Unless stated otherwise, references to "we," "our," or "us" relate to the consolidation of National Rural Utilities Cooperative Finance Corporation ("National Rural"), Rural Telephone Finance Cooperative ("RTFC"), National Cooperative Services Corporation ("NCSC") and certain entities created and controlled by National Rural to hold foreclosed assets and accommodate loan securitization transactions. The following discussion and analysis is designed to provide a better understanding of our consolidated financial condition and results of operations and as such should be read in conjunction with the consolidated financial statements, including the notes thereto. We refer to our financial measures that are not in accordance with generally accepted accounting principles ("GAAP") as "adjusted" throughout this document. See Non-GAAP Financial Measures for further explanation of why the non-GAAP measures are useful and for a reconciliation to GAAP amounts.

This Form 10-Q contains forward-looking statements within the meaning of the Securities Act of 1933, as amended, and the Exchange Act of 1934, as amended. Forward-looking statements, which are based on certain assumptions and describe our future plans, strategies and expectations, are generally identified by our use of words such as "intend," "plan," "may," "should," "will," "project," "estimate," "anticipate," "believe," "expect," "continue," "potential," "opportunity," and similar expressions, whether in the negative or affirmative. All statements that address expectations or projections about the future, including statements about loan growth, the adequacy of the loan loss allowance, net income growth, leverage and debt to equity ratios, and borrower financial performance are forward-looking statements. Although we believe that the expectations reflected in our forward-looking statements are based on reasonable assumptions, actual results and performance could differ materially from those set forth in the forward-looking statements. Factors that could cause future results to vary from current expectations include, but are not limited to, general economic conditions, legislative changes, governmental monetary and fiscal policies, changes in tax policies, changes in interest rates, demand for our loan products, changes in the quality or composition of our loan and investment portfolios, changes in accounting principles, policies or guidelines, and other economic and governmental factors affecting our operations. Some of these and other factors are discussed in our annual and quarterly reports previously filed with the Securities and Exchange Commission ("SEC"). Except as required by law, we undertake no obligation to update or publicly release any revisions to forward-looking statements to reflect events, circumstances or changes in expectations after the date on which the statement is made.

The following discussion and analysis is designed to provide a better understanding of our consolidated financial condition and results of operations and as such should be read in conjunction with the consolidated financial statements, including the notes thereto and the information contained elsewhere in this Form 10-Q, in addition to Part I, Item 1A. Risk Factors in our Form 10-K for the year ended May 31, 2009.

Business Overview

National Rural was formed in 1969 by rural electric cooperatives to provide a source of financing to supplement the loan programs of the Rural Utilities Service ("RUS"). National Rural is organized as a cooperative and is a tax-exempt entity under Section 501(c)(4) of the Internal Revenue Code.

RTFC is a private cooperative association created to provide and/or arrange financing for its rural telecommunications members and their affiliates. RTFC is a taxable cooperative that pays income tax based on its net income, excluding net income allocated to its members, as allowed by law under Subchapter T of the Internal Revenue Code. NCSC also is a private cooperative association. The principal purpose of NCSC is to provide financing to the for-profit or non-profit entities that are owned, operated or controlled by or provide substantial benefit to, members of National Rural. NCSC is a taxable corporation.

Our primary objective as a cooperative is to provide financial products to our rural electric and telecommunications members at a low cost while maintaining sound financial results required for investment grade credit ratings on our debt instruments. Our goal is not to maximize profit on loans to members, but to balance charging our members low rates on loans and maintaining the financial performance required to access the capital markets on behalf of our members. Therefore, the rates we charge our borrowers reflect our funding costs plus a spread to cover our operating expenses and a provision for loan losses and to provide earnings sufficient to preserve interest coverage to meet our financial objectives.

We obtain funding from the capital markets, private placements of debt and our members. We enter the capital markets, based on the combined strength of our members, to borrow the funds to fulfill our members' financing requirements. We regularly obtain funding in the capital markets by issuing:
· fixed-rate or variable-rate secured collateral trust bonds;

· fixed-rate or variable-rate unsecured medium-term notes including retail notes;

· commercial paper;

· bank bid note agreements; and

· fixed-rate subordinated deferrable debt.

