due during the three-year period immediately prior to the date the loan is either purchased by Farmer Mac or made subject to an LTSPC. As is the case with the secondary market for residential mortgages, there is no requirement that each loan’s compliance with the underwriting standards be re-evaluated after Farmer Mac accepts the loan into its program.

The due diligence Farmer Mac performs before purchasing, guaranteeing securities backed by, or committing to purchase seasoned loans includes:
 
 
·
evaluation of loan database information to determine conformity to the criteria set forth in the preceding paragraphs;
 
·
confirmation that loan file data conform to database information;
 
·
validation of supporting credit information in the loan files; and
 
·
review of loan documentation and collateral appraisals.
 
All of the foregoing are performed through methods that give due regard to the size, age, leverage and nature of the collateral for the loans.

Required documentation for all Farmer Mac I loans includes a first lien mortgage or deed of trust, a written promissory note and assurance of Farmer Mac’s lien position through either a title insurance policy or title opinion from an experienced real estate attorney in geographic areas where title insurance is not the industry practice.


As Farmer Mac develops new credit products, it establishes underwriting guidelines for them. Those guidelines result in industry-specific measures equivalent to the basic underwriting standards and provide Farmer Mac the flexibility to deliver the benefits of a secondary market to farmers, ranchers and rural homeowners in diverse sectors of the agricultural economy.

Appraisals. Farmer Mac’s appraisal standards for newly originated loans purchased or placed under a Farmer Mac I Guaranteed Security or LTSPC require, among other things, that a current appraisal be performed independently of the credit decision-making process and conform to the Uniform Standards of Professional Appraisal Practice promulgated by the Appraisal Standards Board. Farmer Mac’s appraisal standards require the appraisal function to be conducted or administered by an individual meeting specific qualification and competence criteria who:
 
 
·
is not associated, except by the engagement for the appraisal, with the credit underwriters making the loan decision, though both the appraiser and the credit underwriter may be directly or indirectly employed by a common employer;
 
·
receives no financial or professional benefit of any kind by virtue of the report content, valuation or credit decision made or based on the appraisal product; and
 
·
has no present or contemplated future direct or indirect interest in the appraised property.
 
The appraisal standards also require uniform reporting of reliable and credible opinions of the market value, market rent and property net income characteristics of the mortgaged property and the relative market forces.

For seasoned loans, Farmer Mac obtains appraisal updates as considered necessary by its assessment of collateral risk determined in the due diligence process. If a current or updated appraisal is required for a seasoned loan, the appraisal standards described above would apply.

Farmer Mac utilizes experienced internal agricultural credit underwriters and external agricultural loan servicing and appraisal contractors (under Farmer Mac supervision and review) to perform those respective functions on loans that come into the Farmer Mac I program. Those contractors afford Farmer Mac the benefits of their servicing centers at fees based upon their marginal costs, which allows Farmer Mac to avoid the fixed costs, and some of the marginal costs, associated with such operations. Farmer Mac believes that the combined expertise of its own internal staff and those third-party service providers provides the Corporation adequate resources for performing the necessary underwriting, appraisal and servicing functions.

Sellers

As of December 31, 2005, Farmer Mac had 137 approved loan sellers eligible to participate in the Farmer Mac I program, ranging from single-office to multi-branch institutions, spanning community banks, FCS institutions, mortgage companies, commercial banks and insurance companies. The reduction in the number of approved Farmer Mac I loan sellers from 157 as of December 31, 2004 is principally the result of decertification by Farmer Mac of inactive sellers during second quarter 2005. In addition to participating directly in the Farmer Mac I program, some of the approved loan sellers enable other lenders to participate indirectly in the Farmer Mac I program by managing correspondent networks of lenders from which they purchase loans to sell to Farmer Mac. As of December 31, 2005, approximately 100 lenders were participating in those networks. As of December 31, 2005, more than 350 lenders were participating, directly or indirectly, in one or both of the Farmer Mac I or Farmer Mac II programs.


To be considered for approval as a Farmer Mac I seller, a financial institution must meet the criteria that Farmer Mac establishes, including:
 
 
·
owning a requisite amount of Farmer Mac Class A or Class B voting common stock according to a schedule prescribed for the size and type of institution;
 
·
having, in the judgment of Farmer Mac, the ability and experience to make or purchase and sell agricultural mortgage loans of the type that will qualify for purchase by Farmer Mac and service such mortgage loans in accordance with Farmer Mac requirements either through its own staff or through contractors and originators;
 
·
maintaining a minimum adjusted net worth of $1.0 million; and
 
·
entering into a Seller/Servicer agreement to comply with the terms of the Farmer Mac Seller/Servicer Guide, including representations and warranties regarding the eligibility of the loans and accuracy of loan data provided to Farmer Mac.
 
Servicing

Farmer Mac generally does not directly service loans held in its portfolio, although it does act as “master servicer” for pools of loans and loans underlying Farmer Mac I Guaranteed Securities. Farmer Mac also may assume direct servicing for loans that become impaired. Farmer Mac’s loans and the loans underlying its Farmer Mac Guaranteed Securities are serviced only by Farmer Mac-approved entities designated as “central servicers” that have entered into central servicing contracts with Farmer Mac. Sellers of eligible mortgage loans sold into the Farmer Mac I program have a right to retain certain “field servicing” functions (typically direct borrower contacts) and may enter into contracts with Farmer Mac’s central servicers that specify such servicing functions. Loans underlying LTSPCs and AgVantage securities are serviced by the holders of those loans in accordance with those lenders’ servicing procedures, which are reviewed and approved by Farmer Mac before entering into those transactions.
 
Farmer Mac I Guaranteed Securities

Farmer Mac guarantees the timely payment of principal and interest on Farmer Mac Guaranteed Securities. Farmer Mac Guaranteed Securities backed by agricultural mortgage loans eligible for the Farmer Mac I program are referred to as “Farmer Mac I Guaranteed Securities.”

Farmer Mac’s statutory charter requires offerings of Farmer Mac Guaranteed Securities to be registered under the Securities Act of 1933, as amended (“the “Securities Act”) unless an exemption for an offering is available. Accordingly, Farmer Mac, through its subsidiary Farmer Mac Mortgage Securities Corporation, maintains a shelf registration statement with the SEC through which Farmer Mac Guaranteed Securities may be publicly offered from time to time. Farmer Mac also may offer Farmer Mac Guaranteed Securities in offerings exempt from registration under the Securities Act such as in private, unregistered offerings. U.S. Bank National Association, a national banking association based in Minneapolis, Minnesota, or Farmer Mac serves as trustee for the trusts that acquire eligible loans and issue Farmer Mac Guaranteed Securities.


Farmer Mac I Guaranteed Securities represent beneficial interests in pools of agricultural mortgage loans or in obligations issued by agricultural lenders, which obligations are backed by pools of agricultural mortgage loans, and guaranteed by Farmer Mac. These securities are customarily issued through special purpose trusts and entitle each investor in a class of securities to receive a portion of the payments of principal and interest on the related underlying pool of loans or obligation equal to the investor’s proportionate interest in the pool or obligation as specified in the applicable transaction documents. These securities also may support other Farmer Mac I Guaranteed Securities, including real estate mortgage investment conduit securities, commonly referred to as REMICs, and other agricultural mortgage-backed securities. Farmer Mac I Guaranteed Securities issued prior to the enactment of changes to Farmer Mac’s statutory charter in 1996 are supported by first-loss subordinated interests that represented ten percent of the balance of the loans underlying the securities at issuance and are neither guaranteed nor owned by Farmer Mac.

Farmer Mac I Guaranteed Securities are not assets of Farmer Mac, except when acquired for investment purposes, and are not recorded as liabilities on Farmer Mac’s consolidated financial statements. Farmer Mac, however, is liable under its guarantee on the securities to make timely payments to investors of principal (including balloon payments) and interest based on the scheduled payments on the underlying loans or obligations, regardless of whether the trust has actually received such scheduled payments. Because it guarantees timely payments on Farmer Mac I Guaranteed Securities, Farmer Mac assumes the ultimate credit risk of borrower defaults on the underlying loans and issuer default on the underlying obligations which are backed by agricultural mortgage loans. All of the loans supporting Farmer Mac I Guaranteed Securities are subject to the applicable underwriting standards described above in “Underwriting and Appraisal Standards.” See also “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Risk Management—Credit Risk - Loans.”

Farmer Mac receives guarantee fees in return for its guarantee obligations on Farmer Mac I Guaranteed Securities. These fees typically are collected out of installment payments made on the underlying loans or obligations until those loans or obligations have been repaid or otherwise liquidated (generally as a result of default). The aggregate amount of guarantee fees received on Farmer Mac I Guaranteed Securities depends upon the amount of such securities outstanding and on the applicable guarantee fee rate, which Farmer Mac’s statutory charter caps at 50 basis points (0.50 percent) per annum. The Farmer Mac I guarantee fee rate typically ranges from 15 to 50 basis points (0.15 to 0.50 percent) per annum, depending on the credit quality of and other criteria regarding the loans or obligations. The amount of Farmer Mac I Guaranteed Securities outstanding representing interests in loans is influenced by the repayment rates on the underlying loans and by the rate at which Farmer Mac issues new Farmer Mac I Guaranteed Securities. In general, when the level of interest rates declines significantly below the interest rates on loans underlying Farmer Mac I Guaranteed Securities, the rate of prepayments is likely to increase; conversely, when interest rates rise above the interest rates on the loans underlying Farmer Mac I Guaranteed Securities, the rate of prepayments is likely to decrease. In addition to changes in interest rates, the rate of principal payments on Farmer Mac I Guaranteed Securities also is influenced by a variety of economic, demographic and other considerations, such as yield maintenance provisions that may be associated with loans underlying Farmer Mac I Guaranteed Securities. For more information regarding yield maintenance provisions, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Risk Management—Interest Rate Risk.”


For each of the years ended December 31, 2005 and 2004, Farmer Mac sold Farmer Mac I Guaranteed Securities in the amounts of $53.3 million and $94.1 million, respectively, to related parties. In 2004, Farmer Mac recognized a $0.4 million gain on the sale of $26.9 million of Farmer Mac Guaranteed Securities. In 2005, Farmer Mac recognized no gain or loss on any such sale. In addition to the Farmer Mac I Guaranteed Securities it sold in 2005, in January 2006 Farmer Mac guaranteed $500.0 million principal amount of AgVantage securities supported by a five-year mortgage-backed obligation of Metropolitan Life Insurance Company that is backed by eligible agricultural mortgage loans. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Results of Operations—Business Volume.”

Farmer Mac I Transactions

During the year ended December 31, 2005, Farmer Mac purchased or placed under guarantee or LTSPC $571.5 million of loans under the Farmer Mac I program. As of December 31, 2005, loans held and loans underlying Farmer Mac I Guaranteed Securities and LTSPCs totaled $4.4 billion. The 1996 Act revised Farmer Mac’s statutory charter to eliminate the requirement of a first-loss subordinated interest in Farmer Mac I Guaranteed Securities. As of December 31, 2005, $13.0 million of Farmer Mac I Guaranteed Securities issued prior to the 1996 Act remained outstanding.

The following table summarizes loans purchased or newly placed under guarantees or LTSPCs under the Farmer Mac I program for each of the years ended December 31, 2005, 2004 and 2003.

   
For the Year Ended December 31,
  
   
2005
  
2004
  
2003
  
   
(in thousands)
  
               
Loans and Guaranteed Securities
  
$
110,056
  
$
104,404
  
$
192,577
  
LTSPCs
    
461,441
   
392,559
   
763,342
 
Total
  
$
571,497
  
$
496,963
  
$
955,919
  


The following table presents the outstanding balances of Farmer Mac I loans held and loans underlying Farmer Mac I Guaranteed Securities and LTSPCs as of the dates indicated:

   
Outstanding Balances
as of December 31,
  
   
2005
  
2004
  
2003
  
   
(in thousands)
  
               
Post-1996 Act:
              
Loans and Guaranteed Securities
  
$
2,097,942
  
$
2,371,405
  
$
2,696,530
  
LTSPCs
    
2,329,798
   
2,295,103
   
2,348,702
 
Pre-1996 Act
    
13,046
   
18,640
   
24,734
 
Total Farmer Mac I program
  
$
4,440,786
  
$
4,685,148
  
$
5,069,966
  
 

Funding of Guarantee and Purchase Commitment Obligations

The principal sources of funding for the payment of Farmer Mac’s obligations under its guarantees and LTSPCs are the fees for its guarantees and commitments, net interest income and the proceeds of debt issuances. Farmer Mac satisfies its guarantee and purchase commitment obligations by purchasing defaulted loans out of LTSPCs and from the related trusts for Farmer Mac Guaranteed Securities. Farmer Mac typically recovers a significant portion of the value of defaulted loans purchased either through borrower payments, loan payoffs, payments by third parties or foreclosure and sale of the property securing the loans. Ultimate losses arising from Farmer Mac’s guarantees and commitments are reflected in the Corporation’s charge-offs against its allowance for losses and gains and losses on the sale of real estate owned. During 2005, Farmer Mac’s net recoveries were $0.3 million, compared to $4.5 million in net charge-offs during 2004. Net gains on the sale of real estate owned were $0.1 million and $0.5 million for each of the years ended December 31, 2005 and 2004, respectively.

