FARM CREDIT SERVICES SOUTHWEST

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2 FARM CREDIT SERVICES SOUTHWEST 2014 Annual Report Table of Contents Chairman and President s Letter 1 Five Year Summary of Selected Financial Data 3 Management s Discussion and Analysis of Financial Condition and Results of Operations 5 Report of Management 35 Audit Committee Report 36 Report on Internal Control over Financial Reporting Independent Auditor s Report Consolidated Statements of Condition 39 Consolidated Statements of Comprehensive Income 40 Consolidated Statements of Changes in Members Equity 41 Consolidated Statements of Cash Flows 42 Notes to Consolidated Financial Statements 44 FCA Required Disclosures 82

3 FARM CREDIT SERVICES SOUTHWEST TO OUR STOCKHOLDERS For Farm Credit Services Southwest (FCSSW), 2014 was an exceptionally challenging year. As you will see in this year s annual report, we experienced a significant loss over several years resulting from the delinquency of certain identifiable loans in our loan portfolio. The financial statements in this 2014 annual report have been restated to reflect the losses in accordance with generally accepted accounting principles. The cumulative losses resulting from these identifiable loans totaled $49.7 million and are recognized beginning in 2009 through These losses depleted our total members equity by about 25%, but fortunately FCSSW had built adequate capital to absorb the losses and we continue to exceed regulatory capital requirements in all years. We have also maintained borrowing base requirements and other key elements of our general financing agreement with CoBank, our funding bank, that allow us to continue to have access to low-cost funding to support our borrowers needs. The Board and management became suspicious of increasing delinquencies and losses during the third quarter of We contacted our regulator, the Farm Credit Administration (FCA), established a special investigative committee of the Board to work with FCA and contracted with an experienced third party to investigate the cause of the losses. We have been operating under supervisory letters issued by FCA since that time. The Board also contracted with an independent third party to thoroughly review our processes and internal controls. Based on the recommendations developed from that review and the special investigation, we have strengthened our internal controls and accountability to provide additional security to FCSSW and our customers. These actions should be relatively transparent to our customers. We continue to focus on providing flexible loan products with competitive interest rates to our customers. Our knowledgeable staff remains committed to providing superior service to you and will continue to work even harder to earn your trust and loyalty. After evaluating strategic alternatives and considering many factors, including the events of 2014 described above, our efforts to comply with the supervisory letters and the volatility that agriculture in our region has experienced over the past years, in January 2015 your Board ultimately decided to enter into a letter of intent to merge with Farm Credit West (FCW). Additionally, in connection with the merger process, we executed a joint management agreement with FCW in February 2015 where Mark Littlefield, FCW s President/CEO, also became the President/CEO for FCSSW. In April 2015, a definitive plan of merger was executed with FCW. FCW is a large association with assets totaling $7.5 billion at year-end 2014 and a territory spanning much of California and a portion of Nevada. The Board considered FCW s diversity, financial strength and historic robust patronage program, among other factors, when entering into the letter of intent to merge. Together we believe that the merger will maximize the long-term best interests of all members in the combined territory to be served by FCW following the merger. Furthermore, your Board believes that FCSSW members will have the opportunity to resume receiving patronage payments sooner following the merger than might otherwise be possible without the merger with FCW. On behalf of the FCSSW Board, I can assure you that we are a strong organization and we remain committed to looking for ways to better serve our members now and long into the future. 1

4 We believe that a merger with FCW will present enhanced opportunities and financial strength for the benefit of our members. You will receive detailed information later this year regarding the merger and the special meeting to vote upon the definitive plan of merger. Thank you for your continued confidence and for being a member of Farm Credit Services Southwest. Sincerely, John O. Grizzle Chairman of the Board Mark D. Littlefield President and CEO July 29,

5 FARM CREDIT SERVICES SOUTHWEST FIVE-YEAR SUMMARY OF SELECTED FINANCIAL DATA ($ In thousands) Balance Sheet As As Restated Restated Unaudited 2011 As Restated Unaudited 2010 As Restated Loans $994,342 $950,888 $962,781 $921,199 $975,280 Allowance for loan losses (14,828) (8,296) (6,645) (9,095) (7,185) Net loans 979, , , , ,095 Other property owned 1,130 1, ,197 Accrued interest receivable 6,954 8,605 8,985 9,332 10,358 Cash 632 3,927 12,039 Investment in the bank 41,002 40,604 40,315 40,009 28,607 Other assets 21,610 20,458 17,136 12,446 6,465 Total assets $1,049,080 $1,014,021 $1,023,702 $978,124 $1,026,761 Obligations with maturity of one year or less $183,627 $238,223 $286,805 $233,248 $245,412 Obligations with maturity longer than one year 721, , , , ,614 Total liabilities 905, , , , ,026 At-risk equity: Capital stock and participation certificates Unallocated retained earnings* 6,320 17,501 24,023 42,798 30,228 Non-qualified allocated retained earnings 137, , ,122 78,709 74,273 Accumulated other comprehensive loss (967) (774) (732) (761) (625) Total members' equity 143, , , , ,735 Total liabilities and members equity $1,049,080 $1,014,021 $1,023,702 $978,124 $1,026,761 Statement of Income Net interest income $23,753 $24,405 $24,202 $26,368 $28,268 Provision for loan losses 5,148 2,431 2,681 13,050 14,675 Tax-free reorganization distribution 13,122 Other expenses, net 13,592 9,217 7,337 4,823 11,102 Income tax provision Net income $5,013 $12,757 $14,184 $21,617 $2,491 Cash patronage refunds payable $4,732 $4,535 $4,611 $2,500 *Beginning Unallocated retained earnings at January 1, 2010 have been reduced by $22.3 million to reflect the impact of restatement losses in years prior to

6 FARM CREDIT SERVICES SOUTHWEST FIVE-YEAR SUMMARY OF SELECTED FINANCIAL DATA (Continued) As As Restated Restated Unaudited 2011 As Restated Unaudited 2010 As Restated Key Financial Ratios Return on average assets 0.50% 1.30% 1.49% 2.27% 0.24% Return on average total members' equity 3.43% 9.39% 11.07% 19.73% 2.34% Net interest income as a percentage of average earning assets 2.61% 2.72% 2.79% 2.97% 2.92% Total members equity as a percentage of total assets 13.73% 13.73% 12.82% 12.43% 10.20% Debt as a ratio to members equity 6.29:1 6.28:1 6.80:1 7.04:1 8.80:1 Net (recoveries) charge-offs as a percentage of average loans (0.15%) 0.09% 0.58% 1.24% 1.42% Allowance for loan losses as a percentage of loans 1.49% 0.87% 0.69% 0.99% 0.74% Permanent capital ratio 13.73% 13.02% 12.34% 12.12% 10.04% Total surplus ratio 13.63% 12.92% 12.23% 12.01% 9.94% Core surplus ratio 12.90% 12.07% 11.44% 10.98% 9.64% 4

7 FARM CREDIT SERVICES SOUTHWEST MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS INTRODUCTION The following discussion summarizes the financial position and results of operations of Farm Credit Services Southwest, ACA (FCSSW or Association) for the year ended December 31, Comparisons to prior years are included. During the third quarter of 2014, Association management noted a sudden significant increase in the level of delinquent loans affecting an identifiable portion of the Association s lending portfolio. An in-depth special investigation identified material weaknesses in internal controls relating to credit origination, administration and servicing procedures. Certain loans were made to ineligible borrowers under the Farm Credit Act and/or were inadequately secured. Since these loans would not have met the Association s underwriting standards or regulatory requirements when originated, they should not have been recognized in the Association s consolidated financial statements. During the special investigation, loans originating over a span of several years were identified as subject to significant risk exposure as described above. Some loans with underlying secured collateral that are generally able to support the related outstanding debt have been classified as nonaccrual loans due to uncertainty regarding full collection of the debt. Each of these nonaccrual loans has been individually evaluated for impairment and a specific allowance for loan loss has been assigned, when necessary, beginning in the year the loan was considered impaired. The remaining loans identified in the special investigation have been charged off in their year of origination. The combination of classifying loans as nonaccrual and charging off loans resulted in a cumulative loss of earnings of $49.7 million beginning in years prior to 2010 and including years through A significant portion of that loss was identified as occurring prior to January 1, Therefore, the beginning retained earnings balance at January 1, 2010 has been adjusted to reflect the prior years $22.3 million loss of earnings. Losses of $27.4 million are reflected in years 2010 through The financial statements and this discussion and analysis reflect the impact of the losses in the applicable years presented here. We have emphasized material known trends, commitments, events, or uncertainties that have impacted, or are reasonably likely to impact our financial condition and results of operations. All tables and graphs in the management discussion reflect restated amounts for all periods presented. You should read these comments along with the accompanying consolidated financial statements, footnotes, and other sections of this report. The accompanying consolidated financial statements were prepared under the oversight of our Audit Committee. In the opinion of management, the financial statements herein fairly present the financial condition of the institution as restated in accordance with generally accepted accounting principles. The Management s Discussion and Analysis includes the following sections: Business Overview Economic Overview Loan Portfolio Credit Risk Management Results of Operations Liquidity Capital Resources Regulatory Matters Litigation 5

8 Governance Forward-Looking Information Critical Accounting Policies and Estimates Borrower Privacy Annual reports are available approximately 75 days after calendar year end. Quarterly reports to shareholders are available approximately 40 days after the calendar quarter end. However, the Association s prior years annual reports and quarterly reports can no longer be relied upon and are not available. This annual report includes the required and restated prior years financial information. This annual report may be obtained free of charge on our website, or upon request by calling (602) or writing Farm Credit Services Southwest, 3003 S. Fair Lane, Tempe, AZ