We issue fixed-rate and variable-rate debt to private funding sources. We also obtain debt financing from our members and other qualified investors through the direct sale of our commercial paper, daily liquidity fund and unsecured medium-term notes.

As a condition of membership, rural electric cooperatives have generally been required to purchase membership subordinated certificates from us. Members are sometimes required to make an additional investment in us by purchasing loan or guarantee subordinated certificates as a condition for obtaining long-term loans or guarantees. Requirements for the purchase of such equity certificates depend upon several factors, including but not limited to the borrower's debt to equity ratio with us, the relative size of the credit facility, and the relative risk of the transaction. The membership subordinated certificates and the loan and guarantee subordinated certificates are unsecured and subordinate to our senior debt. During the 2009 fiscal year, we began offering member capital securities to our voting members. These securities represent members' voluntary investments in us. Effective June 1, 2009, member capital securities may be purchased by members in an amount we determine to meet their capital contribution requirements as a condition of obtaining additional credit facilities from us.

National Rural is required by District of Columbia cooperative law to have a mechanism to allocate our net income to our members. We allocate our net income, excluding the non-cash effects of the accounting for derivative financial instruments and foreign currency translation, annually to a cooperative educational fund, a members' capital reserve and to members based on each member's patronage of our loan programs during the year. RTFC annually allocates its net income to a cooperative educational fund and to its members based on each member's patronage of its loan programs during the year. NCSC does not allocate its net income to its members, but does allocate a portion of its margins to a cooperative educational fund.

Our performance is closely tied to the performance of our member rural electric and telecommunications systems due to the near 100 percent concentration of our loan and guarantee portfolio in those industries.

Financial Overview

In this section, we analyze our results of operations, financial condition, liquidity and market risk. We also analyze trends and significant transactions completed in the periods covered by this Form 10-Q.

Results of Operations
We use a times interest earned ratio ("TIER") instead of the dollar amount of net interest income or net income as our primary performance indicator, since net income can fluctuate as total loans outstanding and/or interest rates change. TIER is a measure of our ability to cover the interest expense on our debt obligations. TIER is calculated by dividing the sum of interest expense and the net income prior to the cumulative effect of change in accounting principle by the interest expense. Adjusted net income is calculated by excluding the effect of derivatives. Due to the adoption of new accounting guidance regarding noncontrolling interests on June 1, 2009, minority interest net income is included in total net income in the consolidated income statement. As a result, it is not necessary to adjust net income to include minority interest net income as it was in prior periods. As required, we have reflected changes in presentation and disclosure of noncontrolling interest in our consolidated financial statements for all periods presented in this Form 10-Q, including the adjusted net income and adjusted TIER calculations for the three months ended August 31, 2008. Adjusted TIER is calculated by using adjusted net income and including all derivative cash settlements in interest expense. See Non-GAAP Financial Measures for more information on the adjustments we make to our financial results for our own analysis and covenant compliance.

For the three months ended August 31, 2009, we reported net income of $16 million, which resulted in a TIER calculation of 1.07 compared to net income of $13 million and TIER of 1.06 for the prior-year period. For the three months ended August 31, 2009, we reported an adjusted net income of $27 million with an adjusted TIER of 1.11, compared with an adjusted net income of $24 million and adjusted TIER of 1.11 for the prior-year period. The $3 million increase in net income for the three months ended August 31, 2009 compared with the prior-year period was primarily due to the $27 million increase in the recovery for loan losses which was partly offset by the $16 million decrease in net interest income and the $4 million decrease in derivative cash settlements.

Interest income of $269 million for the three months ended August 31, 2009 increased 2 percent compared with the prior-year period. During the three months ended August 31, 2009, there was an increase of $1 billion or 5 percent to the average balance of loans outstanding which was largely offset by a 14 basis point decline in the weighted-average yield earned on the loan portfolio as compared with the prior-year period. The decline in the yield earned on the loan portfolio was the result of the lower interest rates earned on variable-rate loans.