The Act requires Farmer Mac to set aside, as an allowance for losses in a reserve account, a portion of the guarantee fees it receives from its guarantee activities. Among other things, that reserve account must be exhausted before Farmer Mac may issue obligations to the U.S. Treasury against the $1.5 billion Farmer Mac is statutorily authorized to borrow from the U.S. Treasury to fulfill its guarantee obligations. That borrowing authority is not intended to be a routine funding source and has never been used. Although total outstanding guarantees and LTSPCs exceed the amount held as an allowance for losses and the amount the Corporation may borrow from the U.S. Treasury, Farmer Mac does not expect its obligations under the guarantees and LTSPCs to exceed amounts available to satisfy those obligations. For information regarding the allowance for losses, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Risk Management—Credit Risk - Loans” and Note 2(j) and Note 8 to the consolidated financial statements. For a more detailed discussion of Farmer Mac’s borrowing authority from the U.S. Treasury, see “Business—Farmer Mac’s Authority to Borrow from the U.S. Treasury.”

Portfolio Diversification

It is Farmer Mac’s policy to diversify its portfolio of loans held and loans underlying Farmer Mac I Guaranteed Securities and LTSPCs, both geographically and by agricultural commodity/product. Farmer Mac directs its marketing efforts toward agricultural lenders throughout the nation to achieve commodity/product and geographic diversification in its exposure to credit risk. Farmer Mac evaluates its credit exposure in particular geographic regions and commodities/products, adjusted for the credit quality of the loans in those particular geographic regions or commodity/product groups relative to the total principal amount of all outstanding loans held and loans underlying Farmer Mac I Guaranteed Securities and LTSPCs.

Farmer Mac is not obligated to purchase, or commit to purchase, every loan that meets its underwriting and appraisal standards submitted by an eligible seller. Farmer Mac considers other factors such as its overall portfolio diversification, commodity and farming forecasts and risk management objectives in deciding whether to accept the loans into the Farmer Mac I program. For example, if industry forecasts indicate possible weakness in a geographic area or agricultural commodity or product, Farmer Mac may decide not to purchase or commit to purchase an affected loan as part of managing its overall portfolio exposure to areas of possible heightened risk exposure. Because Farmer Mac effectively assumes the credit risk on all loans under an LTSPC, Farmer Mac’s commodity/product and geographic diversification disclosures reflect all loans under LTSPCs and any loans that have been purchased out of LTSPC pools. For information regarding the diversification of Farmer Mac’s existing portfolio, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Risk Management—Credit Risk - Loans” and Note 8 to the consolidated financial statements.

 
Farmer Mac II

General

The Farmer Mac II program was initiated in 1992 and is authorized under sections 8.0(3) and 8.0(9)(B) of Farmer Mac’s statutory charter (12 U.S.C. §§ 2279aa(3) and 2279aa(9)(B)), which provide that:
 
 
·
USDA-guaranteed portions are statutorily included in the definition of loans eligible for Farmer Mac’s secondary market programs;
 
·
USDA-guaranteed portions are exempted from the credit underwriting, appraisal and other standards that other loans must meet to be eligible for Farmer Mac programs, and are exempted from any diversification and internal credit enhancement that may be required of pools of other loans eligible for Farmer Mac programs; and
 
·
Farmer Mac is authorized to pool and issue Farmer Mac Guaranteed Securities backed by USDA-guaranteed portions.

United States Department of Agriculture Guaranteed Loan Programs

The United States Department of Agriculture (“USDA”), acting through its various agencies, currently administers the federal rural credit programs first developed in the mid-1930s. The USDA makes direct loans and guarantees portions of loans made and serviced by USDA-qualified lenders for various purposes. The USDA’s guarantee is supported by the full faith and credit of the United States. USDA-guaranteed portions represent up to 95 percent of the principal amount of guaranteed loans.

Through its Farmer Mac II program, Farmer Mac is one of several competing purchasers of USDA-guaranteed portions of farm ownership loans, farm operating loans, business and industry loans and other loans that are fully guaranteed as to principal and interest by the USDA (collectively, the “guaranteed loans”).

USDA Guarantees. Each USDA guarantee is a full faith and credit obligation of the United States and becomes enforceable if a lender fails to repurchase the USDA-guaranteed portion from its owner within 30 days after written demand from the owner when:
 
 
·
the borrower under the guaranteed loan is in default not less than 60 days in the payment of any principal or interest due on the USDA-guaranteed portion; or
 
·
the lender has failed to remit to the owner the payment made by the borrower on the USDA-guaranteed portion or any related loan subsidy within 30 days after the lender’s receipt of the payment.

If the lender does not repurchase the USDA-guaranteed portion as provided above, the USDA is required to purchase the unpaid principal balance of the USDA-guaranteed portion together with accrued interest (including any loan subsidy) to the date of purchase, less the servicing fee, within 30 days after written demand upon the USDA by the owner. While the USDA guarantee will not cover the note interest to the owner on USDA-guaranteed portions accruing after 90 days from the date of the original demand letter of the owner to the lender requesting repurchase, Farmer Mac has established procedures to require prompt tendering of USDA-guaranteed portions.
 
 
If, in the opinion of the lender (with the concurrence of the USDA) or in the opinion of the USDA, repurchase of the USDA-guaranteed portion is necessary to service the related guaranteed loan adequately, the owner will sell the USDA-guaranteed portion to the lender or USDA for an amount equal to the unpaid principal balance and accrued interest (including any loan subsidy) on such USDA-guaranteed portion less the lender’s servicing fee. Federal regulations prohibit the lender from repurchasing USDA-guaranteed portions for arbitrage purposes.
 
Lenders. Any lender authorized by the USDA to obtain a USDA guarantee on a loan may be a seller in the Farmer Mac II program. As of December 31, 2005, there were 120 active sellers in the Farmer Mac II program, consisting mostly of community and regional banks, compared to 133 sellers as of December 31, 2004, for a decrease of 13 active sellers. In the aggregate, more than 350 sellers were participating either directly or indirectly in one or both of the Farmer Mac I or Farmer Mac II programs during 2005.

Loan Servicing. The lender on each guaranteed loan is required by regulation to retain the unguaranteed portion of the guaranteed loan, to service the entire underlying guaranteed loan, including the USDA-guaranteed portion, and to remain mortgagee and/or secured party of record. The USDA-guaranteed portion and the unguaranteed portion of the underlying guaranteed loan are to be secured by the same security with equal lien priority. The USDA-guaranteed portion cannot be paid later than, or in any way be subordinated to, the related unguaranteed portion.

Farmer Mac II Guaranteed Securities

Farmer Mac guarantees the timely payment of principal and interest on Farmer Mac II Guaranteed Securities backed by USDA-guaranteed portions. Farmer Mac does not guarantee the repayment of the USDA-guaranteed portions, only the Farmer Mac II Guaranteed Securities that are backed by USDA-guaranteed portions. In addition to purchasing USDA-guaranteed portions for retention in its portfolio, Farmer Mac offers Farmer Mac II Guaranteed Securities to lenders in swap transactions or to other investors for cash.

Farmer Mac II Transactions

During the years ended December 31, 2005 and 2004, Farmer Mac issued $200.2 million and $174.1 million of Farmer Mac II Guaranteed Securities, respectively. As of December 31, 2005 and 2004, $835.7 million and 768.5 million of Farmer Mac II Guaranteed Securities were outstanding, respectively. See Note 5 and Note 12 to the consolidated financial statements. The following table presents Farmer Mac II Guaranteed Securities issued for each of the years indicated:

   
For the Year Ended December 31,
  
   
2005
  
2004
  
2003
  
   
(in thousands)
  
               
Purchased and retained
  
$
199,843
  
$
162,286
  
$
270,727
  
Swaps (issued to third parties)
    
325
   
11,788
   
502
 
Total
  
$
200,168
  
$
174,074
  
$
271,229
  
 

The following table presents the outstanding balance of Farmer Mac II Guaranteed Securities as of the dates indicated:

   
Outstanding Balance of
Farmer Mac II Guaranteed Securites
as of December 31,
  
   
2005
  
2004
  
2003
  
   
(in thousands)
          
               
On-balance sheet
  
$
796,224
  
$
712,653
  
$
678,229
  
Off-balance sheet
    
39,508
   
55,889
   
51,241
 
Total
  
$
835,732
  
$
768,542
  
$
729,470
  


As of December 31, 2005, Farmer Mac had experienced no credit losses on any of its Farmer Mac II transactions. As of December 31, 2005, Farmer Mac had outstanding $0.4 million of principal and interest advances on Farmer Mac II Guaranteed Securities, compared to $0.5 million as of December 31, 2004.

Financing

Debt Issuance

Section 8.6(e) of Farmer Mac’s statutory charter (12 U.S.C. § 2279aa-6(e)) authorizes Farmer Mac to issue debt obligations to purchase eligible mortgage loans and Farmer Mac Guaranteed Securities and to maintain reasonable available cash and cash equivalents for business operations, including adequate liquidity. Farmer Mac funds its purchases of program, mission-related and non-program assets primarily by issuing debt obligations of various maturities in the public capital markets. Farmer Mac funds its program purchases primarily by issuing debt obligations, consisting of discount notes and medium-term notes of various maturities, in the public capital markets. Farmer Mac also issues discount notes and medium-term notes to obtain funds to finance its investments, transaction costs, guarantee payments and LTSPC purchase obligations.

The Corporation’s discount notes and medium-term notes are obligations of Farmer Mac only and are not rated by a nationally recognized statistical rating organization (“NRSRO”). The interest and principal thereon are not guaranteed by, and do not constitute debts or obligations of, FCA or the United States or any agency or instrumentality of the United States other than Farmer Mac. Farmer Mac is an institution of the FCS, but is not liable for any debt or obligation of any other institution of the FCS. Likewise, neither the FCS nor any other individual institution of the FCS is liable for any debt or obligation of Farmer Mac. Income to the purchaser of a Farmer Mac discount note or medium-term note is not exempt under federal law from federal, state or local taxation.

Farmer Mac’s board of directors has authorized the issuance of up to $5.0 billion outstanding of discount notes and medium-term notes, subject to periodic review of the adequacy of that level relative to Farmer Mac’s borrowing requirements. Farmer Mac invests the proceeds of such issuances in loans, Farmer Mac Guaranteed Securities, mission-related assets and non-program investment assets in accordance with policies established by its board of directors. In compliance with regulations issued by FCA in 2005, including dollar amount, issuer concentration and credit quality limitations, Farmer Mac’s current policies authorize non-program investments in:

 
 
·
obligations of the United States;
 
·
obligations of government-sponsored enterprises (“GSEs”);
 
·
municipal securities;
 
·
international and multilateral development bank obligations;
 
·
money market instruments;
 
·
diversified investment funds;
 
·
asset-backed securities;
 
·
corporate debt securities; and
 
·
mortgage securities.
 
For more information about Farmer Mac’s outstanding investments and indebtedness, see Note 4 and Note 7 to the consolidated financial statements.

Equity Issuance

The Act authorizes Farmer Mac to issue voting common stock, non-voting common stock and non-voting preferred stock. Only banks, other financial entities, insurance companies and institutions of the FCS eligible to participate in one or more of the Farmer Mac programs may hold voting common stock. No holder of Class A voting common stock may directly or indirectly be a beneficial owner of more than 33 percent of the outstanding shares of Class A voting common stock. No ownership restrictions apply to Class C non-voting common stock or preferred stock, and they are freely transferable.