9 FARM CREDIT SERVICES SOUTHWEST MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) BUSINESS OVERVIEW Farm Credit System Structure and Mission As of December 31, 2014, we are one of approximately 77 associations in the Farm Credit System (System), which was created by Congress in 1916 and has served agricultural producers for over 90 years. The System mission is to provide sound and dependable credit to American farmers, ranchers, and producers or harvesters of aquatic products, and farm-related businesses through a member-owned cooperative system. This is done by making loans and providing financial services. Through its commitment and dedication to agriculture, the System continues to have the largest portfolio of agricultural loans of any lender in the United States. The Farm Credit Administration (FCA) is the System s independent safety and soundness federal regulator and was established to supervise, examine, and regulate System institutions. Our Structure and Focus As a cooperative, we are owned by the members we serve. Our territory served extends across a diverse agricultural region of Arizona and Imperial County, California. We make long-term real estate mortgage loans to farmers, ranchers, and agribusinesses and production and intermediate-term loans for agricultural production or operating purposes. Additionally, we provide other related services to our borrowers, such as credit life insurance, multi-peril crop and crop hail insurance and appraisal services. Our success begins with our extensive agricultural experience and knowledge of the market and is dependent on the level of satisfaction we can provide to our borrowers. As part of the System, we obtain the funding for our lending and operations from a Farm Credit Bank. Our funding bank, CoBank, ACB (CoBank or Bank), is a cooperative of which we are a member. Prior to its merger with CoBank on January 1, 2012, U.S. AgBank, FCB (AgBank) was our funding bank. CoBank, its related associations, and AgVantis, Inc. (a technology service corporation owned by several associations) are referred to as the District. Effective January 1, 2012, AgBank merged with and into CoBank, FCB, a wholly owned subsidiary of CoBank, ACB. CoBank is headquartered just outside Denver, Colorado. As result of the merger, the investment in AgBank stock was converted to CoBank stock. We, along with the borrower s investment in our Association, are materially affected by CoBank s financial condition and results of operations. The CoBank quarterly and annual reports are available free of charge by accessing CoBank s website, or may be obtained at no charge by contacting us at Farm Credit Services Southwest, 3003 S. Fair Lane, Tempe, AZ or calling (602) CoBank annual reports are available within 75 days after yearend and quarterly reports are available within 40 days after each calendar quarter end. We purchase technology and other operational services from Financial Partners, Inc, which is a technology service corporation that supports several Farm Credit institutions. Farm Credit Foundations, a human resource provider for a number of Farm Credit institutions, provides our payroll and other services related to human resources. ECONOMIC OVERVIEW Overall conditions for most of our borrowers were satisfactory in Dairy continues to be the largest commodity concentration in our loan portfolio. During 2014, dairy producers were supported by lower production costs, particularly feed costs, and favorable commodity prices which allowed for strong earnings in 2014 for most producers. However, milk prices declined at the end of 2014 and we are beginning to see some stress in dairy cash flows. Another 7

10 FARM CREDIT SERVICES SOUTHWEST MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) commodity concentration is hay, which experienced a drop in market prices from peaks at August Hay growers should be above break-even at current price levels and most are well diversified and have the ability to adjust crop rotations if weakness in hay prices would continue. We expect other key commodities supporting our loan portfolio to remain profitable in Additionally, the Agricultural Act of 2014 should reduce risk for growers but will also likely result in an average reduction in income from government payments as compared to recent years. Risks in our area stem from economic conditions, commodity pricing issues, political issues and resource management. The risks include the national farm bill, water rights, grazing rights on public lands and national or world economic factors that may affect the revenue stream of our borrowers. Additionally, drought conditions within the State of Arizona are at abnormal to severe levels across much of the state. The most recent forecasts indicate that drought conditions have shown a small improvement; however, statewide reservoir levels remain somewhat low and are at 73% of average as of the end of the year, which is a concern. Reduced run-off in the Colorado River watershed and corresponding reductions in reservoir levels also has the potential to impact our mortgage portfolio. Improving economic conditions and historically low interest rates should benefit borrowers who rely on off-farm income. We expect the regional economy, particularly in central Arizona, to continue to recover as the housing and commercial real estate markets expand. Land values have stabilized or have experienced some increase since the bottom of the last downturn. However, volatility remains an on-going risk in our central Arizona lending territory. We expect interest rates to remain near their historic lows until about mid-year 2015 when forecasts indicate that rates will begin to rise. Low interest rates have both positive and negative effects on the Association. From a positive standpoint, low interest rates reduce our member s interest expense, which should improve their profitability and credit quality. Interest rate movements directly affect many of our members because variable, adjustable, or prime-based loans comprise about 77% of our loan portfolio. On the other hand, low rates reduce the Association s earnings by reducing the interest earned on the Association s lendable net worth. LOAN PORTFOLIO The losses that resulted in a restatement of our financial information as discussed previously had a significant impact on loan portfolio information. All historic information presented here has been restated. Total loan volume was $994.3 million at December 31, 2014, an increase of $43.4 million, or 4.6%, from loans at December 31, 2013 of $950.9 million. The increase in loans outstanding was due to seasonal demand and year-end activity for production credit, mostly in the dairy industry. Loans Outstanding $ in millions Loans Outstanding (percent increase from prior year) 1,200 1, % 6% 4% 2% 0% -2% -4% -6% -8% 4.6% 4.6% -1.2% -5.5% -5.0%

11 FARM CREDIT SERVICES SOUTHWEST MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) The types of loans outstanding at December 31 are reflected in the following table As Restated 2012 As Restated Percent Percent Percent (dollars in millions) Volume of Total Volume of Total Volume of Total Real estate mortgage $ % $ % $ % Production and intermediateterm % % % Agribusiness: Farm-related business % % % Processing and marketing % % % Cooperatives % % % Lease receivables % % % Rural residential real estate % % % Total $ % $ % $ % The portfolio is comprised of 53.8% mortgage loans, 35.6% production and intermediate-term commercial loans, and 10.6% other loans. The amount of long-term mortgage loans outstanding remained unchanged from Approximately 6% of real estate mortgage volume at December 31, 2014 included purchased participation interests in loans. Long-term mortgage loans are primarily used to purchase, refinance, or improve real estate. These loans may have maturities ranging from five years to 40 years. By regulation, a real estate mortgage loan must be secured by a first lien and may be made only in amounts up to 85% of the original appraised value of the property, or up to 97% of appraised value, if the loan is guaranteed by certain state, federal, or other governmental agencies. Under our current underwriting standards, we loan less than the regulatory limit of 85% of the appraised value of the property. Refer to Note 3 of the Notes to the Financial Statements for more detail. Production and intermediate-term loan volume increased $19.4 million in This increase was mostly in dairy industry loans due to year-end seasonal activity. Approximately 12% of production and intermediate-term volume at December 31, 2014 were purchased participation interests in loans. Production loans are used to finance the ongoing operating needs of agricultural producers. Production loans generally match the borrower s normal production and marketing cycle, which is typically 12 months. Intermediate-term loans are generally used to finance depreciable capital assets of a farm or ranch. Intermediate-term loans are written for a specific term, 1 to 15 years, with most loans being less than 10 years. During 2014, we increased Agribusiness loans $25.7 million primarily by purchasing participation interests in loans from CoBank and other System entities. Portfolio Diversification While we make loans and provide financially-related services to qualified borrowers in agricultural and rural sectors and to certain related entities, our loan portfolio is diversified by loan participations purchased and sold, geographic locations served, commodities financed, and loan size as illustrated in the following four tables. We purchase loan participations and lease participations from other System entities to generate additional earnings and diversify risk related to existing commodities financed and our geographic area served. In addition, we sell portions of our largest loans to other System entities to reduce 9

12 FARM CREDIT SERVICES SOUTHWEST MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) risk and comply with lending limits we have established internally. During , we increased the sale of participation interests in loans to reduce our credit exposure from large loans and to control our exposure to dairy loans. We have partly offset this reduction in loan volume by increasing the purchase of participation interests in loans outside our territory. All of our purchased loan participations are from other System institutions. CoBank accounts for $78.8 million or 60% of total loans purchased and Farm Credit Leasing, a subsidiary of CoBank, accounts for $17.4 million or 13%, of the total purchased portfolio. To increase our market share of broadly syndicated participation loans, we are a party to a shared lending agreement known as AgCap. The agreement includes our Association together with Farm Credit of New Mexico, ACA, Frontier Farm Credit, ACA and Farm Credit of Southwest Kansas, ACA. Along with these associations, we pool our resources to coordinate and enhance the marketing, originating and servicing of large, complex commercial and mortgage loans, as well as diversify risk. This agreement was consummated May 1, Purchased loans are well-diversified by commodity and geographic location with processing and marketing loans accounting for 14% of purchased loans and grain, dairy and forestry accounting for 8% each. All of our participations sold also were to System institutions with CoBank accounting for $199.7 million or over 77% of the participations sold. Dairy loans accounted for 73% of the participations sold. Our volume of participations purchased and sold as of December 31 follows. (dollars in millions) Participations purchased $ $ 97.4 $ 93.6 Participations sold $ $ $ We have no loans sold with recourse, retained subordinated participation interests in loans, or interests in pools of subordinated participation interest that are held in lieu of retaining a subordinated participation interest in the loans sold. Loans are made to borrowers whose residence or principal place of business is located in Arizona or Imperial County, California. The geographic distribution of loans by county at December 31 follows As Restated 2012 As Restated Maricopa 24% 28% 38% Yuma 17% 18% 17% Pinal 12% 12% 12% Imperial, CA 17% 16% 17% Other 30% 26% 16% Total 100% 100% 100% Over recent years, the geographic distribution of the loan portfolio has been relatively stable with on average about 42% of our loans located in Maricopa and Pinal Counties in central Arizona. However in 2013, the percentage of loans in Maricopa County decreased from 38% to 28%. This was primarily due to an increase in sold loans, most of which were dairy loans located in Maricopa County. As noted above, we purchase loan participations outside our territory. These are included in "Other" in the table and account for about 44% of the loans shown in the Other category. 10