Our interest expense increased by $22 million or 10 percent for the three months ended August 31, 2009 as compared with the prior-year period primarily due to the additional interest incurred due to prefunding of debt maturities, including $1,250 million in late August 2009. The prefunding of debt and the 5 percent increase in average loans outstanding resulted in an

8 percent increase in average debt outstanding for the three months ended August 31, 2009 compared with the prior year period. The increase in debt volume came primarily from notes issued to Federal Agricultural Mortgage Corporation ("Farmer Mac"), retail notes and member capital securities. Additionally, a 7 basis point increase in the weighted average cost of debt resulted from a shift from commercial paper funding to higher-cost term debt and member capital securities, as well as higher interest rates on our collateral trust bonds issued in October 2008. These factors were partly offset by lower interest rates on our variable-rate debt and commercial paper funding.

Our adjusted interest expense, which includes derivative cash settlements in interest expense, increased by $26 million for the three months ended August 31, 2009 compared to the prior-year period. In addition to the factors above, the increase in the adjusted interest expense was largely due to the $4 million decrease in cash settlements for the quarter ended August 31, 2009 from the prior-year period resulting from lower short-term interest rates on the receive leg of pay fixed-receive variable swaps during the quarter ended August 31, 2009 compared with the prior-year period.

During the quarter ended August 31, 2009, there was a loan loss recovery of $16 million compared to a provision of $11 million in the prior-year period. The recovery of loan losses during the three months ended August 31, 2009 was primarily due to payments received on impaired loans and the net decrease in our variable interest rates from May 31, 2009 to August 31, 2009. The remaining decrease in the loan loss allowance for the three months ended August 31, 2009 was primarily due to decreases in the outstanding balance and the weighted average maturity of loans in the general portfolio.

The loan loss provision is affected by changes in the calculated impairment on our impaired loans due to changes in interest rates. The impairment amount for certain loans is calculated by discounting future expected cash flows using the original contract interest rate on the loan, a portion of which is based on our variable interest rates. Changes to our variable interest rates are based on the underlying cost of funding, competition and other factors. Based on the current balance of impaired loans at August 31, 2009, an increase or decrease of 25 basis points to our short-term and long-term variable interest rates results in an increase or decrease of approximately $9 million, respectively, to the calculated impairment on loans irrespective of a change in the credit fundamentals of the impaired borrower.

Financial Condition
At August 31, 2009, total loans outstanding remained relatively flat as compared with May 31, 2009 due to a $105 million decrease in electric loans and a $13 million decrease in NCSC loans mostly offset by a $56 million increase in RTFC loans. See further discussion of our loan portfolio in Financial Condition, Loan and Guarantee Portfolio Assessment. We expect loan growth to remain relatively stable during fiscal year 2010.

New loan advances have continued to substantially offset loan amortization and maturities despite the slowdown in the economy. The current economic conditions reduced the competition for power supply loans from investment and commercial banks. In addition, there is currently a need for utilities to improve their infrastructure, including base load generation, transmission and distribution plants, a significant portion of which is typically financed with borrowed capital.

The current difficult economic conditions have not resulted in a rise in delinquencies or defaults in our members' receivables. Calendar year 2008 data from member systems shows no increase in late payments or write-offs for the year ended December 31, 2008 compared to the prior calendar year. The majority of the cooperatives' customers are residential, and electricity is considered an essential service, so we continue to believe the impact of the recession on collections will likely be moderate.

Total debt outstanding decreased by $133 million at August 31, 2009 as compared with May 31, 2009 due to the following debt maturities or paydowns:
· Approximately $1,669 million of medium-term notes matured; and

· $200 million term loan was paid off early.

These decreases were mostly offset by the following increases to debt outstanding:
· $918 million to commercial paper and the daily liquidity fund;

· $625 million in fixed-rate notes to Farmer Mac with maturities through August 2014;

· $165 million of various member and dealer medium-term notes including retail notes; and

· $59 million of member capital securities.

In September 2009, we issued $250 million of 2.625 percent collateral trust bonds due 2012 and $250 million of 3.875 percent collateral trust bonds due 2015.