Upon liquidation, dissolution or winding up of the business of Farmer Mac, after payment and provision for payment of outstanding debt of the Corporation, the holders of shares of preferred stock would be paid in full at par value, plus all accrued dividends, before the holders of shares of common stock received any payment. The dividend rights of all three classes of the Corporation’s common stock are the same, and dividends may be paid on common stock only when, as, and if declared by Farmer Mac’s board of directors in its sole discretion, subject to the payment of dividends on outstanding preferred stock.

As of December 31, 2005, 1,030,780 shares of Class A voting common stock, 500,301 shares of Class B voting common stock, 9,559,554 shares of Class C non-voting common stock and 700,000 shares of 6.40 percent non-voting cumulative preferred stock, Series A were outstanding.  Farmer Mac may obtain additional capital from future issuances of voting and non-voting common stock and non-voting preferred stock. Farmer Mac has no present intention to issue any additional shares of common stock, except pursuant to programs in which employees, members of management or the board of directors may be granted or may purchase Class C non-voting common stock, or exercise options to purchase Class C non-voting common stock granted as part of their compensation arrangements.
 
- 22 -

The following table presents the dividends declared on the common stock during and subsequent to 2005:

Date
Dividend
Declared
  
Per
Share
Amount
    
For
Period
Beginning
    
For
Period
Ending
    
Date
Paid
     
 
                  
February 10, 2005
  
$
0.10
    
January 1, 2005
    
March 31, 2005
    
March 31, 2005
May 19, 2005
    
0.10
   
April 1, 2005
    
June 30, 2005
    
June 30, 2005
August 4, 2005
    
0.10
   
July 1, 2005
    
September 30, 2005
    
September 30, 2005
October 6, 2005
    
0.10
   
October 1, 2005
    
December 31, 2005
    
December 30, 2005
February 2, 2006
    
0.10
   
January 1, 2006
    
March 31, 2006
    
*

* The dividend declared on February 2, 2006 is scheduled to be paid on March 31, 2006.

Farmer Mac’s ability to declare and pay common stock dividends could be restricted if it were to fail to comply with its regulatory capital requirements. See Note 9 to the consolidated financial statements and “Business—Government Regulation of Farmer Mac—Regulation—Capital Standards—Enforcement levels.”
 
The cumulative preferred stock, Series A has a redemption price and liquidation preference of $50.00 per share, plus accrued and unpaid dividends. The preferred stock does not have a maturity date. Beginning on June 30, 2012, Farmer Mac has the option to redeem the preferred stock at any time, in whole or in part, at the redemption price of $50.00 per share, plus accrued and unpaid dividends through and including the redemption date. The costs of issuing the preferred stock were charged to additional paid-in capital. Farmer Mac pays cumulative dividends on the preferred stock quarterly in arrears, when and if declared by the board of directors. Farmer Mac’s ability to declare and pay a dividend could be restricted if it failed to comply with regulatory capital requirements. The following table presents the dividends declared on the preferred stock during and subsequent to 2005:

Date
Dividend
Declared
  
Per
Share
Amount
    
For
Period
Beginning
    
For
Period
Ending
    
Date
Paid
                         
February 10, 2005
  
$
0.80
    
January 1, 2005
    
March 31, 2005
    
March 31, 2005
May 19, 2005
    
0.80
   
April 1, 2005
    
June 30, 2005
    
June 30, 2005
August 4, 2005
    
0.80
   
July 1, 2005
    
September 30, 2005
    
September 30, 2005
October 6, 2005
    
0.80
   
October 1, 2005
    
December 31, 2005
    
January 3, 2006
February 2, 2006
    
0.80
   
January 1, 2005
    
March 31, 2006
    
*

* The dividend declared on February 2, 2006 is scheduled to be paid on March 31, 2006.
 
On August 4, 2004, Farmer Mac established a program to repurchase up to 10 percent, or 1,055,500 shares, of the Corporation’s outstanding Class C non-voting common stock. During third quarter 2005, the aggregate number of shares repurchased by Farmer Mac under that program, at an average purchase price of $20.73 per share, reached the maximum number of authorized shares, thereby terminating the program according to its terms. On November 11, 2005, Farmer Mac established a new program to repurchase up to an additional 10 percent, or 958,632 shares, of the Corporation’s outstanding Class C non-voting common stock. The authority for this new stock repurchase program expires in November 2007. During 2005, Farmer Mac repurchased 43,950 shares of its Class C non-voting common stock under the new repurchase program at an average price of $27.97 per share. All of the shares repurchased under both programs were purchased in open market transactions and were retired to become authorized but unissued shares available for future issuance.


FARMER MAC’S AUTHORITY TO BORROW FROM THE U.S. TREASURY

Farmer Mac may, in extreme circumstances, issue obligations to the U.S. Treasury in a cumulative amount not to exceed $1.5 billion. The proceeds of such obligations may be used solely for the purpose of fulfilling Farmer Mac’s guarantee obligations under the Farmer Mac I and Farmer Mac II programs. The Act provides that the U.S. Treasury is required to purchase such obligations of Farmer Mac if Farmer Mac certifies that:
 
 
·
a portion of the guarantee fees assessed by Farmer Mac has been set aside as a reserve against losses arising out of Farmer Mac’s guarantee activities in an amount determined by Farmer Mac’s board of directors to be necessary and such reserve has been exhausted; and
 
·
the proceeds of such obligations are needed to fulfill Farmer Mac’s guarantee obligations.
 
Such obligations would bear interest at a rate determined by the U.S. Treasury, taking into consideration the average rate on outstanding marketable obligations of the United States as of the last day of the last calendar month ending before the date of the purchase of the obligations from Farmer Mac, and would be required to be repurchased from the U.S. Treasury by Farmer Mac within a “reasonable time.”

The United States government does not guarantee payments due on Farmer Mac Guaranteed Securities, funds invested in the equity or debt securities of Farmer Mac, any dividend payments on shares of Farmer Mac stock or the profitability of Farmer Mac.
 
GOVERNMENT REGULATION OF FARMER MAC

General

Farmer Mac’s statutory charter requires offerings of Farmer Mac Guaranteed Securities to be registered under the Securities Act unless an exemption for an offering is available. Farmer Mac also is required to file reports with the SEC pursuant to the SEC’s periodic reporting requirements.

Regulation

Office of Secondary Market Oversight

As an institution of the FCS, Farmer Mac is subject to the regulatory authority of FCA. FCA, acting through its Office of Secondary Market Oversight, has general regulatory and enforcement authority over Farmer Mac, including the authority to promulgate rules and regulations governing the activities of Farmer Mac and to apply its general enforcement powers to Farmer Mac and its activities. The Director of the Office of Secondary Market Oversight, who is selected by and reports to the FCA board, is responsible for the examination of Farmer Mac and the general supervision of the safe and sound performance by Farmer Mac of the powers and duties vested in it by the Act. The Act requires an annual examination of the financial transactions of Farmer Mac and authorizes FCA to assess Farmer Mac for the cost of its regulatory activities, including the cost of any examination. Farmer Mac is required to file quarterly reports of condition with FCA.


Department of the Treasury

In connection with the passage of the 1996 Act, the Chairmen of the House and Senate Agriculture Committees requested FCA, in a cooperative effort with the Department of the Treasury, to “monitor and review the operations and financial condition of Farmer Mac and to report in writing to the appropriate subcommittees of the House Agriculture Committee, the House Financial Services Committee and the Senate Agriculture, Nutrition and Forestry Committee at six-month intervals during the capital deferral period and beyond, if necessary.” The “capital deferral period” expired on January 1, 1999, the risk-based capital rule went into effect on May 23, 2002 and the last semi-annual FCA report to Congress was submitted with respect to the period ended June 30, 2004.

Capital Standards

General. The Act, as amended by the 1996 Act, establishes three capital standards for Farmer Mac:
 
 
·
Minimum capital - Farmer Mac’s minimum capital level is an amount of core capital equal to the sum of 2.75 percent of Farmer Mac’s aggregate on-balance sheet assets, as calculated for regulatory purposes, plus 0.75 percent of Farmer Mac’s aggregate off-balance sheet obligations, specifically including:  
 
o
the unpaid principal balance of outstanding Farmer Mac Guaranteed Securities;
 
o
instruments issued or guaranteed by Farmer Mac that are substantially equivalent to Farmer Mac Guaranteed Securities, including LTSPCs; and
 
o
other off-balance sheet obligations of Farmer Mac.
 
·
Critical capital - Farmer Mac’s critical capital level is an amount of core capital equal to 50 percent of the total minimum capital requirement at that time.
 
·
Risk-based capital - The Act directs FCA to establish a risk-based capital stress test for Farmer Mac, using specified stress-test parameters. While the Act does not specify the required level of risk-based capital, that level is permitted to exceed the statutory minimum capital requirement applicable to Farmer Mac, if so indicated by the risk-based capital stress test.
 
Farmer Mac is required to comply with the higher of the minimum capital requirement or the risk-based capital requirement.

 
The risk-based capital stress test promulgated by FCA is intended to determine the amount of regulatory capital (core capital plus the allowance for losses, but excluding the valuation allowance for real estate owned) that Farmer Mac would need to maintain positive capital during a ten-year period in which:
 
 
·
annual losses occur at a rate of default and severity “reasonably related” to the rates of the highest sequential two years in a limited U.S. geographic area; and
 
·
interest rates increase to a level equal to the lesser of 600 basis points or 50 percent of the ten-year U.S. Treasury rate, and interest rates remain at such level for the remainder of the period.
 
The risk-based capital stress test then adds an additional 30 percent to the resulting capital requirement for management and operational risk. On November 17, 2005, FCA published in the Federal Register a proposed regulation that would revise the risk-based capital regulation. For a discussion of that proposed regulation, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Regulatory Matters.”

As of December 31, 2005, Farmer Mac’s minimum and critical capital requirements were $142.5 million and $71.2 million, respectively, and its actual core capital level was $230.8 million, $88.3 million above the minimum capital requirement and $159.6 million above the critical capital requirement. Based on the risk-based capital stress test, Farmer Mac’s risk-based capital requirement as of December 31, 2005 was $29.5 million and Farmer Mac’s regulatory capital of $239.4 million exceeded that amount by approximately $209.9 million. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources—Capital Requirements” for a presentation of Farmer Mac’s current regulatory capital position.

Enforcement levels. The Act directs FCA to classify Farmer Mac within one of four enforcement levels for purposes of determining compliance with capital standards. As of December 31, 2005, Farmer Mac was classified as within level I—the highest compliance level.
 
Failure to comply with the applicable required capital level in the Act would result in Farmer Mac being classified as within level II (below the applicable risk-based capital level, but above the minimum capital level), level III (below the minimum capital level, but above the critical capital level) or level IV (below the critical capital level). In the event that Farmer Mac were classified as within level II, III or IV, the Act requires the Director of the Office of Secondary Market Oversight to take a number of mandatory supervisory measures and provides the Director with discretionary authority to take various optional supervisory measures depending on the level in which Farmer Mac is classified. The mandatory measures applicable to level II include:
 
 
·
requiring Farmer Mac to submit and comply with a capital restoration plan;
 
·
prohibiting the payment of dividends if such payment would result in Farmer Mac being reclassified as within level III or IV, and requiring the pre-approval of any dividend payment even if such payment would not result in reclassification as within level IV; and
 
·
reclassifying Farmer Mac as within level III if it does not submit a capital restoration plan that is approved by the Director, or the Director determines that Farmer Mac has failed to make, in good faith, reasonable efforts to comply with such a plan and fulfill the schedule for the plan approved by the Director.

 
The mandatory measures applicable to level III include:
 
 
·
requiring Farmer Mac to submit (and comply with) a capital restoration plan;
 
·
prohibiting the payment of dividends if such payment would result in Farmer Mac being reclassified as within level IV and requiring the pre-approval of any dividend payment even if such payment would not result in reclassification as within level IV; and
 
·
reclassifying Farmer Mac as within a lower level if it does not submit a capital restoration plan that is approved by the Director or the Director determines that Farmer Mac has failed to make, in good faith, reasonable efforts to comply with such a plan and fulfill the schedule for the plan approved by the Director.
 
If Farmer Mac were classified as within level III, then, in addition to the foregoing mandatory supervisory measures, the Director of the Office of Secondary Market Oversight could take any of the following discretionary supervisory measures:
 
 
·
imposing limits on any increase in, or ordering the reduction of, any obligations of Farmer Mac, including off-balance sheet obligations;
 
·
limiting or prohibiting asset growth or requiring the reduction of assets;
 
·
requiring the acquisition of new capital in an amount sufficient to provide for reclassification as within a higher level;
 
·
terminating, reducing or modifying any activity the Director determines creates excessive risk to Farmer Mac; or
 
·
appointing a conservator or a receiver for Farmer Mac.
 