13 FARM CREDIT SERVICES SOUTHWEST MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) The following table shows the primary agricultural commodities produced by our borrowers based on the Standard Industrial Codes System (SIC) published by the federal government. This system is used to assign commodity or industry categories based on the primary business of the customer. A primary business category is assigned when the commodity or industry accounts for 50% or more of the total value of sales for its business; however, a large percentage of agricultural operations typically include more than one commodity. Repayment ability of our borrowers is closely related to the production and profitability of the commodities they produce. If a loan fails to perform, restructuring and/or other servicing alternatives are influenced by the underlying value of the collateral which is impacted by industry economics. Our future performance would be negatively impacted by adverse agricultural conditions. The degree of the adverse impact would be correlated to the commodities negatively affected and the magnitude and duration of the adverse agricultural conditions to our borrowers. The Association is not dependent on any single commodity that could materially affect the financial operations of the organization, with the possible exception of the dairy industry. The As Restated 2012 As Restated Dairy 25% 28% 31% Hay 18% 18% 18% Livestock 10% 9% 10% Field crops 7% 7% 6% Vegetables 7% 8% 8% Fruit 6% 6% 4% Cotton 6% 6% 6% Farm-related business 5% 3% 4% Cash rent 5% 5% 4% Feed grains 5% 4% 4% Nuts 3% 2% 2% Other 3% 4% 3% Total 100% 100% 100% Our commodity structure has remained unchanged in recent years. The top four commodity groups (dairy, hay, livestock and field crops) account for 60% of loans. Dairy loans comprise one-fourth of our loans and are concentrated primarily in central Arizona. The decline in the dairy commodity segment in 2013 and 2014 is due mainly to the sale of loan participations to CoBank. The average size of our loans at December 31, 2014 was $649 thousand compared with $585 thousand at December 31, Over 72% of our loans, by outstanding volume, have a principal balance greater than $1 million. The principal balance outstanding at December 31, 2014 for loans $250 thousand or less accounted for only 5% of loan volume but 53% of the number of loans. The table below details loan principal by dollar size at December 31. (dollars in thousands) Amount outstanding As Restated Number of Amount loans outstanding Number of loans Amount outstanding 2012 As Restated Number of loans $1 - $250 $53, $59, $64, $251 - $500 81, , , $501 - $1, , , , $1,001 - $5, , , , $5,001 - $15, , , , Total $994,342 1,532 $950,888 1,626 $962,781 1,665

14 FARM CREDIT SERVICES SOUTHWEST MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) dairy industry comprises a relatively large portion of our loans and any prolonged recession in the dairy industry such as that occurring in 2009 and 2010 could negatively affect the Association s loan quality and operating results such as we experienced in those years. Additionally, approximately 10% of our loans outstanding are attributable to our top 10 borrowers, which is unchanged from Due to their size, which ranged from $9.5 to $11.0 million at December 31, 2014, the loss of any of these loans or the failure of any of these loans to perform could adversely affect the portfolio and our future operating results. The credit risk of some long-term real estate mortgage loans has been reduced by entering into agreements that provide long-term standby commitments by the Federal Agricultural Mortgage Corporation (Farmer Mac) to purchase the loans in the event of default. The amount of loans subject to these Farmer Mac credit enhancements was $240 million at December 31, 2014, $232 million at December 31, 2013, and $246 million at December 31, Under the Farmer Mac long-term standby commitment to purchase agreements, we continue to hold the loans in our portfolio, and we pay commitment fees to Farmer Mac for the right to put a loan designated in these agreements to Farmer Mac at par in the event of the loan becomes significantly delinquent (typically three months past due). If the borrower cures the default, we must repurchase the loan and the commitment remains in place. Farmer Mac long-term standby commitments to purchase agreements are further described in Note 3 in the accompanying consolidated financial statements. Fees paid for the Farmer Mac commitments totaled $1.0 million for 2014 and $1.1 million per year for 2013 and 2012 and are reflected as a reduction in interest income. Other than the contractual obligations arising from these business transactions with Farmer Mac, Farmer Mac is not liable for any debt or obligation of ours and we are not liable for any debt or obligation of Farmer Mac. For more information on Farmer Mac, refer to their website at Farmer Mac Guaranteed Loans $ in millions FSA Guaranteed Loans $ in millions We also have credit guarantees with U.S. government agencies, primarily the Farm Services Agency (FSA). Approximately $29 million of FSA-guaranteed loans were outstanding at December 31, We often use FSA guarantees to make loans to young, beginning, and small farmers, to reduce our risk on large loans, and to assist borrowers experiencing financial difficulties. Credit Commitments We may participate in financial instruments with off-balance-sheet risk to satisfy the financing needs of our borrowers. These financial instruments include commitments to extend credit. The instruments involve, to varying degrees, elements of credit risk in excess of the amount recognized in our consolidated financial statements. Commitments to extend credit are agreements to lend to a borrower as long as there is not a violation of any condition established in the contract. Commitments and letters of credit generally have fixed expiration dates or other 12

15 FARM CREDIT SERVICES SOUTHWEST MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) termination clauses and may require payment of a fee by the borrower. We may also participate in standby letters of credit to satisfy the financing needs of our borrowers. The following table summarizes the maturity distribution of unfunded credit commitments on loans at December 31, (dollars in millions) Less than 1 year 1 3 years 4 5 years Over 5 years Total Commitments to extend credit $162.5 $51.7 $69.7 $44.5 $328.4 Commercial/other letters of credit Since many of these commitments are expected to expire without being drawn upon, the total commitments do not necessarily represent future cash requirements. However, these creditrelated financial instruments have off-balance-sheet credit risk because their amounts are not reflected on the Consolidated Statements of Condition until funded or drawn upon. The credit risk associated with issuing commitments is substantially the same as that involved in extending loans to borrowers and we apply the same credit policies to these commitments. The amount of collateral obtained, if deemed necessary upon extension of credit, is based on our credit evaluation of the borrower. At December 31, 2014, we had a $1.3 million standby letter of credit obligation, included in commitments in the preceding table, on behalf of a borrower in nonaccrual status. We will be required to fund that if called upon to do so. High Risk Assets Nonperforming loan volume is comprised of nonaccrual loans, restructured loans, and loans 90 days past due still accruing interest and are referred to as impaired loans. High risk assets consist of impaired loans and other property owned. Comparative information regarding high risk assets in the portfolio, including accrued interest, follows. (dollars in thousands) As Restated 2012 As Restated Nonaccrual loans: Real estate mortgage $23,688 $15,433 $16,943 Production and intermediate-term 18,052 6,785 6,814 Total nonaccrual loans 41,740 22,218 23,757 Accruing loans 90 days or more past due: Production and intermediate-term Total accruing 90 days or more past due Accruing restructured loans: Real estate mortgage 7,286 9,882 10,068 Total accruing restructured loans 7,286 9,882 10,068 Total impaired loans 49,026 32,205 33,825 Other property owned 0 1,130 1,130 Total high risk assets $49,026 $33,335 $34,955 Nonaccrual loans to total loans 4.20% 2.34% 2.47% Impaired loans to total loans 4.93% 3.39% 3.51% High risk assets to total loans 4.93% 3.51% 3.63% High risk assets to total members equity 34.11% 23.95% 26.68% 13

16 FARM CREDIT SERVICES SOUTHWEST MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) Total high risk assets increased to $49.0 million at December 31, 2014 as compared with $33.3 million at December 31, This increase was primarily the result of nonaccrual loans identified in the special investigation discussed earlier. Nonaccrual loans represent loans where there is a reasonable doubt as to the collection of all principal and/or interest. At December 31, 2014, the Association held $41.7 million of nonaccrual loans, approximately 4.20% of loans outstanding. Nonaccrual loan volume increased $19.5 million compared with December 31, 2013 primarily as a result of determinations following the special investigation that some loans were inadequately secured and full collection of some loans were in doubt. Approximately 83% of nonaccrual loans were not delinquent on December 31, The average nonaccrual outstandings by borrower was approximately $1.1 million. Nonaccrual Loans $ in millions Nonaccrual Loans % of loans outstanding % 4.0% 4.2% % 2.0% 2.3% 2.5% 2.8% 1.5% % % Accruing restructured loans, including related accrued interest, decreased to $7.3 million in These loans are or were adversely classified loans in which we have temporarily altered the terms of the loan in order to improve the member s operating results and restore the loan to longterm financial viability. The accruing restructured loans include only the year-end balances of loans and related accrued interest on which monetary concessions have been granted to borrowers and that are in accrual status. Accruing restructured loans do not include loans on which monetary concessions have been granted but which remain in nonaccrual status. At December 31, 2014, we had three restructured loans totaling $4.3 million in nonaccrual status. We expect high risk asset volume to decrease as we work aggressively through collection efforts especially related to the loans that were moved to nonaccrual status following the special investigation. Other property owned is real or personal property that has been acquired through foreclosure, deed in lieu of foreclosure, or other means. On December 31, 2014, we had no other property owned as compared to December 31, 2013 when we held five properties valued at $1.1 million. The properties held at December 31, 2013 were sold during 2014 at a net loss of $268 thousand. 14