Total equity decreased $26 million from May 31, 2009 to August 31, 2009 primarily due to the board authorized patronage capital retirement totaling $41 million partly offset by net income of $16 million for the three months ended August 31, 2009. The patronage capital retirement was returned to members in cash at the end of September 2009. Total equity fluctuates based on the changes in earnings which are significantly affected by changes in the fair value of our derivative instruments. The fair values of these derivative instruments are sensitive to changes in interest rates. As a result, it is difficult to predict the future changes in equity due to the uncertainty of the movement in future interest rates. In our internal analysis and for covenant compliance under our credit agreements, we adjust equity to exclude the non-cash effects of the accounting for derivative financial instruments and foreign currency translation.

Liquidity
Our primary sources of liquidity include:
· scheduled member loan principal prepayments and repayments and the interest on those loans;

· member investments (member commercial paper, the daily liquidity fund, member medium-term notes and member capital securities);

· revolving bank line facilities;

· capital market debt issuances (dealer commercial paper, collateral trust bonds, medium-term notes and retail notes); and

· private debt issuances (Farmer Mac and Rural Economic Development Loan and Grant ("REDLG")).

Our primary uses of liquidity include:
· principal repayments and interest on debt;

· loan advances; and

· patronage capital retirements.

We face liquidity risk in refinancing maturing obligations. At August 31, 2009, we had $2,976 million of commercial paper, daily liquidity fund, and bank bid notes scheduled to mature during the next 12 months. Based on past history, we expect to continue to maintain member investments in commercial paper and the daily liquidity fund at approximately the current level of $1,383 million at August 31, 2009. Dealer commercial paper and bank bid notes of $1,567 million and non-member commercial paper of $26 million at August 31, 2009 were reduced by the $500 million issuance of collateral trust bonds in September 2009. We currently believe that we have the market access to maintain dealer commercial paper and bank bid notes at approximately $1 billion to $1.5 billion.

At August 31, 2009, we had $3 billion in available lines of credit with financial institutions. These revolving credit agreements provide backup liquidity for 100% of our dealer and member commercial paper. We expect to be in compliance with the covenants under our revolving credit agreements, therefore we can maintain a commercial paper balance up to $3 billion in order to meet maturing debt obligations. Additionally, we could draw on these facilities to repay any amount of dealer or member commercial paper that cannot be rolled over in the event of market disruptions.

We also have access to the Commercial Paper Funding Facility ("CPFF") created by the Federal Reserve Board to provide liquidity to highly-rated U.S. issuers of commercial paper through February 2010, where we have the capacity to issue a maximum of $3 billion of commercial paper. At this time, there is no intention to make use of the more expensive funding through the CPFF since there is sufficient demand in the dealer and member commercial paper markets.

At August 31, 2009, we had long-term debt maturing in the next 12 months totaling $1,482 million. This amount includes $268 million of medium-term notes sold through dealers (including retail notes), $412 million of medium-term notes sold to members, $610 million of collateral trust bonds, $188 million of secured notes payable and $4 million of unsecured notes payable. Based on past history, we expect to maintain the level of member and dealer investments in medium-term notes within a range of the current outstanding balance. We have experienced a significant increase in demand for our retail notes since January 2009 and expect that we should be able to maintain our total retail note balance at least at the current level. The total balance of retail notes outstanding has increased $804 million over the past 12 months to $1,055 million at August 31, 2009. We expect to refinance the remaining $802 million of long-term debt maturing in the next 12 months through capital market and private placement issuances, our member capital securities program and our cash on hand at August 31, 2009.

We believe that our $500 million issuance of collateral trust bonds in September 2009 demonstrates that our access to the capital markets remains strong. Secured notes payable scheduled to mature in the next twelve months were issued under revolving credit facilities with Farmer Mac that allow us to borrow, repay and re-borrow funds as market conditions permit. We had $575 million available under revolving note purchase agreements with Farmer Mac at August 31, 2009, subject to market conditions. Our members also continue to support the member capital securities program with the sale of $337 million securities as of August 31, 2009. In addition, we had $527 million of cash on hand to meet our maturing obligations at August 31, 2009.

We face liquidity risk in the funding of our loan portfolio based on member demand for new loans, although we expect loans outstanding to remain relatively stable during fiscal year 2010. We also face liquidity risk in our ability to renew our revolving credit agreements at current commitment levels. Our $1.0 billion 364-day revolving credit agreement matures in March 2010. If we are not able to renew this agreement at the current commitment level, it would reduce the amount of commercial paper funding we could obtain in the future.