The Act does not specify any supervisory measures, either mandatory or discretionary, to be taken by the Director in the event Farmer Mac were classified as within level IV.

The Director of the Office of Secondary Market Oversight has the discretionary authority to reclassify Farmer Mac to a level that is one level below its then current level (for example, from level I to level II) if the Director determines that Farmer Mac is engaging in any action not approved by the Director that could result in a rapid depletion of core capital or if the value of property subject to mortgages backing Farmer Mac Guaranteed Securities has decreased significantly.

Risk Factors

Farmer Mac’s business activities, financial performance and results of operations are, by their nature, subject to a number of risks and uncertainties. Consequently, the Corporation’s net interest income, total revenues and net income have been, and are likely to continue to be, subject to fluctuations that reflect the effect of many factors, including the risk factors described below. These risks are not exhaustive. Other sections of this report may include additional factors that could adversely affect Farmer Mac’s business and its financial performance and results of operations. Furthermore, because new risk factors likely will emerge from time to time, management can neither predict all such risk factors nor assess the effects of such factors on Farmer Mac’s business, operating results and financial condition or the extent to which any factor, or combination of factors, may affect the Corporation’s actual results and financial condition. If any of the following risks materialize, Farmer Mac’s business, financial condition or results of operations could be materially adversely affected.


Farmer Mac’s business, operating results and financial condition may be materially and adversely affected by external factors that may be beyond its control.
 
Farmer Mac’s business, operating results and financial condition may be materially and adversely affected by external factors that may be beyond its control, including but not limited to:
 
 
·
legislative or regulatory developments or interpretations of Farmer Mac’s statutory charter that could adversely affect Farmer Mac, its ability to offer new products, the ability or motivation of certain lenders to participate in its programs or the terms of any such participation, or increase the cost of regulation and related corporate activities, including but not limited to:
 
o
the possible establishment of additional statutory or regulatory restrictions or constraints on Farmer Mac that could hamper its growth or diminish its profitability; and
 
o
the possible effect of Farmer Mac’s risk-based capital requirement, which could, under certain circumstances, exceed its statutory minimum capital requirement;
 
·
Farmer Mac’s access to the debt markets at favorable rates and terms;
 
·
competitive pressures in the purchase of agricultural mortgage loans and the sale of Farmer Mac Guaranteed Securities and debt securities;
 
·
substantial changes in interest rates, agricultural land values, commodity prices, export demand for U.S. agricultural products, the general economy, and other factors that may affect delinquency levels and credit losses on agricultural mortgage loans;
 
·
protracted adverse weather, animal and plant disease outbreaks, market or other conditions affecting particular geographic regions or particular agricultural commodities or products related to agricultural mortgage loans backing Farmer Mac I Guaranteed Securities or under LTSPCs; and
 
·
the effects of any changes in federal assistance for agriculture on the agricultural economy or the value of agricultural real estate.

Farmer Mac’s business development and profitability depend on the continued growth of the secondary market for agricultural mortgage loans, the future of which remains uncertain.
 
Continued growth in Farmer Mac’s business may be constrained by conditions that limit the need for agricultural lenders to obtain the benefits of Farmer Mac’s programs, including for example:
 
 
·
high levels of available capital and liquidity of agricultural lenders;
 
·
the availability of alternative sources of funding and credit enhancement for agricultural lenders;
·
downturns in the agricultural economy that could reduce growth rates and the need for capital in the agricultural mortgage market;
 
·
increased competition in the secondary market for purchases of quality agricultural mortgage loans;
 
·
reduced growth rates in the agricultural mortgage market, due largely to the strong liquidity of many farmers and ranchers;
 
·
the lower rate of growth of the Farm Credit System mortgage portfolio, reducing the demand for LTSPCs;
 
·
the historical preference of many agricultural lending institutions to retain loans in their portfolios rather than to sell them into the secondary market, notwithstanding the corporate finance and capital planning benefits they might otherwise realize through participation in Farmer Mac’s programs;
 
·
the ability of some lending institutions to subsidize, in effect, their agricultural mortgage loan rates through low-return use of equity or acceptance of greater asset and liability mismatch; and
 
·
legislative and regulatory developments in this area, as further discussed below.


As a result of these factors, Farmer Mac may not be able to meet its business development and profitability goals. To the extent that Farmer Mac fails to meet these goals, its total revenues, net income and financial condition could be materially adversely affected.

Farmer Mac is a government-sponsored enterprise whose continued growth may be adversely affected by legislative and regulatory developments.

Farmer Mac is a government-sponsored enterprise that is governed by a statutory charter controlled by the U.S. Congress and regulated by governmental agencies. Consequently, Farmer Mac is subject to risks related to legislative, regulatory or political developments. Such developments could affect the ability of lenders to participate in Farmer Mac’s programs or the terms on which they may participate. Further, from time to time, legislative or regulatory initiatives are commenced that, if successful, could result in the enactment of legislation or the promulgation of regulations that could affect negatively the growth or operation of the secondary market for agricultural mortgages. Any of these political or regulatory developments could have a material and adverse effect on Farmer Mac’s business. See “Government Regulation of Farmer Mac” in Item 1 of this report for additional discussion on the rules and regulations governing Farmer Mac’s activities.

Farmer Mac Guaranteed Securities and LTSPCs expose Farmer Mac to significant contingent liabilities and its ability to fulfill its obligations under its guarantees and LTSPCs may be limited.

Farmer Mac guarantees the timely payment of principal and interest on Farmer Mac Guaranteed Securities, which are backed by qualified agricultural real estate mortgage loans. As a result of its guarantee, Farmer Mac assumes the ultimate credit risk of borrower defaults on the underlying loans. Farmer Mac also issues LTSPCs for pools of qualified loans that commit Farmer Mac to purchase certain loans under enumerated circumstances on undetermined future dates.

Repayment of the qualified loans underlying Farmer Mac Guaranteed Securities or subject to LTSPCs typically depends on the success of the related farming operation, which, in turn, depends on many variables and factors over which farmers may have little or no control, such as weather conditions, animal and plant disease outbreaks, economic conditions (both domestic and international) and political conditions. If the cash flow from a farming operation decreases (for example, as a result of adverse weather conditions that destroy a crop or that prevent the planting or harvesting of a crop), the farmer’s ability to repay the loan may be impaired. Protracted adverse weather, animal and plant disease outbreaks, market or other conditions affecting a particular geographic region and particular commodities related to the agricultural mortgage loans backing Farmer Mac Guaranteed Securities or subject to LTSPCs, or significant loan payment defaults by farmers for other reasons, could require Farmer Mac to pay under its guarantees and LTSPCs and could have a material adverse effect on the Corporation’s financial condition and results of operations.


Farmer Mac Guaranteed Securities and LTSPCs are obligations of Farmer Mac only, and are not backed by the full faith and credit of the United States, FCA or any other agency or instrumentality of the United States other than Farmer Mac. Farmer Mac’s principal source of funds for the payment of claims under its guarantees and purchase commitments are the fees received in connection with outstanding Farmer Mac Guaranteed Securities and LTSPCs. These amounts are, and will continue to be, substantially less than the amount of Farmer Mac’s aggregate contingent liabilities under its guarantees and LTSPCs. Farmer Mac is required to set aside a portion of the fees it receives as a reserve against losses from its guarantee and commitment activities. Farmer Mac expects that its future contingent liabilities for its guarantee and commitment activities will continue to grow and will exceed Farmer Mac’s resources, including amounts in the Corporation’s allowance for losses and its limited ability to borrow from the United States Treasury.

Farmer Mac is exposed to credit risk and interest rate risk that could materially and adversely affect its financial condition and future earnings.

The primary types of risk in the conduct of Farmer Mac’s business are:
 
 
·
credit risk associated with the agricultural mortgage loans that Farmer Mac purchases or commits to purchase or that back Farmer Mac Guaranteed Securities;
 
·
interest rate risk on all program and non-program assets held on balance sheet, that results principally from:
 
o
potential changes in the relationship between the interest rates paid by the Corporation on its liabilities and the yields it receives on investments of like maturity or reset term; or
 
o
potential timing differences between the maturities or interest rate resets of the assets and the liabilities used to fund the acquisition and carry of the assets;
 
·
credit risk associated with Farmer Mac’s business relationships with other institutions, such as counterparties to swap and other hedging arrangements; and
 
·
risks as to the creditworthiness of the issuers of AgVantage securities and the Corporation’s non-program investments.

Any of these risks could materially and adversely affect Farmer Mac’s financial condition and future earnings. For additional discussion about the Corporation’s risk management, see “Management’s Discussion and Analysis of Financial Condition and Results of Operation—Risk Management” in Item 7 of this report.

Item 1B.
Unresolved Staff Comments

Not applicable.

Properties

Farmer Mac currently occupies its principal offices, which are located at 1133 Twenty-First Street, N.W., Washington, D.C. 20036, under the terms of a lease that expires on November 30, 2011 and covers approximately 13,500 square feet of office space. Farmer Mac also maintains an underwriting office located at 415 Clark Avenue, Ames, Iowa 50010, under the terms of a lease that expires on June 15, 2008 (Farmer Mac has the option to renew the lease for an additional 3-year term) and covers approximately 1,750 square feet of office space. Farmer Mac’s offices are suitable and adequate for its current and currently anticipated needs.


Item 3.
Legal Proceedings

Farmer Mac is not a party to any material pending legal proceedings.

Submission of Matters to a Vote of Security Holders

Not applicable.


PART II

Item 5.
Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

(a)    Farmer Mac has three classes of common stock outstanding. Ownership of Class A voting common stock is restricted to banks, insurance companies and other financial institutions or similar entities that are not institutions of the FCS. Ownership of Class B voting common stock is restricted to institutions of the FCS. There are no ownership restrictions on the Class C non-voting common stock. Under the terms of the original public offering of the Class A and Class B voting common stock, the Corporation reserved the right to redeem at book value any shares of either class held by an ineligible holder.

Farmer Mac’s Class A voting common stock and Class C non-voting common stock trade on the New York Stock Exchange under the symbols AGM.A and AGM, respectively. The Class B voting common stock, which has a limited market and trades infrequently, is not listed or quoted on any exchange or other medium, and Farmer Mac is unaware of any publicly available quotations or prices for that class.

The information below represents the high and low closing sales prices for the Class A and Class C common stocks for the periods indicated as reported by the New York Stock Exchange.

   
Sales Prices
  
   
Class A Stock
  
Class C Stock
  
   
High
  
Low
  
High
  
Low
  
   
(per share)
  
                   
2006
                  
First quarter (through March 1, 2006)
  
$
21.65
  
$
19.80
  
$
31.06
  
$
27.53
  
                           
2005
                          
Fourth quarter
    
23.15
   
17.51
   
32.21
   
22.75
 
Third quarter
    
20.35
   
16.56
   
26.65
   
22.60
 
Second quarter
    
16.40
   
12.89
   
22.05
   
15.67
 
First quarter
    
17.20
   
14.00
   
23.36
   
16.80
 
                           
2004
                          
Fourth quarter
    
17.80
   
15.60
   
24.03
   
19.60
 
Third quarter
    
19.05
   
16.80
   
23.85
   
17.13
 
Second quarter
    
20.30
   
19.00
   
27.00
   
21.78
 
First quarter
    
22.85
   
19.45
   
31.19
   
25.00
 

As of March 1, 2006, Farmer Mac estimates that there were 1,330 registered owners of the Class A voting common stock, 98 registered owners of the Class B voting common stock and 1,257 registered owners of the Class C non-voting common stock.


The dividend rights of all three classes of the Corporation’s common stock are the same, and dividends may be paid on common stock only when, as and if declared by Farmer Mac’s board of directors in its sole discretion. Beginning in the fourth quarter 2004, Farmer Mac has paid a quarterly dividend of $0.10 per share on all classes of the Corporation’s common stock pursuant to a policy adopted by the Corporation’s board of directors. On February 2, 2006, Farmer Mac’s board of directors declared a quarterly dividend of $0.10 per share on the Corporation’s common stock payable on March 31, 2006. Farmer Mac expects to continue to pay comparable quarterly cash dividends for the foreseeable future, subject to the outlook and indicated capital needs of the Corporation and the determination of the board of directors. Farmer Mac’s ability to declare and pay dividends could be restricted if it were to fail to comply with regulatory capital requirements. See “Business—Government Regulation of Farmer Mac—Regulation—Capital Standards—Enforcement levels.” Farmer Mac’s ability to pay dividends on its common stock is also subject to the payment of dividends on its outstanding preferred stock.