17 Credit Quality FARM CREDIT SERVICES SOUTHWEST MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) We review the credit quality of the loan portfolio on an ongoing basis as part of our risk management practices. Each loan is classified according to the Uniform Classification System (UCS), which is used by all Farm Credit System institutions. Following are the classification definitions. Acceptable Assets are expected to be fully collectible and represent the highest quality. Other Assets Especially Mentioned (OAEM) Assets are currently collectible but exhibit some potential weakness. Substandard Assets exhibit some serious weakness in repayment capacity, equity, and/or collateral pledged on the loan. Doubtful Assets exhibit similar weaknesses as substandard assets. However, doubtful assets have additional weaknesses in existing facts, conditions and values that make collection in full highly questionable. Loss Assets are not considered collectible. The following table presents statistics based on UCS related to the credit quality of the loan portfolio, including accrued interest, at December 31. UCS Classification As Restated 2012 As Restated Acceptable 92.3% 93.7% 92.1% OAEM 2.6% 1.2% 3.5% Substandard 4.0% 4.6% 4.1% Doubtful 1.1% 0.5% 0.3% Total 100.0% 100.0% 100.0% Loans classified as Acceptable or OAEM as a percentage of total loans and accrued interest receivable were 94.9% at December 31, 2014 and December 31, 2013 and 95.6% at December 31, We expect credit quality to remain at about the current level in Further improvement in our credit quality largely depends on improved profitability in the dairy industry and the collection efforts addressing the substandard and doubtful loans identified by the special investigation. Loan delinquencies (accruing loans more than 30 days past due) remain very low. There were no accrual loans which were delinquent on December 31, Allowance for Loan Losses We maintain an allowance for loan losses at a level consistent with the probable and estimable losses inherent in the loan portfolio identified by management. The allowance for loan losses at each period end was considered to be adequate to absorb probable losses existing in the loan portfolio. Because the allowance for loan losses considers factors such as current agricultural and economic conditions, loan loss experience, portfolio quality, and loan portfolio composition, there will be a direct impact to the allowance for loan losses and our income statement when there is a change in any of those factors. The following table provides relevant information regarding the allowance for loan losses as of December

18 FARM CREDIT SERVICES SOUTHWEST MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) (dollars in thousands) As Restated 2012 As Restated Balance at beginning of year $8,296 $6,645 $9,095 Charge-offs: Real estate mortgage 30 1,126 2,631 Production and intermediate-term ,371 Total charge-offs $387 $1,303 $6,002 Recoveries: Real estate mortgage Production and intermediate-term 1, Total recoveries $1,771 $523 $871 Net (recoveries)/charge-offs ($1,384) $780 $5,131 Provision for loan losses/(loan loss reversal) $5,148 $2,431 $2,681 Balance at December 31 $14,828 $8,296 $6,645 Net (recoveries)/charge-offs to average net loans (0.15%) 0.09% 0.58% The following table presents the allowance for loan losses by loan type as of December 31. (dollars in thousands) As Restated 2012 As Restated Real estate mortgage $1,848 $2,522 $2,581 Production and intermediate-term 12,836 5,638 3,920 Agribusiness Lease receivables Total $14,828 $8,296 $6,645 The allowance for loan losses increased to $14.8 million at December 31, 2014 compared with $8.3 million at December 31, 2013, and $6.6 million at December 31, The increase in allowance for loan losses in 2014 was primarily due to an increase in the provision for loan losses of $2.7 million. The 2014 provision was the result of an increase in specific allowance on nonaccrual loans identified in the special investigation and an increase in general allowance to address additional estimated exposure in the accrual loan portfolio. We recorded net recoveries of $1.4 million in 2014 versus net charge-offs of $780 thousand during 2013, and $5.1 million during Charge-offs in 2013 and 2012 were generally a result of loans identified in the special investigation that should not have been made due to ineligibility or inadequate collateral. Comparative allowance for loan losses coverage as a percentage of loans and certain other credit quality indicators as of December 31 are presented in the following table As Restated 2012 As Restated Allowance for loan losses as a percentage of: Loans 1.49% 0.87% 0.69% Impaired loans 30.25% 25.76% 19.65% Nonaccrual loans 35.52% 37.34% 27.97% 16

19 FARM CREDIT SERVICES SOUTHWEST MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) The allowance as a percentage of loans increased to 1.49% and the allowance as a percentage of impaired loans increased to 30.25% in 2014 due to the increase in allowance. The decrease in the allowance as a percentage of nonaccrual loans was due to the $20.5 million increase in nonaccrual loans in Young, Beginning, and Small Farmers and Ranchers Program As part of the Farm Credit System, we are committed to providing sound and dependable credit and related services to young, beginning, and small (YBS) farmers and ranchers. The FCA regulatory definitions for YBS farmers and ranchers are shown below. Young Farmer: A farmer, rancher, or producer or harvester of aquatic products who was age 35 or younger as of the date the loan was originally made. Beginning Farmer: A farmer, rancher, or producer or harvester of aquatic products who had ten years or less farming or ranching experience as of the date the loan was originally made. Small Farmer: A farmer, rancher, or producer or harvester of aquatic products who normally generated less than $250 thousand in annual gross sales of agricultural or aquatic products at the date the loan was originally made. The following table outlines our percentage of YBS loans as a percentage of the number of loans in our loan portfolio. The USDA column represents the percent of farmers and ranchers classified as YBS within our territory per the 2012 USDA Agricultural Census, which is the most current data available. Due to FCA regulatory definitions, a farmer/rancher may be included in multiple categories as they would be included in each category in which the definition was met As Restated 2012 As Restated USDA Young 13.9% 14.2% 14.7% 2.9% Beginning 12.9% 13.6% 14.3% 16.1% Small 10.1% 9.9% 10.6% 94.4% Note that several differences exist in definitions between USDA statistics and our data due to our use of FCA definitions. Young farmers are defined as 34 years old and younger by the USDA, while FCA definitions include farmers 35 years old and younger. Beginning farmers are defined by FCA as those with ten years or less farming experience; however, the USDA identifies beginning farmers as on their current farm less than ten years. This may include both beginning farmers and experienced farmers who have recently changed farmsteads. In its determination of small farms, the USDA includes part-time producers and very small producers that require little or no funding or would be ineligible to borrow from us under the FCA regulations. Our percentages are based on the number of loans in our portfolio, while the USDA percentages are based on the number of farms. While these definition differences do exist, the information will be utilized as it is the best comparative information available. We establish annual marketing goals to maintain or increase market share of loans to YBS farmers and ranchers. Our goals are as follows: Offer related services either directly or in coordination with others that are responsive to the needs of YBS farmers and ranchers in our territory; Take full advantage of opportunities for coordinating credit and services offered with other governmental and private sources of credit who offer credit and services to those who qualify as YBS farmers and ranchers in our territory; and Implement effective outreach programs to attract YBS farmers and ranchers. 17

20 FARM CREDIT SERVICES SOUTHWEST MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) Quarterly reports are provided to our Board of Directors detailing the number of loans and loan volume of our YBS customers against quantitative targets to monitor our progress. The Association uses USDA Census of Agricultural data to establish goals for our YBS program. We have adjusted the USDA data to reflect trends based on time and have made certain assumptions to reflect the difference between total farmer and rancher numbers and those that require financing. At December 31, 2014, the Association had the following number and volume of loans outstanding (excluding leases) to YBS producers in comparison to the Association s business planning goals for Young Producers Goal Actual Number of loans Volume of loans $213.5 million $210.6 million Beginning Producers Number of loans Volume of loans $151.2 million $148.5 million Small Producers Number of loans Volume of loans $60.0 million $57.3 million To ensure that credit and services offered to our YBS farmers and ranchers are provided in a safe and sound manner and within our risk-bearing capacity, we establish specific loan standards for YBS producers, offer concessionary loan fees and loan interest rates, and limit YBS loans made with specific loan standards. Other credit enhancements such as guarantees and cosigners are utilized to provide financial services to a significant number of YBS producers. Frequently, in order to meet the Association s lending requirements, loans to YBS producers are backed by guarantees from government entities such as the FSA or third parties. Additionally, we are actively involved in developing and sponsoring educational opportunities, leadership training, business financial training, and insurance services for YBS farmers and ranchers. The Association has established a Young Farmer and Rancher Institute that provides training to YBS producers in areas such as farm record keeping and financial statement analysis. Our commitment to YBS producers is formalized in our Association mission statement, Board policy, and business plan. 18

21 FARM CREDIT SERVICES SOUTHWEST MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) CREDIT RISK MANAGEMENT Credit risk arises from the potential failure of a borrower to meet repayment obligations that result in a financial loss to the lender. Credit risk exists in our loan portfolio and also in our unfunded loan commitments and standby letters of credit. Credit risk is managed on an individual and portfolio basis through application of sound lending and underwriting standards, policies and procedures. During 2014, as discussed previously, a special investigation identified material weaknesses in our internal controls related to credit origination, administration and servicing. The Association has taken action to remediate weaknesses in those areas and continues to review all internal controls and processes. Underwriting standards are utilized to determine an applicant s operational, financial, and managerial resources available for repaying debt within the terms of the note and loan agreement. Underwriting standards include among other things, an evaluation of: character borrower integrity, management, and credit history; capacity repayment capacity of the borrower based on cash flows from operations or other sources of income; collateral to protect the lender in the event of default and also serve as a secondary source of loan repayment; capital ability of the operation to survive unanticipated risks; and, conditions intended use of the loan funds, terms, restrictions, etc. We have reviewed and strengthened processes for information gathering, balance sheet and income statement verification, loan analysis, credit approvals, disbursements of proceeds and subsequent loan servicing actions. Underwriting standards vary by industry and are updated periodically to reflect market and industry conditions. By regulation, we cannot have loan commitments to one borrower for more than 15% of our permanent capital. Additionally, we set our own lending limits to manage loan concentration risk. Lending limits have been established for individual loan size, commodity type, special lending programs and geographic concentrations. We limit individual loan size to less than 7.5% of permanent capital (about $8 million at December 31, 2014). Exceptions to this limit are approved at the highest level of credit authority and are reserved for our highest quality borrowers. Certain loans that exceed this limit will be gradually reduced over time where possible. Loans above our lending limit generally are participated with other lenders, which is described in more detail under Portfolio Diversification in this report. We have revised internal lending delegations to strengthen controls over the loan approval process. Delegations are based on our risk-bearing ability, loan size, complexity, type and risk, as well as the expertise and position of the credit staff member. Larger and more complex loans or loans perceived to have higher risk are reviewed and approved by our executive loan committee with the most experienced and knowledgeable credit staff serving as members. The majority of our lending is first mortgage real estate loans which must be secured by a first lien on real estate. Production and intermediate-term lending accounts for most of the remaining volume and is typically secured by livestock, crops, and equipment. Collateral evaluations are completed in compliance with FCA and Uniform Standards of Professional Appraisal Practices requirements. All property is valued at market value. All collateral evaluations must be performed by a qualified inspector. Certain appraisals must be performed by individuals with a state certification or license. We use a two-dimensional risk rating model (Model) based on the Farm Credit System s Combined System Risk Rating Guidance. The Model estimates each loan s probability of default (PD) and loss given default (LGD). PD estimates the probability that a borrower will experience a 19