At August 31, 2009, we believe that our sources of liquidity are adequate to cover our expected uses of liquidity.

Results of Operations

Three months ended August 31, 2009 versus August 31, 2008 results
The following table presents the results of operations for the three months
ended August 31, 2009 and 2008.

                                     August 31,      August 31,          Increase
(dollar amounts in thousands)           2009            2008            (Decrease)
Interest income                    $    269,457    $    263,117     $          6,340
Interest expense                       (242,629 )      (220,149 )            (22,480 )
   Net interest income                   26,828          42,968              (16,140 )
Recovery of (provision for) loan                                )             26,852
losses                                   16,171         (10,681
Net interest income after                                                     10,712
recovery of (provision for) loan
losses                                   42,999          32,287

Non-interest income:
   Fee and other income                   3,734           3,582                  152
   Derivative cash settlements           (3,494 )           431               (3,925 )
   Results of operations of                                                     (659 )
foreclosed assets                           587           1,246
      Total non-interest income             827           5,259               (4,432 )

Non-interest (expense) income:
   Salaries and employee                        )               )                (67 )
benefits                                 (9,918          (9,851
   Other general and                            )               )             (2,366 )
administrative expenses                  (7,108          (4,742
   Recovery of guarantee                                                       1,690
liability                                 2,395             705
   Market adjustment on                         )                             (1,750 )
foreclosed assets                        (1,750               -
   Derivative forward value             (10,834 )       (11,028 )                194
   Other                                   (146 )          (160 )                 14
     Total non-interest expense         (27,361 )       (25,076 )             (2,285 )

Income prior to income taxes             16,465          12,470                3,995

Income tax (expense) benefit                (32 )           760                 (792 )
   Net income                            16,433          13,230                3,203
Less: Net income attributable to                )                             (1,432 )
noncontrolling interest                    (191           1,241
   Net income attributable to      $               $                $          1,771
National Rural                           16,242          14,471

TIER                                       1.07            1.06
Adjusted TIER (1)                          1.11            1.11

(1) Adjusted to exclude the effect of the derivative forward value from net income and to include all derivative cash settlements in the interest expense. See Non-GAAP Financial Measures for further explanation and a reconciliation of these adjustments.

The following tables provide a breakout of the average yield on loans, the average cost on debt and the change to interest income, interest expense and net interest income due to changes in average loan and debt volume versus changes to interest rates summarized by loan and debt type. The following tables also include a breakout of the change to derivative cash settlements due to changes in the average notional amount of our derivative portfolio versus changes to the net difference between the average rate paid and the average rate received. Management calculates an adjusted interest expense, which includes all derivative cash settlements in interest expense. See Non-GAAP Financial Measures for further explanation of the adjustment we make in our financial analysis to include all derivative cash settlements in interest expense.

Average balances and interest rates - Assets

                             Average volume              Interest income              Average yield
(dollar amounts in       August 31,   August 31,     August 31,   August 31,     August 31,    August 31,
thousands)                  2009         2008           2009         2008           2009          2008

Long-term fixed-rate   $ 15,177,050 $              $            $                      5.84 %        5.85 %
loans (1)                             15,211,835        223,526      224,402
Long-term variable-rate   2,618,435                                                    4.03          3.52
loans (1)                              1,710,832         26,565       15,180
Short-term loans (1)      1,897,878    1,750,335         16,035       19,504           3.35          4.42
Non-performing loans        523,759      498,414              -            -              -             -
  Total loans            20,217,122   19,171,416        266,126      259,086           5.22          5.36
Investments                 984,400      503,871                                       0.67          1.72
(2)                                                       1,657        2,181
Fee income                        -            -          1,674        1,850              -             -
  Total                $ 21,201,522 $ 19,675,287   $    269,457 $    263,117           5.04 %        5.31 %

(1) Interest income on loans to members.
(2) Interest income on the investment of excess cash, preferred stock and trading securities.

Average balances and interest rates - Liabilities

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