Information about securities authorized for issuance under Farmer Mac’s equity compensation plans appears under “Equity Compensation Plans” in the Corporation’s definitive proxy statement to be filed on or about April 21, 2006. That portion of the definitive proxy statement is incorporated by reference into this report.

Farmer Mac is a federally chartered instrumentality of the United States and its common stock is exempt from registration pursuant to Section 3(a)(2) of the Securities Act of 1933. On October 5, 2005, pursuant to Farmer Mac’s policy that permits directors of Farmer Mac to elect to receive shares of Class C non-voting common stock in lieu of their cash retainers, Farmer Mac issued an aggregate of 607 shares of its Class C non-voting common stock, at an issue price of $24.34 per share, to the eight directors who elected to receive such stock in lieu of their cash retainers. On October 6, 2005, Farmer Mac granted options under its 1997 Stock Option Plan to purchase 6,000 shares of Class C non-voting common stock, at an exercise price of $24.14 per share, to a non-officer employee as incentive compensation. On December 30, 2005, Farmer Mac granted options under its 1997 Stock Option Plan to purchase 6,000 shares of Class C non-voting common stock, at an exercise price of $29.93 per share, to a non-officer employee in connection with the employee’s commencement of employment.

 
(b)
Not applicable.

(c)    As shown in the table below, Farmer Mac repurchased 43,950 shares of its Class C non-voting common stock during fourth quarter 2005 at an average price of $27.97 per share. All of the repurchased shares were purchased in open market transactions and were retired to become authorized but unissued shares available for future issuance.

Issuer Purchases of Equity Securities
  
Period
  
Total Number
of Class C
Shares Purchased
  
Average
Price Paid
per Class
C Share
  
Total Number of
Class C Shares
Purchased as Part
of Publicly Announced
Program*
  
Maximum Number
of Class C Shares
that May Yet Be
Purchased Under
the Program
  
                   
October 1, 2005 - October 31, 2005
    
-
 
$
-
    
-
   
-
 
November 1, 2005 - November 30, 2005
    
23,350
   
27.98
   
23,350
   
935,282
 
December 1, 2005 - December 31, 2005
    
20,600
   
27.96
   
20,600
   
914,682
 
Total
    
43,950
 
$
27.97
    
43,950
   
914,682
 
* On November 17, 2005, Farmer Mac publicly announced that its board of directors had authorized a program to repurchase up to 10 percent of the Corporation’s outstanding Class C non-voting common stock (958,632 shares). The authority for this stock repurchase program expires in November 2007.


Item 6.
Selected Financial Data

   
As of December 31,
  
Summary of Financial Condition:
  
2005
 
2004
 
2003
 
2002
 
2001
  
   
(As Restated)(1)
 
(As Restated)(1)
 
(As Restated)(1)
 
(As Restated)(1)
 
(As Restated)(1)
  
   
(dollars in thousands)
  
Cash and cash equivalents 
  
$
458,852
  
$
430,504
  
$
623,674
  
$
723,800
  
$
437,831
  
Investment securities 
    
1,621,941
   
1,056,143
   
1,064,782
   
830,409
   
1,007,954
 
Farmer Mac Guaranteed Securities 
    
1,330,976
   
1,376,847
   
1,508,134
   
1,608,507
   
1,690,376
 
Loans, net 
    
799,516
   
882,874
   
982,446
   
962,355
   
197,676
 
Total assets 
    
4,341,445
   
3,847,410
   
4,299,670
   
4,222,003
   
3,413,639
 
Notes payable: 
                                
 Due within one year
    
2,587,704
   
2,620,172
   
2,799,384
   
2,895,746
   
2,233,267
 
 Due after one year
    
1,406,527
   
864,412
   
1,138,892
   
985,318
   
968,463
 
Total liabilities 
    
4,095,416
   
3,612,176
   
4,089,178
   
4,039,344
   
3,284,642
 
Stockholders' equity 
    
246,029
   
235,234
   
210,492
   
182,659
   
128,997
 
                                 
Selected Financial Ratios:
                                
Return on average assets 
    
1.15
%
  
0.96
%
  
0.92
%
  
-0.60
%
  
0.06
%
Return on average common equity 
    
22.87
%
  
20.76
%
  
24.16
%
  
-16.65
%
  
1.57
%
Average equity to assets 
    
5.88
%
  
5.47
%
  
4.61
%
  
4.08
%
  
3.99
%

   
For the Year Ended December 31,
  
Summary of Operations:
  
2005
  
2004
  
2003
  
2002
  
2001
  
   
(As Restated)(1)
  
(As Restated)(1)
  
(As Restated)(1)
  
(As Restated)(1)
  
(As Restated)(1)
  
   
(in thousands, except per share amounts)
  
Net interest income after recovery/ (provision) for loan losses
  
$
50,689
  
$
65,763
  
$
72,278
  
$
71,993
  
$
40,035
  
Guarantee and commitment fees
    
19,554
    
20,977
    
20,685
    
19,277
    
15,807
  
Gains/(losses) on financial derivatives and trading assets
    
11,537
    
(14,687
)
  
(17,653
)
  
(110,860
)
  
(37,726
)
Gain on sale of Farmer Mac Guaranteed
                                
Securities
    
-
    
367
    
-
    
-
    
-
  
Gains on the repurchase of debt
    
116
    
-
    
-
    
1,368
    
-
  
Gains on the sale of real estate owned
    
34
    
523
    
178
    
24
    
61
  
Representation and warranty claims income
    
79
    
2,816
    
-
    
-
    
-
  
Other income
    
1,872
    
1,495
    
812
    
1,332
    
560
  
Total revenues
    
83,881
    
77,254
    
76,300
    
(16,866
)
  
18,737
  
Total operating expenses
    
11,518
    
16,263
    
15,182
    
18,767
    
16,616
  
Income/(loss) before income taxes and cumulative effect of change in accounting principles
    
72,363
    
60,991
    
61,118
    
(35,633
)
  
2,121
  
Income tax expense/(benefit)
    
23,091
    
19,751
    
19,847
    
(14,059
)
  
263
  
Cumulative effect of change in accounting principles, net of taxes
    
-
    
-
    
-
    
-
    
198
  
Net income/(loss)
    
49,272
    
41,240
    
41,271
    
(21,574
)
  
2,056
  
Preferred stock dividends
    
(2,240
)
  
(2,240
)
  
(2,240
)
  
(1,456
)
  
-
  
Net income/(loss) available to common stockholders
  
$
47,032
  
$
39,000
  
$
39,031
  
$
(23,030
)
$
2,056
  
                                 
Allowance for Losses Activity:
                                
Provision for losses
  
$
(8,777
)
$
(412
)
$
7,285
  
$
8,247
  
$
6,786
  
Net charge-offs/(recoveries)
    
(329
)
  
4,540
    
5,243
    
4,120
    
2,225
  
Ending balance
    
8,653
    
17,101
    
22,053
    
20,011
    
15,884
  
                                 
Earnings Per Common Share and Dividends:
                                
Basic earnings/(loss) per common share
  
$
4.14
  
$
3.24
  
$
3.32
  
$
(1.98
)
$
0.18
  
Diluted earnings/(loss) per common share
  
$
4.09
  
$
3.20
  
$
3.24
  
$
(1.98
)
$
0.17
  
Common stock dividends per common share
  
$
0.40
  
$
0.10
  
$
-
  
$
-
  
$
-
  

 
(1)
See Note 15 to the consolidated financial statements included in Item 8 of this Form 10-K/A for additional information.
 

Item 7.
Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following management’s discussion and analysis of financial condition and results of operations set forth in this Item 7 reflects revisions in financial reporting resulting from the Corporation’s restatement to correct for errors relating to its accounting for financial derivative transactions under SFAS 133 that were contained in the Corporation’s consolidated financial statements and other financial information for the years ended December 31, 2005, 2004, and 2003 as discussed below and in Note 15 to the consolidated financial statements. Financial information as of and for each of the years ended December 31, 2005, 2004 and 2003 is consolidated to include the accounts of Farmer Mac and its wholly-owned subsidiary, Farmer Mac Mortgage Securities Corporation.

This discussion and analysis of financial condition and results of operations should be read together with our restated consolidated financial statements and the related notes to the restated consolidated financial statements that are filed as part of this Amendment.

The discussion below is not necessarily indicative of future results.

Forward-Looking Statements

Some statements made in this Form 10-K/A 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 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 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;
 
·
trends in provisions for losses;
 
·
trends in expenses;
 
·
changes in capital position; and
 
·
other business and financial matters.
 
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 this report and uncertainties regarding:

 
 
·
increases in general and administrative expenses attributable to growth of the business and regulatory environment, including the hiring of additional personnel with expertise in key functional areas;
 
·
the rate and direction of development of the secondary market for agricultural mortgage loans;
 
·
the general rate of growth in agricultural mortgage indebtedness;
 
·
lender interest in Farmer Mac credit products and the Farmer Mac secondary market;
 
·
borrower preferences for fixed-rate agricultural mortgage indebtedness;
 
·
the willingness of investors to invest in Farmer Mac Guaranteed Securities; and
 
·
possible reaction in the financial markets to events involving GSEs other than Farmer Mac.
 
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.

Restatement of Consolidated Financial Statements
 
The Corporation is restating its consolidated financial statements as of December 31, 2005 and 2004, and for the years ended December 31, 2005, 2004 and 2003, and other financial information as of and for the years ended December 31, 2002 and 2001 and the quarterly unaudited data for 2005 and 2004. The Corporation is concurrently filing amendments to its Forms 10-Q for the quarters ended March 31, 2006 and June 30, 2006 to restate the quarterly unaudited interim consolidated financial statements and other financial information contained in those reports. These restatements and resulting revisions relate to the accounting treatment for derivative transactions under SFAS 133. In this regard, investors should rely on the restated financial results for the years and each of the quarters in the years 2005, 2004, 2003, 2002 and 2001 and the first and second quarters of 2006 and, as the Corporation previously reported on Form 8-K on October 6, 2006, should not rely on the Corporation’s previously issued consolidated financial statements and other financial information for these reporting periods.

The Corporation, in light of SEC staff comments, has recently concluded a reassessment of its documentation and accounting treatment of financial derivative transactions under SFAS 133, interpretations of which have evolved. Based on the reassessment, while the transactions engaged in by the Corporation were highly effective economic hedges of interest rate risk, the Corporation has determined that it was not appropriately applying hedge accounting in accordance with SFAS 133.

As a result, the accompanying consolidated financial statements for the years ended December 31, 2005, 2004 and 2003 included in Item 8 have been restated from the amounts previously reported to correct the accounting for financial derivatives. The corrections related to the Corporation’s accounting for fair value hedges and cash flow hedges as described in more detail below.

The Corporation reduced its stockholders’ equity by $0.9 million as of January 1, 2003 as the cumulative effect of the corrections to its accounting for financial derivatives for all periods preceding January 1, 2003, and restated its consolidated statements of operations and cash flows for the years ended December 31, 2005, 2004 and 2003 and its consolidated balance sheet as of December 31, 2005 and 2004. The restatement resulted in increases to previously reported net income available to common stockholders of $19.8 million ($1.72 per diluted common share), $10.8 million ($0.88 per diluted common share), and $14.0 million ($1.16 per diluted common share) for each of the years ended December 31, 2005, 2004 and 2003, respectively. In addition to the increases in net income available to common stockholders, the net impact related to the correction of these errors for fair value and cash flow hedges was to increase net interest income by $17.4 million, $34.1 million and $41.6 million for 2005, 2004 and 2003, respectively. Gains/(losses) on financial derivatives changed $13.0 million, $(17.5) million and $(20.0) million for 2005, 2004 and 2003, respectively. There was no impact on net cash flows, core earnings or the amount of dividends declared for any years presented.


Fair Value Hedges:

The Corporation has determined that it did not meet the specific documentation requirements required by SFAS 133 to assume no ineffectiveness in its fair value hedge relationships or to apply hedge accounting to its fair value hedges. As a result, the Corporation’s designation of its financial derivatives as fair value hedges for the period from January 1, 2001 to December 31, 2005 did not meet the requirements of SFAS 133.