22 FARM CREDIT SERVICES SOUTHWEST MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) default within 12 months from the date of determination. LGD provides an estimation of the anticipated loss with respect to a specific financial obligation of a borrower assuming a default has occurred or will occur within the next 12 months. The Model uses objective and subjective criteria to identify inherent strengths, weaknesses, and risks in each loan. PDs and LGDs are utilized in loan and portfolio management processes and are utilized for the allowance for loan losses estimate. The Model s 14-point probability of default scale provides for nine acceptable categories, one OAEM category, two substandard categories, one doubtful category, and one loss category; each carrying a distinct percentage of default probability. The Model s LGD scale provides six categories, A through F, that have the following anticipated principal loss and range of economic loss expectations: A 0% anticipated principal loss; 0% to 5% range of economic loss B 0% to 3% anticipated principal loss; 5% to 15% range of economic loss C > 3% to 7% anticipated principal loss; 15% to 20% range of economic loss D > 7% to 15% anticipated principal loss; 20% to 25% range of economic loss E > 15% to 40% anticipated principal loss; 25% to 50% range of economic loss F above 40% anticipated loss; above 50% range of economic loss 20

23 FARM CREDIT SERVICES SOUTHWEST MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) RESULTS OF OPERATIONS In 2014, we recorded $5.0 million of net income, compared with $12.8 million in 2013, and $14.2 million in The following table presents the changes in the significant components of net income from the previous year. Prior years have been restated as discussed previously. Net Income $ in millions (dollars in thousands) As Restated 2012 As Restated Net income $5,013 $12,757 $14,184 Prior year net income 12,757 14,184 21,617 (Decrease) increase in net income ($7,744) ($1,427) ($7,433) (Decrease) increase in net income attributable to: Interest income ($1,253) ($494) ($3,234) Interest expense ,068 Net interest income (652) 203 (2,166) Provision for loan losses (2,717) ,369 Patronage distribution from Farm Credit Institutions Tax-free reorganization distribution (444) 0 (1,767) (13,122) Other income (310) (699) 499 Salaries and employee benefits 582 (987) (774) Loss on other property owned (453) 424 (207) Purchased services (3,735) 29 (16) Other expenses (676) (203) (249) Income taxes (Decrease) increase in net income ($7,744) ($1,427) ($7,433) The $7.7 million decrease in 2014 net income was due to a $2.7 million increase in provision for loan losses, a $3.7 million increase in purchased services, and a $652 thousand decrease in net interest income. The decrease in net income in 2013 was due mostly to a $987 thousand increase in salaries and benefits and a decrease of $699 thousand in other income. 21

24 FARM CREDIT SERVICES SOUTHWEST MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) Net Interest Income Net interest income totaled $23.8 million for 2014 compared with $24.4 million for 2013 and $24.2 million for Net interest income is our principal source of earnings and is impacted by interest-earning asset volume, yields on assets and cost of debt. Net Interest Income $ in millions The following table presents the components of the year-to-year change in net interest income for the past three years. (dollars in thousands) (Decrease) increase in net interest income due to changes in: 2014 vs As Restated 2013 vs As Restated 2012 vs As Restated Interest rates earned on accruing assets ($986) ($1,698) ($2,774) Average accruing assets 463 1,221 (881) Interest reversed on loans transferred to nonaccrual status (536) (193) 404 Interest income recognized on nonaccrual loans (194) Decrease in interest income (1,253) (494) (3,234) Interest rates paid on interest-bearing liabilities 692 1, Average interest-bearing liabilities (91) (310) 292 Decrease in interest expense ,068 (Decrease) increase in net interest income ($652) $203 ($2,166) During 2014, the average interest rate on our loans decreased 0.19%, which decreased interest income $1.0 million as compared to This was offset somewhat by an increase in the average amount of accrual loans outstanding of $11.8 million, which increased interest income $463 thousand. Interest reversed on loans transferred to nonaccrual status increased $536 22

25 FARM CREDIT SERVICES SOUTHWEST MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) thousand due to the increase in nonaccrual loans in Overall, the Association s interest income declined $1.3 million in During 2014, the average rate on the Association s interest-bearing liabilities decreased 0.08%, which decreased interest expense $692 thousand as compared to The average amount of debt outstanding increased $7.1 million, which increased interest expense $91 thousand. Overall, interest expense declined $601 thousand. As a result, net interest income, the difference between interest earned on loans and interest paid on debt, decreased $652 thousand in 2014 as compared to The spread between the rate the Association earns on loans and the rate paid on interest-bearing liabilities also affects net interest income. The following table illustrates the average interest rates on loans and debt, interest rate spread and net interest margin As Restated 2012 As Restated Effective interest rate on: Average loans 3.72% 3.91% 4.10% Average interest-bearing liabilities 1.19% 1.27% 1.39% Interest rate spread 2.53% 2.64% 2.71% Net interest margin 2.61% 2.72% 2.79% Interest rate spread has declined, mostly in variable rate loans, due to increasing competition from other agricultural lenders in our region, which has occurred as the regional agricultural economy has improved. In 2014, interest spread declined to 2.53%, a 0.11% decrease from Net interest margin (net interest income as a percent of average earning assets) also decreased 0.11% to 2.61% in 2014 as a result of the decrease in interest rate spread and lower earnings on our own capital. We expect our interest rate spread and net interest margin to return to the levels experienced prior to 2009 as market interest rates increase. Interest Rate Spread Net Interest Margin 3.50% 3.00% 2.50% 2.00% 1.50% 2.53% 2.64% 2.71% 3.50% 3.00% 2.50% 2.00% 1.50% 2.61% 2.72% 2.79% 1.00% 1.00% 0.50% 0.50% 0.00% %

26 FARM CREDIT SERVICES SOUTHWEST MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) Noninterest Income During 2014, we recorded $7.2 million of noninterest income, compared with $7.3 million in 2013 and $8.4 million in Noninterest income in 2011 included a one-time recapitalization distribution from AgBank of $13.1 million. Noninterest Income $ in millions Patronage distributions from our funding bank are our primary source of noninterest income. Patronage is accrued in the year earned although received from CoBank in the following year. CoBank patronage is distributed in cash and stock. Patronage earned from CoBank was $5.5 million in 2014, $5.3 million in 2013 and $5.7 million in Included in the patronage distributions is patronage paid to us by CoBank in return for selling participation interests in certain of our loans to CoBank. See Portfolio Diversification. Amounts included for these distributions totaled $1.7 million in 2014, $1.5 million in 2013 and $2.0 million in During 2012, we received from Farm Credit System Insurance Corporation (FCSIC) a distribution of $1.1 million representing our allocated portion of the excess amount in the System s insurance fund above the 2% secure base amount. No such distribution was received in 2014 or Our noninterest income also includes loan and appraisal fees, financially-related services income, and other noninterest income. Loan fees and other noninterest income totaled $1.7 million in 2014 compared with $2.0 million in 2013, and $1.6 million in

27 FARM CREDIT SERVICES SOUTHWEST MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) Noninterest Expense Noninterest expense totaled $20.8 million for 2014 compared with $16.5 million in 2013 and $15.8 million in Noninterest Expense $ in millions The major components of noninterest expenses for 2014 were employee salaries and benefits, which accounted for 50% of noninterest expense, and purchased services of $4.4 million which accounted for 21% of noninterest expense. No other expense category accounted for more than 10% of total noninterest expense. Major factors affecting noninterest expense for 2014 as compared to 2013 were: (1) a $3.7 million increase in purchased services due to additional professional fees related to the special investigation, (2) a $582 thousand decrease in salaries and benefits expense as there was no annual incentive accrued for 2014, (3) a $453 thousand increase in losses on other property owned, and (4) a $179 thousand increase in FCSIC premiums, which resulted from an increase in the insurance premium rate. Noninterest expense for each of the three years ended December 31 is summarized below: Percent of Change (dollars in thousands) / /2012 Salaries & employee benefits $10,305 $10,887 $9,900 (5.3%) 10.0% Occupancy & equipment (12.1%) 3.9% Purchased services 4, n/a (4.4%) Other 4,140 3,563 3, % (5.1%) Total operating expense 19,388 15,738 14, % 5.3% Losses on acquired property, net n/a (99.5%) Farm Credit Insurance Fund premium % 96.1% Total noninterest expense $20,777 $16,495 $15, % 4.7% Provision for Loan Losses We monitor our loan portfolio on a regular basis to determine if any increase through provision for loan losses or decrease through a loan loss reversal in our allowance for loan losses is warranted based on our assessment of the probable losses in our loan portfolio. We recorded a $5.1 million loan loss provision in 2014, as compared to a $2.4 million loan loss provision in 2013, and a $2.7 million loan loss provision in The increase in loan loss provision in 2014 was the result of an increase in specific allowance on nonaccrual loans identified in the special investigation and 25