The impact of the restatement on the consolidated statements of operations related to fair value hedges was to reverse previously applied hedge accounting for all hedging relationships. For financial derivatives previously accounted for as fair value hedges, the net accruals for the derivatives were previously recorded to net interest income, and net changes in fair values of the financial derivatives were previously recorded as basis adjustments to the hedged items, such as notes payable, loans held for sale, or investment securities. As a result of the restatement, the previous accounting treatment was reversed (i.e., the net accruals recorded to net interest income were reclassified to gains and losses on financial derivatives and basis adjustments for the hedged items was reversed), and the total changes in the fair values of the derivative instruments, including interest accrual settlements, were recorded directly to gains/(losses) on financial derivatives and trading assets.

Cash Flow Hedges:

The Corporation determined also that it did not meet specific documentation and other requirements of SFAS 133 to apply hedge accounting to its cash flow hedges. In this regard, the Corporation has determined that its forecasted transactions were not documented with sufficient specificity at the inception of the hedge relationship to allow those transactions to be identified as the intended “hedged transactions” when they occurred; some of its forecasted transactions related to the acquisitions of assets, or incurrences of liabilities, involved subsequent remeasurements with changes in fair value attributable to the hedged risk reported currently in earnings; and the benchmark index identified for its basis swaps did not meet the definition of a “benchmark interest rate” as that term is defined in SFAS 133. As a result, the Corporation’s designation of its financial derivatives as cash flow hedges for the period from January 1, 2001 to December 31, 2005 did not meet the requirements of SFAS 133.

The impact of the restatement on the consolidated statements of operations related to cash flow hedges was to reverse previously applied hedge accounting for all hedging relationships. For financial derivatives previously accounted for as cash flow hedges, the Corporation recorded accruals from the financial derivatives to net interest income and recorded net changes in the fair values of the derivatives, net-of-tax, to accumulated other comprehensive income (“OCI”). As a result of the restatement, the previous accounting treatment for cash flow hedges was reversed from accumulated OCI and net interest income, and recorded to gains/(losses) on financial derivatives and trading assets.


Critical Accounting Policy and Estimates

The preparation of the consolidated financial statements in conformity with accounting principles generally accepted in the United States 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 policy that is both important to the portrayal of Farmer Mac’s financial condition and results of operations and requires complex, subjective judgments is the accounting policy for the allowance for losses. Farmer Mac’s allowance for losses is presented in three components on its consolidated balance sheet:
 
 
·
an “Allowance for loan losses” on loans held for investment;
 
·
a valuation allowance on real estate owned, which is included in the balance sheet under “Real estate owned”; and
 
·
an allowance for losses on loans underlying post-1996 Act Farmer Mac I Guaranteed Securities and LTSPCs, which is included in the balance sheet under “Reserve for losses.”

Farmer Mac’s provision for losses is presented in two components on the consolidated statement of operations:
 
 
·
a “Provision for loan losses,” which represents losses on Farmer Mac’s loans held for investment; and
 
·
a “Provision for losses,” which represents losses on loans underlying post-1996 Act Farmer Mac I Guaranteed Securities and LTSPCs and real estate owned.

The purpose of the allowance for losses is to provide for estimated losses that are probable to have occurred as of the balance sheet date, and not to predict or account for future potential losses. The determination of the allowance for losses requires management to make significant estimates based on information available as of the balance sheet date, including the amounts and timing of losses and current market and economic conditions. These estimates are subject to change in future reporting periods if such conditions and information change. For example, a decline in the national or agricultural economy could result in an increase in delinquencies or foreclosures, which may require additional allowances for losses in future periods.

Farmer Mac maintains an allowance for losses to cover estimated probable losses on loans held for investment, real estate owned and loans underlying post-1996 Act Farmer Mac I Guaranteed Securities and LTSPCs. Historically, Farmer Mac estimated probable losses using a systematic process that began with management’s evaluation of the results of a proprietary loan pool simulation and guarantee fee model. That model drew upon historical information from a data set of agricultural mortgage loans screened to include only those loans with credit characteristics similar to those eligible for Farmer Mac’s programs. The results generated by that model were then modified, as necessary, by the application of management’s judgment.

During third quarter 2005, Farmer Mac completed the planned migration of its methodology for determining its allowance for losses away from one based on its loan pool simulation and guarantee fee model to one based on its own historical portfolio loss experience and credit trends. Farmer Mac recorded the effects of that change as a change in accounting estimate as of September 30, 2005.


Farmer Mac’s new methodology for determining its allowance for losses incorporates the Corporation’s proprietary automated loan classification system. That system scores loans based on criteria such as historical repayment performance, loan seasoning, loan size and LTV. For the purposes of the loss allowance methodology, the loans in Farmer Mac’s portfolio of loans and loans underlying post-1996 Act Farmer Mac I Guaranteed Securities and LTSPCs have been scored and classified for each calendar quarter since first quarter 2000. The new allowance methodology captures the migration of loan scores across concurrent and overlapping 3-year time horizons and calculates loss rates separately within each loan classification for (1) loans underlying LTSPCs and (2) loans held and loans underlying post-1996 Act Farmer Mac I Guaranteed Securities. The calculated loss rates are applied to the current classification distribution of Farmer Mac’s portfolio to estimate inherent losses, on the assumption that the historical credit losses and trends used to calculate loss rates will continue in the future. Management evaluates this assumption by taking into consideration several factors, including:
 
 
·
economic conditions;
 
·
geographic and agricultural commodity/product concentrations in the portfolio;
 
·
the credit profile of the portfolio;
 
·
delinquency trends of the portfolio; and
 
·
historical charge-off and recovery activities of the portfolio.
 
If, based on that evaluation, management concludes that the assumption is not valid, the loss allowance calculation is modified by the addition of further assumptions to capture current portfolio trends and characteristics that differ from historical experience.

The allowance for losses is increased through periodic provisions for loan losses that are charged against net interest income and provisions for losses charged to operating expenses and reduced by charge-offs for actual losses, net of recoveries. Negative provisions for loan losses or negative provisions for losses are recorded in the event that the estimate of probable losses as of the end of a period is lower than the estimate at the beginning of the period. The establishment of and periodic adjustments to the valuation allowance for real estate owned are charged against income as a portion of the provision for losses charged to operating expense. Gains and losses on the sale of real estate owned are recorded in income based on the difference between the recorded investment at the time of sale and liquidation proceeds.

No allowance for losses has been made for loans underlying Farmer Mac I Guaranteed Securities issued prior to the 1996 Act or Farmer Mac II Guaranteed Securities. Farmer Mac I Guaranteed Securities issued prior to the 1996 Act are supported by unguaranteed first loss subordinated interests, which are expected to exceed the estimated credit losses on those loans. USDA-guaranteed portions collateralizing Farmer Mac II Guaranteed Securities are obligations backed by the full faith and credit of the United States. As of December 31, 2005, Farmer Mac had experienced no credit losses on any pre-1996 Act Farmer Mac I Guaranteed Securities or on any Farmer Mac II Guaranteed Securities and does not expect to incur any such losses in the future.

Further information regarding the allowance for losses is included in “—Risk Management—Credit Risk - Loans.”


Results of Operations

Overview. Net income available to common stockholders for 2005 was $47.0 million or $4.09 per diluted common share, compared to $39.0 million or $3.20 per diluted common share in 2004 and $39.0 million or $3.24 per diluted common share in 2003. The effects of Farmer Mac’s stock repurchases of 800,202 shares and 299,248 shares during 2005 and 2004, respectively, on diluted earnings per share for 2005 and 2004 were increases of $0.21 and $0.02, respectively.

During 2005, Farmer Mac’s program volume totaled $771.7 million, compared to 2004 volume of $671.0 million. In addition, Farmer Mac added $500.0 million of mission-related investments during 2005. Farmer Mac’s outstanding program volume as of December 31, 2005 was $5.3 billion, compared to $5.5 billion as of December 31, 2004. For 2005, Farmer Mac’s new business volume included the:
 
 
·
addition of $461.4 million of Farmer Mac I eligible loans under LTSPCs;
 
·
purchase of $110.1 million of newly originated Farmer Mac I eligible loans;
 
·
purchase of $200.2 million of Farmer Mac II USDA-guaranteed portions; and
 
·
purchase of a mission-related investment of $500.0 million in notes issued by the National Rural Utilities Cooperative Finance Corporation (“CFC”), and secured by mortgage indebtedness issued by CFC-member rural electric distribution cooperatives serving communities across rural America, in accordance with parameters established by FCA.

As part of Farmer Mac’s continuing evaluation of the overall credit quality of its portfolio, the state of the U.S. agricultural economy, the recent upward trends in agricultural land values, the level of Farmer Mac’s outstanding guarantees and commitments and the recordation of a change in accounting estimate resulting from the implementation during third quarter 2005 of a new methodology to estimate probable losses inherent in its post-1996 Act Farmer Mac I portfolio, Farmer Mac determined that the appropriate level of allowance for losses as of December 31, 2005 was $8.7 million. This resulted in the release of approximately $8.8 million from the allowance for losses during 2005, compared to the release of $0.4 million from its allowance for losses in 2004 and provisions for losses of $7.3 million in 2003. During 2005, the release from the allowance for losses included $4.8 million recorded as a change in accounting estimate in third quarter 2005. As of December 31, 2005, the allowance for losses was $8.7 million and 20 basis points relative to the outstanding post-1996 Act Farmer Mac I portfolio, compared to $10.9 million and 25 basis points as of September 30, 2005 and $17.1 million and 47 basis points as of December 31, 2004. For further discussion of the change in the allowance for losses and provision for losses, see “—Risk Management—Credit Risk - Loans.”

As of December 31, 2005, the percentage of 90-day delinquencies (Farmer Mac I loans purchased or placed under Farmer Mac I Guaranteed Securities or LTSPCs after changes to Farmer Mac’s statutory charter in 1996 that were 90 days or more past due, in foreclosure, restructured after delinquency, or in bankruptcy, excluding loans performing under either their original loan terms or a court-approved bankruptcy plan) was 0.58 percent of the principal balance of all loans held and loans underlying post-1996 Act Farmer Mac I Guaranteed Securities and LTSPCs, compared to 0.55 percent as of December 31, 2004 and 0.60 percent as of December 31, 2003.


The following table presents Farmer Mac’s non-performing assets, which represents the aggregate of 90-day delinquencies, loans performing in bankruptcy and real estate owned.

   
As of December 31,
  
   
2005
  
2004
  
   
(in thousands)
  
90-day delinquencies (including loans in foreclosure and loans restructured after delinquency)
  
$
25,461
  
$
25,283
  
Loans performing in bankruptcy
    
19,771
   
21,508
 
Real estate owned
    
3,532
   
3,845
 
Non-performing assets
  
$
48,764
  
$
50,636
  

The following table presents historical information regarding Farmer Mac’s non-performing assets and 90-day delinquencies:

   
Outstanding
Post-1996 Act
Loans,
Guarantees and
LTSPCs
  
Non-
performing
Assets
  
Percentage
  
Less:
REO and
Performing
Bankruptcies
  
90-day
Delinquencies
  
Percentage
  
   
(dollars in thousands)
  
As of:                          
December 31, 2005
  
$
4,399,189
  
$
48,764
    
1.11
%
$
23,303
  
$
25,461
    
0.58
%
September 30, 2005
    
4,273,268
   
64,186
   
1.50
%
  
23,602
   
40,584
   
0.95
%
June 30, 2005
    
4,360,670
   
60,696
   
1.39
%
  
23,925
   
36,771
   
0.85
%
March 31, 2005
    
4,433,087
   
70,349
   
1.59
%
  
24,561
   
45,788
   
1.04
%
December 31, 2004
    
4,642,208
   
50,636
   
1.09
%
  
25,353
   
25,283
   
0.55
%
September 30, 2004
    
4,756,839
   
75,022
   
1.58
%
  
27,438
   
47,584
   
1.01
%
June 30, 2004
    
4,882,505
   
69,751
   
1.43
%
  
36,978
   
32,773
   
0.68
%
March 31, 2004
    
4,922,759
   
91,326
   
1.86
%
  
33,951
   
57,375
   
1.17
%
December 31, 2003
    
5,020,032
   
69,964
   
1.39
%
  
39,908
   
30,056
   
0.60
%
September 30, 2003
    
4,871,756
   
84,583
   
1.74
%
  
37,442
   
47,141
   
0.98
%
June 30, 2003
    
4,875,059
   
80,169
   
1.64
%
  
28,883
   
51,286
   
1.06
%
March 31, 2003
    
4,820,887
   
94,822
   
1.97
%
  
18,662
   
76,160
   
1.58
%
December 31, 2002
    
4,821,634
   
75,308
   
1.56
%
  
17,094
   
58,214
   
1.21
%

Farmer Mac experienced $0.3 million in net recoveries in 2005, compared with $4.5 million in net losses for 2004 and $5.2 million in 2003. Farmer Mac recorded gains on the sale of real estate owned of $0.1 million, $0.5 million and $0.2 million in 2005, 2004 and 2003, respectively. During 2005 and 2004, Farmer Mac recovered approximately $0.1 million and $2.8 million, respectively, from sellers (one of which was Zions First National Bank, a related party, as described in Note 3 to the consolidated financial statements) for breaches of representations and warranties associated with prior sales of agricultural mortgage loans to Farmer Mac, which amounts Farmer Mac had previously charged off as losses on the associated loans, consistent with its policy on accounting for claims for breaches of representations and warranties. As these payments are received from sellers rather than borrowers, these recoveries are reported as income and are not reflected as recoveries in the net losses charged against the allowance for losses.