28 FARM CREDIT SERVICES SOUTHWEST MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) an increase in general allowance to address additional inherent exposure in the accrual loan portfolio related to historic loss assumptions given the restated loan losses. Provision for Income Taxes We recorded no provision for income taxes during 2014, 2013 or 2012 due to recognition of a tax loss or as a result of tax loss carry-forwards from prior years. Tax expense was also impacted by our patronage refund program. We operate as a Subchapter T cooperative for tax purposes and thus may deduct from taxable income certain amounts that are distributed from net earnings to borrowers. See Note 10 for additional information. Return on Assets and Return on Members Equity The Association s return on average assets (net income as a percentage of average total assets) decreased to 0.50% in 2014 versus 1.30% in 2013 and 1.49% in The factors that significantly affected return on assets in 2014 were a $2.7 million increase in provision for loan losses, which reduced return on assets 0.28%; and a $3.7 million increase in purchased services, which reduced return on assets 0.38%. The return on average total members equity (net income as a percentage of average member s equity) decreased to 3.43% as a result of these factors. The factor that most affected our return on assets in 2011 was the $13.1 million recapitalization distribution, which increased return on assets and return on members equity in Return on Average Assets Percent Return on Members' Equity Percent 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 2.27% 1.30% 1.49% 0.50% 0.24% 25.0% 20.0% 15.0% 10.0% 5.0% 19.73% 9.39% 11.07% 3.43% 2.34% 0.0% % LIQUIDITY Liquidity is necessary to meet our financial obligations. Liquidity is needed to pay our note with CoBank, fund loans and other commitments, and fund business operations in a cost-effective manner. Our liquidity policy is intended to manage short-term cash flow, maximize debt reduction, and liquidate nonearning assets. Our direct loan with CoBank, cash on hand, and loan repayments provide adequate liquidity to fund our ongoing operations and other commitments. Funding Sources Our primary source of liquidity is the ability to obtain funds for our operations through a borrowing relationship with CoBank. Our note payable to CoBank is collateralized by a pledge to CoBank of substantially all of our assets. Substantially all cash received is applied to the note payable and all cash disbursements are drawn on the note payable. The indebtedness is governed by a General Financing Agreement (GFA) with CoBank which matures on May 31, The annual average principal balance of the note payable to CoBank was $835 million in 2014, $827 million 26

29 FARM CREDIT SERVICES SOUTHWEST MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) in 2013 and $802 million in The increase in the average note payable to CoBank in 2014 was due to the increase in average loans outstanding. We plan to continue to fund lending operations through the utilization of our funding arrangement with CoBank, retained earnings from current and prior years, and from borrower stock investments. CoBank s primary source of funds is the ability to issue Systemwide Debt Securities to investors through the Federal Farm Credit Bank Funding Corporation. This access has traditionally provided a dependable source of competitively-priced debt that is critical for supporting our mission of providing credit to agriculture and rural America. Interest Rate Risk The interest rate risk inherent in our loan portfolio is substantially mitigated through our funding relationship with CoBank, which allows for loans to be match-funded. Borrowings from CoBank match the pricing, maturity, and option characteristics of our loans to borrowers. CoBank manages interest rate risk through direct loan pricing and asset/liability management processes. Although CoBank incurs and manages the primary sources of interest rate risk, we may still be exposed to interest rate risk from the impact of interest rate changes on earnings generated from our loanable funds (the difference between our average earning assets and our average interestbearing liabilities). To stabilize earnings from loanable funds, we have committed a small portion of our excess loanable funds with CoBank at a fixed rate for a specific term as a part of CoBank s Association Equity Positioning Program (AEPP). This enables us to reduce our overall cost of funds with CoBank without significantly increasing our overall interest rate risk position. Funds Management We offer variable, fixed, adjustable, and LIBOR-based rate loans to borrowers. Interest rates are determined based on the following factors: (1) the interest rate charged by the Bank; (2) our existing rates and spreads; (3) the competitive environment; and (4) our profitability objectives. CAPITAL RESOURCES Capital supports asset growth and provides protection for unexpected credit and operating losses such as experienced with the recent losses identified in Capital is also needed for investments in new products and services. We believe a sound capital position is critical to our long-term financial success due to the volatility and cycles in agriculture. However, as discussed previously with regard to the special investigation, the combination of classifying loans as nonaccrual and charging-off loans has resulted in an overall loss of earnings of $49.7 million that has reduced our capital. A significant portion of that loss, $22.3 million, was identified as occurring prior to January 1, We build capital primarily through net income retained after cash patronage. Members equity at December 31, 2014 totaled $144 million, compared with $139 million at December 31, 2013 and $131 million at December 31, The $5 million increase in members equity in 2014 reflects net income partly offset by net stock retired and an increase in accumulated other comprehensive loss. 27

30 FARM CREDIT SERVICES SOUTHWEST MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) Members' Equity $ in millions Members' Equity Percent of Assets % % 10% 13.73% 13.73% 12.82% 12.43% 10.20% 50 5% % Our capital position is reflected in the following ratio comparisons As Restated 2012 As Restated Debt to members equity 6.29:1 6.28:1 6.80:1 Members equity as a percent of loans 14.49% 14.62% 13.60% Members equity as a percent of assets 13.73% 13.73% 12.82% We require borrowers to purchase stock equal to the lesser of 2% of the borrower s combined loan volume or $1 thousand per customer. Stock is retired at our Board's discretion. We expect to continue to be able to retire at-risk stock during Management is not aware of any other trends, commitments, contingencies or events, at this time, that are reasonably likely to have a material adverse effect on the adequacy of available risk funds. Although we are involved in litigation, as discussed on page 31, and cannot estimate potential losses which may be associated with the litigation, we do not believe this will ultimately have a material adverse effect on our risk funds. Patronage Program We have a Patronage Program that allows us to distribute our available net earnings to our members. This program provides for the application of net earnings in the manner described in our Bylaws. In addition to determining the amount and method of patronage to be distributed, the Bylaws address increasing surplus to meet capital adequacy standards established by regulations; increasing surplus to a level necessary to support competitive pricing at targeted earnings levels; and increasing surplus for reasonable reserves. Patronage distributions are based on business done with us during the year. As a result of the losses identified during 2014, we did not declare cash patronage distributions in We declared cash patronage distribution of $4.7 million in 2013 and $4.5 million in

31 FARM CREDIT SERVICES SOUTHWEST MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) FCSSW Patronage Refunds $ in millions Our goal in paying patronage refunds is to return at least 10% of our interest income to our members. However, the actual amount paid depends on our net earnings, how much capital we need to remain adequately capitalized, and on our potential Federal and state tax liability. Accumulated Other Comprehensive Losses Accumulated other comprehensive losses totaled $967 thousand at December 31, 2014, compared with $774 thousand at December 31, 2013, and $732 thousand at December 31, Certain employees participate in a non-qualified Defined Benefit Pension Restoration Plan (Plan). We follow FASB guidance which requires recognition of the Plan s underfunded status and unamortized actuarial gains and losses and prior service costs or credits as a liability with an offsetting adjustment to accumulated other comprehensive losses. Capital Plan and Regulatory Capital Requirements Our Board of Directors establishes a formal capital adequacy plan that addresses capital goals in relation to risks. The capital adequacy plan assesses the capital level necessary for financial viability and to provide for growth. Our plan is updated annually and approved by our Board of Directors. FCA regulations require that the plan consider the following factors in determining optimal capital levels, including: Regulatory capital requirements; Asset quality; Needs of our customer base; and, Other risk-oriented activities such as funding and interest rate risks, contingent and offbalance sheet liabilities and other conditions warranting additional capital. FCA regulations establish minimum capital standards expressed as a ratio of capital to assets, taking into account relative risk factors for all System institutions. In general, the regulations provide for a relative risk weighting of assets and establish a minimum ratio of permanent capital, total surplus, and core surplus to risk-weighted assets. However, the FCA minimum ratios were not meant to be adopted as the optimum capital level, so we have established goals in excess of the regulatory minimum. Our capital ratios as of December 31 and the FCA minimum requirements are shown in the following table. 29

32 FARM CREDIT SERVICES SOUTHWEST MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) As Restated As Restated Regulatory Minimum Association Goal Permanent capital ratio 13.73% 13.02% 12.34% 7.00% 16.00% Total surplus ratio 13.63% 12.92% 12.23% 7.00% 16.00% Core surplus ratio 12.90% 12.07% 11.44% 3.50% 16.00% At December 31, 2014, we exceeded the regulatory minimum capital ratios and expect to do so throughout However, we do not expect to achieve the Board-established capital goals during Proposed Regulatory Capital Requirements On May 8, 2014, the FCA approved a proposed rule to modify the regulatory capital requirements for System associations. The primary objectives of the proposed rule are to modernize capital requirements while ensuring that institutions continue to hold sufficient regulatory capital; make System regulatory capital requirements more transparent; and meet certain requirements of the Dodd-Frank Act. As currently drafted, the proposed rule would, among other things, eliminate the core surplus and total surplus requirements and introduce common equity tier 1, tier 1 and total capital (tier 1 + tier 2) risk-based capital ratio requirements. The proposal would add a minimum tier 1 leverage ratio for all System institutions. In addition, the proposal would establish a capital conservation buffer, and modify and expand risk weightings of assets. The revisions to the risk weightings of exposures would include alternatives to the use of credit ratings, as required by the Dodd-Frank Act. The proposed effective date is January 1, The public comment period ended on February 16, While uncertainty exists as to the final form of the proposed rule, based on our preliminary assessment, we do not believe the new rule will impose any significant constraints on our business strategies or capital plan. Building Projects In 2012, we built an office building in Imperial, California to house lending operations for our Imperial Valley Branch. This office replaced our prior branch location in El Centro, California. This project was funded by sale proceeds from our prior location and cash from operations. In 2013, we built an office building in Safford, Arizona to house lending operations for our Rural Arizona Branch. This office replaced rented facilities in our prior branch location. This project was funded by cash from operations. REGULATORY MATTERS In conjunction with the special investigation discussed previously, since August 2014 we have been operating under supervisory letters issued by FCA. In February 2015, the FCA issued a supervisory letter to the Association which replaced the 2014 supervisory letters in their entirety. The February 2015 supervisory letter referenced the events described in Note 2, Restatement of Consolidated Financial Statements, and the issuance of an FCA examination report. The 2015 supervisory letter directed the Board of Directors to initiate prompt actions to remediate weaknesses summarized in the examination report to adequately address the cause of those weaknesses. It requires the Association to take certain corrective actions and increase regulatory reporting, including: Addressing the results and recommendations of the special investigation of the increase in the level of delinquent loans affecting the identifiable portion of the Association s lending portfolio,