As of December 31, 2005, approximately $1.3 billion (29 percent) of Farmer Mac’s portfolio of post-1996 Act Farmer Mac I loans and loans underlying LTSPCs and Farmer Mac Guaranteed Securities were in their peak default years (approximately years three through five after origination), compared to $1.4 billion (31 percent) as of December 31, 2004 and $1.7 billion (34 percent) as of December 31, 2003. Notwithstanding the recent historical trends in delinquency rates and the overall agricultural economy, during 2006, the level of 90-day delinquencies could increase and higher charge-offs could follow.

Outlook for 2006. USDA’s most recent publications (as available on USDA’s website as of March 16, 2006) forecast:
 
 
·
2006 net cash farm income to be $64.8 billion, following record years of $82.8 billion in 2005 and $85.5 billion in 2004.
 
·
2006 net farm income to be $56.2 billion, which is a decrease of $16.4 billion from 2005 but still slightly above the 10-year average net farm income of $55.7 billion.
 
·
Total direct U.S. government payments to be $18.5 billion in 2006, down from the forecast of $23.0 billion for 2005, but still higher than the estimate of $13.3 billion for 2004. Direct payment rates are fixed in legislation and are not affected by the level of program crop prices.
 
·
Countercyclical payments are forecast to increase from $4.1 billion in 2005 to $5.3 billion in 2006.
 
·
Marketing loan benefits are projected to be down to $4.1 billion in 2006 from $6.2 billion in 2005.
 
·
The value of U.S. farm real estate to increase 6.5 percent in 2006 to $1.4 trillion, as compared to the 2005 increase of 6.8 percent, and the general economy to improve and so support further growth in farmland values.
 
·
The amount of farm real estate debt to increase by 3.1 percent in 2006 to $122.9 billion, compared to $119.2 billion in 2005.

The USDA forecasts referenced above relate to U.S. agriculture generally, but should be favorable for Farmer Mac’s financial condition relative to its exposure to outstanding guarantees and commitments, as they indicate strong borrower cash flows, and generally increased values in U.S. farm real estate.

While Farmer Mac’s business volume in 2005 was somewhat greater than in 2004, Farmer Mac’s new business with agricultural mortgage lenders continues to be constrained by:
 
 
·
high levels of available capital and liquidity of agricultural lenders;
 
·
alternative sources of funding and credit enhancement for agricultural lenders;
 
·
increased competition in the secondary market for agricultural mortgage loans;
 
·
reduced growth rates in the agricultural mortgage market, due largely to the strong liquidity of many farmers and ranchers; and
 
·
the lower rate of growth of the Farm Credit System mortgage portfolio, reducing the demand for LTSPCs.


As a matter of historical practice, many financial institutions have preferred to retain agricultural mortgage loans in their portfolios rather than sell the loans into the secondary market. That preference persists notwithstanding the corporate finance and capital planning benefits these institutions might otherwise realize through participation in Farmer Mac’s programs, such as greater liquidity, greater lending capacity, increased return on equity, and decreased capital requirements. In recent years, the preference to retain loans has been reinforced by the stronger capital and liquidity positions of agricultural lenders, combined with their willingness to accept greater asset and liability mismatch in light of the typically significant differential between lower, short-term interest rates and higher, long-term rates. Those stronger capital and liquidity positions, in turn, have increased competition in the origination, funding and acquisition (for investment) of the limited supply of new agricultural real estate mortgage lending opportunities. Limited supply and increased demand by FCS institutions, insurance companies, commercial banks and other financial institutions for agricultural mortgage loans have narrowed the investment returns on those loans, as has the ability of some lending institutions to subsidize, in effect, their agricultural mortgage loan rates through low-return use of equity. These conditions have limited the need for many agricultural lenders to obtain the benefits of Farmer Mac’s programs. Farmer Mac expects these conditions to continue through at least 2006. See “—Business Volume.”

Farmer Mac faces significant challenges in its efforts to regain its past growth rates in annual business volume. Outstanding Farmer Mac program volume as of December 31, 2005 was $5.3 billion, which represented 11 percent of management’s estimate of a $48.0 billion market of eligible agricultural mortgage loans. As part of its efforts to capture a greater share of the market, Farmer Mac is proceeding with its alliances with AgStar Financial Services, ACA, a related party FCS institution, and with the American Bankers Association. Farmer Mac envisions additional longer-term opportunities that could lead to expanded growth in business volume as a result of the Corporation’s marketing efforts. Further, Farmer Mac believes that prospects for larger portfolio transactions similar to those that have accounted for a significant portion of growth in the current and prior years continue to exist, but, in light of market conditions, no assurance can be given at this time as to the certainty or timing of such transactions.

While Farmer Mac will continue to market actively its existing secondary market products, it also must address the constraints of the existing business environment, consistent with its charter and purposes. Farmer Mac continues to develop and implement innovative means of serving the financing needs of rural America, and remains confident of opportunities for increased business volume and income growth. Those opportunities, which are a result of the Corporation’s product development, marketing and customer service efforts, are exemplified by the alliance Farmer Mac formed with the American Bankers Association and launched in the fall of 2005; that alliance includes unique product pricing and services with potential for future business generation. Farmer Mac has diversified its marketing focus to include large program transactions that emphasize high asset quality, with greater protection against adverse credit performance and commensurately lower compensation for the assumption of credit risk and administrative costs, resulting in marginal returns on equity equal to or better than the current net return on equity. In January 2006, as a result of those efforts, Farmer Mac guaranteed $500.0 million principal amount of AgVantage securities supported by a five-year mortgage-backed obligation of Metropolitan Life Insurance Company that is backed by eligible agricultural mortgage loans. Management expects these business opportunities to enhance Farmer Mac’s mission accomplishment and net income.


Farmer Mac continues to actively evaluate new loan programs intended to provide for new, diversified business opportunities. In that regard, the Board and management are pursuing initiatives that include agribusiness; federal and state agricultural finance programs; new arrangements to encourage agricultural mortgage sales by banks; and rural development associated with agriculture. Some of the agribusiness and rural development initiatives will require Farmer Mac to consider credit risks that expand upon or differ from those the Corporation has accepted previously. Farmer Mac will use underwriting standards appropriate to those credit risks, and will draw as necessary upon outside expertise to analyze and evaluate the credit and funding aspects of loans submitted pursuant to those initiatives. While Farmer Mac is seeking actively to expand its mix of loan types within the scope of its Congressional charter, investors are cautioned that it is too early to assess the probability of success of these efforts.

While developing its business prospects, Farmer Mac has continued to validate and enhance its risk management practices, internal controls, accounting and financial reporting as a result of ongoing corporate diligence and a number of regulatory considerations, including the Sarbanes-Oxley Act of 2002 and FCA requirements, as well as the general regulatory environment for GSEs.

A detailed presentation of Farmer Mac’s financial results for the years ended December 31, 2005, 2004 and 2003 follows.

Net Interest Income. Net interest income was $50.6 million for 2005, $67.4 million for 2004 and $78.8 million for 2003. The net interest yield was 131 basis points for the year ended December 31, 2005, compared to 175 basis points for the year ended December 31, 2004 and 196 basis points for the year ended December 31, 2003. Net interest income includes guarantee fees for loans purchased after April 1, 2001 (the effective date of Statement of Financial Accounting Standards No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities (“SFAS 140”)), but not for loans purchased prior to that date. The effect of SFAS 140 was a reclassification of approximately $3.7 million (10 basis points) of guarantee fee income as interest income for the year ended December 31, 2005, compared to $4.1 million (10 basis points) for the year ended December 31, 2004 and $4.4 million (11 basis points) for the year ended December 31, 2003.

As discussed in Note 6 and Note 15 to the consolidated financial statements, Farmer Mac accounts for its financial derivatives as undesignated financial derivatives. Accordingly, the Corporation classifies the net interest income and expense realized on financial derivatives as gains and losses on financial derivatives and trading assets. For the years ended December 31, 2005, 2004 and 2003, this classification resulted in a decrease to the net interest yield of 43 basis points, 84 basis points, and 104 basis points, respectively.

The net interest yields for the years ended December 31, 2005, 2004 and 2003 included the benefits of yield maintenance payments of 12 basis points, 13 basis points and 12 basis points, 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 should not be considered indicative of positive or negative trends to gauge future financial results. For the years ended December 31, 2005, 2004 and 2003, the after-tax effects of yield maintenance payments on net income and diluted earnings per share were $3.1 million or $0.27 per diluted share, $3.4 million or $0.28 per diluted share and $3.0 million or $0.25 per diluted share, respectively.


The following table provides information regarding interest-earning assets and funding for the years ended December 31, 2005, 2004 and 2003. The balance of non-accruing loans is included in the average balance of interest-earning loans presented, though no related income is included in the income figures presented. Therefore, as the balance of non-accruing loans increases or decreases, the net interest yield will decrease or increase accordingly. Net interest income and the yield will also fluctuate due to the uncertainty of the timing and size of yield maintenance payments. The average rate earned on cash and cash equivalents reflects the increase in the level of short-term interest rates in 2005 and 2004, compared to 2003, and an increase in short-term market rates in 2005 compared to 2004. The increase in the average rate for investments reflects the floating rate nature of most investments acquired and outstanding during 2005. The higher average rate on loans and Farmer Mac Guaranteed Securities reflects the reset of adjustable-rate mortgages to higher rates and the acquisition of new higher-yielding loans. The higher 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 upward trend in the average rate on notes payable due after one year reflects the issuance of new debt at higher market rates during 2005.

   
2005
  
2004
  
2003
  
   
Average
Balance
  
Income/
Expense
  
Average
Rate
  
Average
 Balance
  
Income/
Expense
  
Average
Rate
  
Average
Balance
  
Income/
Expense
  
Average
Rate
  
   
(dollars in thousands)
  
Interest-earning assets:
                                      
Cash and cash equivalents
  
$
483,966
  
$
15,746
    
3.25
%
$
600,964
  
$
8,429
    
1.40
%
$
677,075
  
$
8,173
    
1.21
%
Investments
    
1,269,769
    
54,668
    
4.31
%
  
973,230
    
27,957
    
2.87
%
  
932,738
    
27,114
    
2.91
%
Loans and Farmer Mac
                                                        
Guaranteed Securities
    
2,120,508
    
122,158
    
5.76
%
  
2,274,046
    
126,515
    
5.56
%
  
2,415,466
    
139,644
    
5.78
%
Total interest-earning assets
  
$
3,874,243
    
192,572
    
4.97
%
$
3,848,240
    
162,901
    
4.23
%
$
4,025,279
    
174,931
    
4.35
%
                                                         
Funding:
                                                        
Notes payable due within one year
  
$
1,920,390
    
61,939
    
3.23
%
$
2,050,934
    
27,708
    
1.35
%
$
2,702,188
    
32,648
    
1.21
%
Notes payable due after one year
    
1,750,436
    
79,998
    
4.57
%
  
1,609,236
    
67,841
    
4.22
%
  
1,188,124
    
63,481
    
5.34
%
Total interest-bearing liabilities
    
3,670,826
    
141,937
    
3.87
%
  
3,660,170
    
95,549
    
2.61
%
  
3,890,312
    
96,129
    
2.47
%
Net non-interest-bearing funding
    
203,417
    
-
    
0.00
%
  
188,070
    
-
    
0.00
%
  
134,967
    
-
    
0.00
%
Total funding
  
$
3,874,243
    
141,937
    
3.66
%
$
3,848,240
    
95,549
    
2.48
%
$
4,025,279
    
96,129
    
2.39
%
Net interest income/ yield
        
$
50,635
    
1.31
%
      
$
67,352
    
1.75
%
      
$
78,802
    
1.96
%

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 increases in income due to changes in rate reflect the reset of variable-rate investments and adjustable-rate mortgages to higher rates and the acquisition of new higher-yielding investments, loans and Farmer Mac Guaranteed Securities, as described above. The increases in expense reflect the increased cost of short-term or floating rate funding due to the increase in short-term interest rates.