33 LITIGATION FARM CREDIT SERVICES SOUTHWEST MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) Submitting to FCA restated financial statements, call reports and a business plan for 2015, Reporting certain employee and compensation matters, Reporting loan servicing plans on a certain portion of the Association s assets, Complying with all applicable merger-related regulations in the Association s proposed merger with FCW, Utilizing specified third parties to conduct the Association s internal credit reviews, and Prohibiting the payment of patronage or dividend distributions without the prior written consent of the FCA. In October 2014, certain plaintiffs filed complaints against the Association and a former employee of the Association seeking unspecified monetary damages and/or reformation or rescission of their loan and guaranty obligations. Some of these plaintiffs also filed bankruptcies and a related adversary complaint in bankruptcy court against the Association in October 2014 seeking to reform, modify or subordinate the Association s loans and security interests in assets and to recover alleged preferential and fraudulent transfers. In January 2015, the Association filed answers and asserted counterclaims against the plaintiffs in these actions. The parties have exchanged initial disclosure statements and discovery is ongoing. The parties also engaged in mediation sessions in June FCSSW cannot at this time estimate potential losses which may be associated with the litigation. In June 2015, certain plaintiffs and the Association settled claims arising out of alleged wrongdoing in connection with the sale of dairy cows in a dairy farm owned by certain plaintiffs. In July 2015, certain plaintiffs and the Association conditionally settled certain disputes which require approval of the bankruptcy court. In January 2015, the Association filed complaints against certain related borrowers for monetary damages aggregating approximately $4.5 million plus interest, fees and costs for failure to repay loans made by the Association to such borrowers. These complaints were not served on the borrowers and were voluntarily dismissed by the Association without prejudice. In February 2015, the Association filed related complaints against third parties regarding payments owed to the Association for the benefit of certain plaintiffs named in the October 2014 complaint. In July 2015, the Association filed an application for entry of default and the defendants filed a motion to dismiss the action. GOVERNANCE Board of Directors We are governed by a 12 member Board that provides direction and oversees our management. Of these directors, ten are elected by the shareholders and two are appointed by the elected directors. The Board of Directors represents the interests of our shareholders. Our Board of Directors meets regularly to perform the following functions, among others: selects, compensates, and evaluates the chief executive officer; approves the strategic plan, capital plan, financial plan, and the annual operating budget; directs management on significant issues; and oversees the financial reporting process, communications with shareholders, and our legal and regulatory compliance. 31

34 FARM CREDIT SERVICES SOUTHWEST MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) Director Independence All directors must exercise sound judgment in deciding matters in our interest. All of our directors are independent from the perspective that none of our management or staff serves as Board members. However, we are a financial service cooperative, and the Farm Credit Act and FCA Regulations require our elected directors to have a loan relationship with us. The elected directors, as borrowers of affiliated associations, have a vested interest in ensuring our Association remains strong and successful. However, our borrowing relationship could be viewed as having the potential to compromise the independence of an elected director. For this reason, the Board has established independence criteria to ensure that a loan relationship does not compromise the independence of our Board. Annually, in conjunction with our independence analysis and reporting on our loans to directors, each director provides financial information and any other documentation and/or assertions needed for the Board to determine the independence of each Board member. Special Investigative Committee A Special Investigative Committee of the Board was formed in the third quarter of 2014 to investigate and address the increasing loan delinquencies and losses described beginning on page 5. Four directors were appointed to this Committee. This Committee contracted with an experienced independent third party to investigate the cause of the loan losses and met with FCA on a regular basis to discuss the findings. Audit Committee The Audit Committee reports to the Board of Directors. The Audit Committee responsibilities include, but are not limited to: oversight of the financial reporting risk and the accuracy of the quarterly and annual shareholder reports; oversight of the system of internal controls related to the preparation of quarterly and annual shareholder reports; review and assessment of the impact of accounting and auditing developments on the consolidated financial statements; establishment and maintenance of procedures for the receipt, retention and treatment of confidential and anonymous submission of concerns regarding accounting, internal control accounting controls, and auditing matters; and oversight of the Association s internal audit program, the independence of the outside auditors, the adequacy of the Association s system of internal controls and procedures, and the adequacy of management s action with respect to recommendations arising from those auditing activities. The Audit Committee is composed of eight members of the Board of Directors and met eleven times in Compensation Committee The Compensation Committee is responsible for the oversight of employee and director compensation. The Compensation Committee is composed of eight members of the Board of Directors and met four times in The Committee annually reviews, evaluates and approves the compensation policies, programs and plans for senior officers and employees including benefits programs. 32

35 FARM CREDIT SERVICES SOUTHWEST MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) Other Governance The Board has monitored the requirements of public companies under the Sarbanes-Oxley Act. While we are not subject to the requirements of this law, we are working to strengthen governance and financial reporting through (1) the receipt and treatment of whistleblower complaints; (2) our code of ethics for our directors, officers, and employees; (3) open lines of communication between the independent auditors, management, and the Audit Committee; (4) use of plain English disclosures and transparency in our annual report; (5) officer certification of accuracy and completeness of the consolidated financial statements; and (6) information disclosure through our website. FORWARD-LOOKING INFORMATION Our discussion contains forward-looking statements. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions that are difficult to predict. Words such as anticipates, believes, could, estimates, may, should, and will, or other variations of these terms are intended to identify forward-looking statements. These statements are based on assumptions and analyses made in light of experience and other historical trends, current conditions, and expected future developments. However, actual results and developments may differ materially from our expectations and predictions due to a number of risks and uncertainties, many of which are beyond our control. These risks and uncertainties include, but are not limited to: political, legal, regulatory, and economic conditions and developments in the United States and abroad; economic fluctuations in the agricultural, rural utility, international, and farm-related business sectors; weather-related, disease, and other adverse climatic or biological conditions that periodically occur that impact agricultural productivity and income; changes in United States government support of the agricultural industry, and/or the Farm Credit System; and actions taken by the Federal Reserve System in implementing monetary policy. CRITICAL ACCOUNTING POLICIES AND ESTIMATES Our consolidated financial statements are based on accounting principles generally accepted in the United States of America. Our significant accounting policies are critical to the understanding of our results of operations and financial position because some accounting policies require us to make complex or subjective judgments and estimates that may affect the value of certain assets or liabilities. These policies are considered critical because we have to make judgments about matters that are inherently uncertain. For a complete discussion of significant accounting policies, see Note 2 of the accompanying consolidated financial statements. The development and selection of critical accounting policies, and the related disclosures, have been reviewed by our Audit Committee. A summary of critical policies relating to determination of the allowance for loan losses follows. 33

36 FARM CREDIT SERVICES SOUTHWEST MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) Allowance for Loan Losses The allowance for loan losses is our best estimate of the amount of probable loan losses existing in and inherent in our loan portfolio as of the balance sheet date. The allowance for loan losses is increased through provisions for loan losses and loan recoveries and is decreased through loan loss reversals and loan charge-offs. We determine the allowance for loan losses based on a regular evaluation of the loan portfolio, which generally considers recent historical charge-off experience adjusted for relevant factors. Loans are evaluated based on the borrower s overall financial condition, resources, and payment record; the prospects for support from any financially responsible guarantor; and, if appropriate, the estimated net realizable value of any collateral. The allowance for loan losses attributable to these loans is established by a process that estimates the probable loss inherent in the loans, taking into account various historical and projected factors, internal risk ratings, and geographic, industry and other factors. Changes in the factors we consider in the evaluation of losses in the loan portfolios could occur for various credit-related reasons and could result in a change in the allowance for loan losses, which would have a direct impact on the provision for loan losses and results of operations. See Note 2 and 3 to the accompanying consolidated financial statements for detailed information regarding the allowance for loan losses. Borrower Privacy Your privacy is important to us. We want you to know that we hold your financial and other personal information in strict confidence. Since 1972, FCA regulations have forbidden the directors and employees of Farm Credit institutions from disclosing personal borrower information to others without your consent. We do not sell or trade our customers personal information to marketing companies or information brokers. FCA rules allow us to disclose customer information in these situations: We may give information to another Farm Credit institution that you do business with or another institution where all or part of your loan may be participated. We can be a credit reference for you with other lenders and provide information to a credit bureau or other consumer-reporting agency. We can provide impersonal information to any reliable organization for its confidential use as permitted in the regulations. We can provide information in certain types of legal or law enforcement proceedings. FCA examiners or other third party reviewers may review loan files during regular examinations of our Association. If one of our employees applies to become a licensed real estate appraiser, we may give copies of real estate appraisal reports to the State agency that licenses appraisers when required. We will first remove as much personal information from the appraisal report as possible. As a member/owner of this institution, your privacy and the security of your personal information are vital to our continued ability to serve your ongoing credit needs. 34

37 FARM CREDIT SERVICES SOUTHWEST REPORT OF MANAGEMENT The consolidated financial statements of Farm Credit Services Southwest, ACA ( Association ) are prepared by management, who are responsible for their integrity and objectivity, including amounts that must necessarily be based on judgments and estimates. The consolidated financial statements, including the restatement for prior years, have been prepared in conformity with generally accepted accounting principles appropriate in the circumstances, and in the opinion of management, fairly present the financial condition of the Association. Other financial information included in the 2014 annual report is consistent with that in the financial statements. To meet its responsibility for reliable financial information, management depends on the Association's accounting and internal control systems, which have been designed to provide reasonable, but not absolute, assurance that assets are safeguarded and transactions are properly authorized and recorded. The consolidated financial statements are examined by PricewaterhouseCoopers LLP, independent auditors, who also conduct a review of internal controls to the extent necessary to comply with generally accepted auditing standards in the United States of America. The Association also is examined by the Farm Credit Administration. During the third quarter of 2014, Association management noted a sudden significant increase in the level of delinquent loans affecting an identifiable portion of the Association s lending portfolio. An in-depth special investigation identified material weaknesses in internal controls relating to credit origination, administration and servicing procedures as well as cash management procedures. The resulting losses have been recognized in the applicable years as reflected in the restated financial statements and beginning members equity. The Association has taken action to correct internal controls and continues to review all internal controls. The Audit Committee of the Board of Directors has overall responsibility for the Association's system of internal control and financial reporting and consults regularly with management. The Audit Committee also reviews the results of examinations by the various entities named above. The independent auditors and regulators have direct access to the Audit Committee. The undersigned certify that the Farm Credit Services Southwest, ACA Annual Report has been reviewed and prepared in accordance with all applicable statutory and regulatory requirements and that the information contained herein is true, correct, and accurate and complete, to the best of our knowledge. John O. Grizzle Chairman of the Board Mark D. Littlefield President and Chief Executive Officer Jean L. Koenck Chief Financial Officer July 29,