   
2005 vs. 2004
  
2004 vs. 2003
  
   
Increase (Decrease) Due to
  
Increase (Decrease) Due to
  
   
Rate
  
Volume
  
Total
  
Rate
  
Volume
  
Total
  
   
(in thousands)
  
Income from interest-earning assets:
                                      
Cash and cash equivalents
  
$
9,237
  
$
(1,919
)
$
7,318
  
$
1,236
  
$
(980
)
$
256
  
Investments
    
16,582
   
10,129
   
26,711
   
(324
)
  
1,166
   
842
 
Loans and Farmer Mac Guaranteed Securities
    
4,384
   
(8,742
)
  
(4,358
)
  
(5,140
)
  
(7,988
)
  
(13,128
)
Total 
    
30,203
   
(532
)
  
29,671
   
(4,228
)
  
(7,802
)
  
(12,030
)
                                       
Expense from interest-bearing liabilities
    
46,109
   
279
   
46,388
   
3,882
   
(4,462
)
  
(580
)
Change in net interest income
  
$
(15,906
)
$
(811
)
$
(16,717
)
$
(8,110
)
$
(3,340
)
$
(11,450
)
 
Guarantee and Commitment Fees. Guarantee and commitment fee income, which compensate Farmer Mac for assuming the credit risk on loans underlying Farmer Mac Guaranteed Securities and LTSPCs, was $19.6 million for 2005, compared to $21.0 million for 2004 and $20.7 million for 2003. The decrease in guarantee and commitment fee income reflects a decrease in the average balance of outstanding guarantees and LTSPCs. For 2005, 2004 and 2003, respectively, the effects of SFAS 140 classified guarantee fees received of $3.7 million, $4.1 million and $4.4 million as interest income, although management considers that amount to have been earned in consideration for the assumption of credit risk. That portion of the difference or “spread” between the cost of Farmer Mac’s debt funding for loans and the yield on post-1996 Act Farmer Mac I Guaranteed Securities held on its books compensates for credit risk. When a post-1996 Act Farmer Mac I Guaranteed Security is sold to a third party, Farmer Mac continues to receive the guarantee fee component of that spread, which continues to compensate Farmer Mac for its assumption of credit risk. The portion of the spread that compensates for interest rate risk would not typically continue to be received by Farmer Mac if the asset were sold, except to the extent attributable to any retained interest-only strip.

Gains and Losses on Financial Derivatives and Trading Assets. SFAS 133 requires the change in the fair values of financial derivatives to be reflected in a company’s net income or accumulated other comprehensive income. As discussed in Note 6 and Note 15 to the consolidated financial statements, the Corporation accounts for its financial derivatives as undesignated financial derivatives. The net effect of gains and losses on financial derivatives and trading assets recorded in Farmer Mac’s consolidated statements of operations was a net gain of $11.5 million for 2005 and net losses of $14.7 million and $17.7 million for 2004 and 2003, respectively.

Gains on the Sale of Real Estate Owned. Gains on the sale of real estate owned were $0.1 million, $0.5 million and $0.2 million for the years ended December 31, 2005, 2004 and 2003, respectively.

Representation and Warranty Claims Income. During 2005 and 2004, Farmer Mac recovered approximately $0.1 million and $2.8 million, respectively, from sellers (one of which during 2004 was Zions First National Bank, a related party, as described in Note 3 to the consolidated financial statements) for breaches of representations and warranties associated with prior sales of agricultural mortgage loans to Farmer Mac. During 2003, Farmer Mac had no representation and warranty claims income.


Other Income. Other income was $1.9 million for 2005, compared to $1.5 million for 2004 and $0.8 million for 2003. The increases were the result of increases in late fees received.

Expenses. During 2003, 2004 and 2005, Farmer Mac undertook several initiatives to validate and enhance its risk management practices, internal controls and accounting and financial reporting. These initiatives are the result of ongoing corporate diligence and a number of regulatory considerations, including compliance with the Sarbanes-Oxley Act of 2002 and FCA requirements, as well as the heightened focus on the regulatory environment for GSEs generally. The general increases in both compensation and employee benefits and general and administrative expenses from 2003 through 2005 reflect the costs of those initiatives, particularly staffing increases relative to the internal controls function. Compensation and employee benefits were $8.2 million, $7.0 million and $6.1 million for 2005, 2004 and 2003, respectively. General and administrative expenses, including legal, independent audit, and consulting fees, were $9.7 million, $8.8 million and $6.0 million for 2005, 2004 and 2003, respectively. Farmer Mac expects all of the above-mentioned expenses to continue at approximately the same levels through 2006.

Regulatory fees were $2.3 million, $2.1 million and $2.0 million for 2005, 2004 and 2003, respectively. FCA has advised Farmer Mac that its estimated assessment for 2006 is $2.4 million. The regulatory assessments from FCA for each of the examination periods corresponding approximately with each of the years ended December 31, 2005, 2004 and 2003 include both their originally estimated assessments and revisions to those estimates that reflect actual costs incurred. These revisions have resulted in both additional assessments and refunds in the past.

Income Tax Expense. Income tax expense totaled $23.1 million in 2005, compared to $19.8 million in 2004 and $19.8 million in 2003. Farmer Mac’s effective tax rates for 2005, 2004 and 2003 were approximately 31.9 percent, 32.4 percent and 32.5 percent, respectively. For more information about income taxes, see Note 10 to the consolidated financial statements.

Gains and Losses on the Repurchase of Debt. During 2005, Farmer Mac recognized a gain of $0.1 million on the repurchase of $21 million of its outstanding debt. During 2004 and 2003, Farmer Mac did not repurchase any of its outstanding debt.

Effects of SFAS 133. Farmer Mac records financial derivatives at fair value on its balance sheet with the related changes in fair value recognized in the consolidated statement of operations. Although the Corporation’s use of financial derivatives achieves its economic and risk management objectives, its classification of financial derivatives as undesignated hedges under SFAS 133 allows factors unrelated to the economic performance of the Corporation's business, such as changes in interest rates, to increase the volatility - even the direction - of the Corporation's earnings under accounting principles generally accepted in the United States of America (“GAAP”).

Farmer Mac enters into financial derivative transactions to protect against risk from the effects of market price or interest rate movements on the value of assets, future cash flows and debt issuance, not for trading or speculative purposes. Farmer Mac enters into interest rate swap contracts to adjust the characteristics of its short-term debt to match more closely the cash flow and duration characteristics of its longer-term mortgage and other assets, and also to adjust the characteristics of its long-term debt to match more closely the cash flow and duration characteristics of its short-term assets, thereby reducing interest rate risk and also to derive an overall lower effective fixed-rate cost of borrowing than would otherwise be available to Farmer Mac in the conventional debt market. Specifically, interest rate swaps convert economically the variable cash flows related to the forecasted issuance of short-term debt to effectively fixed-rate medium-term and long-term notes that match the anticipated duration, repricing and interest rate characteristics of the corresponding assets. Since this strategy provides Farmer Mac with approximately the same cash flows as those that are inherent in the issuance of medium-term notes, Farmer Mac uses either the bond market or the swap market based upon their relative pricing efficiencies.


Farmer Mac uses callable interest rate swaps (in conjunction with the issuance of short-term debt) as an alternative to callable medium-term notes with equivalently structured maturities and call options. The call options on the swaps are designed to match the implicit prepayment options on those mortgage assets without prepayment protection. The blended durations of the swaps are also designed to match the duration of the related mortgages over their estimated lives. If the mortgages prepay, the swaps can be called and the short-term debt repaid; if the mortgages do not prepay, the swaps remain outstanding and the short-term debt is rolled over, effectively providing fixed-rate callable funding over the lives of the related mortgages. Thus, the economics of the assets are closely matched to the economics of the interest rate swap and funding combination.

Non-GAAP Performance Measures. Farmer Mac reports its financial results in accordance with GAAP. In addition to GAAP measures, Farmer Mac presents certain non-GAAP performance measures. Farmer Mac uses the latter measures to develop financial plans, to gauge corporate performance and to set incentive compensation because, in management’s view, the non-GAAP measures more accurately represent Farmer Mac’s economic performance, transaction economics and business trends. Investors and the investment analyst community have previously relied upon similar measures to evaluate Farmer Mac’s historical and future performance. Farmer Mac’s disclosure of non-GAAP measures is not intended to replace GAAP information but, rather, to supplement it.

Farmer Mac developed non-GAAP core earnings to present net income less the after-tax effects of SFAS 133. Core earnings for the years ended December 31, 2005, 2004 and 2003 were $28.7 million, $27.4 million and $23.0 million, respectively. The reconciliation of GAAP net income available to common stockholders to core earnings is presented in the following table:
Reconciliation of GAAP Net Income Available
to Common Stockholders to Core Earnings
  
   
   
For the Year Ended December 31,
  
   
2005
  
2004
  
2003
  
   
(in thousands)
  
               
GAAP net income available to common stockholders
  
$
47,032
  
$
39,000
  
$
39,031
  
                     
Less the effects of SFAS 133:
                    
Unrealized gains/(losses) on financial derivatives and
   
16,730
    
13,241
    
18,009
  
Net effects of settlements on agency forward contracts, net of tax
    
1,597
    
(1,653
)
  
(1,971
)
                     
Core earnings
  
$
28,705
  
$
27,412
  
$
22,993
  


Business Volume. Loans are brought into the Farmer Mac I and Farmer Mac II programs as follows:
 
 
·
Farmer Mac purchases eligible loans and guarantees timely payments of principal and interest of securities backed by those loans as part of the Farmer Mac I program. Farmer Mac may retain some or all of those securities in its portfolio or sell them to third parties in capital markets transactions.
 
·
Farmer Mac purchases USDA-guaranteed portions and guarantees timely payments of principal and interest of securities backed by those guaranteed portions as part of the Farmer Mac II program. Farmer Mac may retain some or all of those securities in its portfolio or sell them to third parties in capital markets transactions.
 
·
Farmer Mac enters into LTSPCs for eligible loans. Farmer Mac’s commitments through LTSPCs include either newly originated or seasoned eligible loans, and are part of the Farmer Mac I program.
 
·
Farmer Mac exchanges Farmer Mac Guaranteed Securities for eligible loans or USDA-guaranteed portions. Farmer Mac Guaranteed Securities exchanged for USDA-guaranteed portions are part of the Farmer Mac II program; Farmer Mac Guaranteed Securities exchanged for any other eligible loans are part of the Farmer Mac I program.
 
·
Farmer Mac purchases and guarantees mortgage-backed bonds collateralized by eligible mortgage loans, which are referred to as AgVantage securities, a category of Farmer Mac Guaranteed Securities and part of the Farmer Mac I program.

During 2005, the volume of loans purchased or placed under Farmer Mac Guaranteed Securities and LTSPCs totaled $771.7 million, an increase from 2004 volume of $671.0 million. That increase was attributable to an increase of $5.7 million in Farmer Mac I loan volume, an increase of $68.9 million in LTSPC volume, and an increase of $26.1 million in Farmer Mac II volume, compared to 2004 volume levels. During 2004, the volume of loans purchased or placed under Farmer Mac Guaranteed Securities and LTSPCs totaled $671.0 million, a decrease from 2003 volume of $1.2 billion. That decrease was attributable to a decrease of $88.2 million in Farmer Mac I loan volume, a decrease of $370.8 million in LTSPC volume, and a decrease of $97.2 million in Farmer Mac II volume, compared to 2004 volume levels. See “Business—Farmer Mac Programs—Farmer Mac I—Off-Balance Sheet Guarantees and Commitments” and Note 12 to the consolidated financial statements for a description of LTSPCs. The following table sets forth information regarding the volume of loans purchased or placed under Farmer Mac Guaranteed Securities or LTSPCs for the periods indicated:

Farmer Mac Loan Purchases, Guarantees and LTSPCs