38 FARM CREDIT SERVICES SOUTHWEST AUDIT COMMITTEE REPORT The Audit Committee (Committee) is comprised of eight Directors of Farm Credit Services Southwest ACA, FLCA, and PCA Board of Directors. In 2014, eleven Committee meetings were held. The Committee oversees the scope of the Association s internal audit program, the independence of the outside auditors, the adequacy of the Association s system of internal controls and procedures, and the adequacy of management s action with respect to recommendations arising from those auditing activities. The Committee s responsibilities are described more fully in the Internal Control Policy, Association Board Committees Policy, and the Audit Committee Charter. The Committee approved the appointment of PricewaterhouseCoopers LLP (PwC) as the Association s independent auditors for The fees paid for professional services rendered for the Association by its independent auditor, PwC, during 2014 were $107,120 for audit services and $16,900 for tax services. The Committee reviewed the non-audit services provided by PwC and concluded these services were not incompatible with maintaining the independent auditor s independence. Management is responsible for the Association s internal controls and the preparation of the consolidated financial statements in accordance with accounting principles generally accepted in the United States of America. PwC is responsible for performing an independent audit of the Association s consolidated financial statements in accordance with auditing standards generally accepted in the United States of America and to issue a report thereon. The Committee s responsibilities include monitoring and overseeing these processes. The Committee is aware of the circumstances related to the special investigation discussed previously and the material weaknesses in internal controls that were identified. The Committee has considered the impact of those findings in its evaluation and approval of the Association s financial statements. In this context, the Committee reviewed and discussed the Association s audited financial statements for the year ended December 31, 2014 and restated years ended December 31, 2013 and 2012 (the Financial Statements ) with management. The Committee also reviews with PwC the matters required to be discussed by Statements on Auditing Standards. Both PwC and the Association s internal auditors directly provide reports on significant matters to the Committee. Based on the foregoing review and discussions and relying thereon, the Committee recommended that the Board of Directors include the Audited Financial Statements in the Association s Annual Report to Shareholders for the years ended December 31, 2014 and restated years 2013 and 2012; and for filing with the FCA. Louis J. Kramer Chairman of the Audit Committee Jon L. Nickerson, Vice Chairman Thomas P. Gargiulo Ben Gingg Dick Eastman Timothy J. LaBrucherie Keith Murfield Greg Pierce Members of the Audit Committee July 29,

39 FARM CREDIT SERVICES SOUTHWEST REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING The Association s principal executives and principal financial officers, or persons performing similar functions, are responsible for establishing and maintaining effective internal control over financial reporting for the Association s consolidated financial statements. For purposes of this report, internal control over financial reporting is defined as a process designed by, or under the supervision of the Association s principal executives and principal financial officers, or persons performing similar functions, and effected by its Board of Directors, management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting information and the preparation of the consolidated financial statements for external purposes in accordance with accounting principles generally accepted in the United States of America and includes those policies and procedures that: (1) pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of the assets of the Association, (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial information in accordance with accounting principles generally accepted in the United States of America, and that receipts and expenditures are being made only in accordance with authorizations of management and directors of the Association, and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the Association s assets that could have a material effect on its consolidated financial statements. During the third quarter of 2014, Association management noted a sudden significant increase in the level of delinquent loans affecting an identifiable portion of the Association s lending portfolio. An in-depth special investigation identified material weaknesses in internal controls relating to credit origination, administration and servicing procedures as well as cash management procedures. An internal control material weakness is a significant deficiency, or aggregation of deficiencies, that does not reduce to a relatively low level the risk that material misstatements in financial statements will be prevented or detected on a timely basis by employees in the normal course of their work. An internal control significant deficiency, or aggregation of deficiencies, is one that could result in a misstatement of the financial statements that is more than inconsequential. The Association s management, through the engagement of an independent third party, completed an assessment of the effectiveness of internal control over financial reporting as of December 31, In making the assessment, management used the framework in Internal Control Integrated Framework (2013), promulgated by the Committee of Sponsoring Organizations of the Treadway Commission, commonly referred to as the COSO criteria. Based on the assessment performed, the Association determined that there were material weaknesses in the internal controls over financial reporting. The Association has taken action to correct internal controls in the areas listed above and continues to review all internal controls. Mark D. Littlefield President and Chief Executive Officer Jean L. Koenck Chief Financial Officer July 29,

40 38

41 Farm Credit Services Southwest, ACA Consolidated Statements of Condition December 31, 2014, 2013 and 2012 (dollars in thousands) As Restated As Restated Assets Cash $ - $ 632 $ - Loans 994, , ,781 Less: Allowance for loan losses (14,828) (8,296) (6,645) Net loans 979, , ,136 Accrued interest receivable 6,954 8,605 8,985 Investment in the Bank 41,002 40,604 40,315 Premises and equipment, net 4,663 4,822 4,125 Other property owned - 1,130 1,130 Other assets 16,947 15,636 13,011 Total assets $ 1,049,080 $ 1,014,021 $ 1,023,702 Liabilities Notes payable to the Bank $ 890,498 $ 855,275 $ 866,942 Advance conditional payments 6,650 5,928 8,881 Accrued interest payable Patronage refunds payable - 4,732 4,535 Unfunded disbursements - - 4,866 Other liabilities 7,121 8,058 6,348 Total liabilities 905, , ,444 Commitments and contingencies (Note 14) Members Equity At-risk equity Capital stock and participation certificates Retained earnings 144, , ,145 Accumulated other comprehensive loss (967) (774) (732) Total members equity 143, , ,258 Total liabilities and members equity $ 1,049,080 $ 1,014,021 $ 1,023,702 The accompanying notes are an integral part of these consolidated financial statements. 39

42 Farm Credit Services Southwest, ACA Consolidated Statements of Comprehensive Income Years Ended December 31, 2014, 2013 and 2012 (dollars in thousands) As Restated As Restated Interest Income Loans $ 33,797 $ 35,050 $ 35,544 Total interest income 33,797 35,050 35,544 Interest Expense Notes payable to the Bank 10,018 10,567 11,260 Advance conditional payments Total interest expense 10,044 10,645 11,342 Net interest income 23,753 24,405 24,202 Provision for loan losses (5,148) (2,431) (2,681) Net interest income after provison for loan losses 18,605 21,974 21,521 Noninterest Income Patronage distribution from Farm Credit Institutions 5,487 5,270 5,714 Refund from Farm Credit System Insurance Corporation - - 1,089 Fees for financially related services Other income 1,371 1,710 1,360 Total noninterest income 7,185 7,278 8,421 Noninterest Expense Salaries and employee benefits 10,305 10,887 9,900 Occupancy and equipment expense Purchased Services 4, Insurance Fund premiums Losses on acquired property, net Other operating expenses 4,140 3,563 3,755 Total noninterest expense 20,777 16,495 15,758 Income before income taxes 5,013 12,757 14,184 Provision for income taxes Net income $ 5,013 $ 12,757 $ 14,184 Comprehensive Income Amortization of retirement credits (193) (42) 29 Total Comprehensive Income $ 4,820 $ 12,715 $ 14,213 The accompanying notes are an integral part of these consolidated financial statements. 40

43 Farm Credit Services Southwest, ACA Consolidated Statements of Changes in Members Equity Years Ended December 31, 2014, 2013 and 2012 Capital Accumulated Stock and Other Total Participation Retained Comprehensive Members (dollars in thousands) Certificates Earnings Income (Loss) Equity December 31, 2011 (previously reported) $ 853 $ 159,627 $ (761) $ 159,719 Adjustments to opening shareholders' equity (38,120) (38,120) December 31, 2011 (as restated) $ 853 $ 121,507 $ (761) $ 121,599 Comprehensive income (as restated) 14, ,213 Patronage distribution payable (4,535) (4,535) Patronage adjustment (11) (11) Capital stock and participation certificates issued Capital stock and participation certificates retired (84) (84) December 31, 2012 (as restated) ,145 (732) 131,258 Comprehensive income (as restated) 12,757 (42) 12,715 Patronage distribution payable (4,732) (4,732) Patronage adjustment (29) (29) Capital stock and participation certificates issued Capital stock and participation certificates retired (67) (67) December 31, 2013 (as restated) ,141 (774) 139,198 Comprehensive income 5,013 (193) 4,820 Patronage adjustment (5) (5) Capital stock and participation certificates issued Capital stock and participation certificates retired (59) (59) December 31, 2014 $ 814 $ 144,149 $ (967) $ 143,996 The accompanying notes are an integral part of these consolidated financial statements. 41

44 Farm Credit Services Southwest, ACA Consolidated Statements of Cash Flows Years Ended December 31, 2014, 2013 and 2012 (dollars in thousands) As Restated As Restated Cash flows from operating activities Net income $ 5,013 $ 12,757 $ 14,184 Adjustments to reconcile net income to net cash provided by operating activities Provision for loan losses 5,148 2,431 2,681 Depreciation Gain on sale of premises and equipment (17) (57) (31) Fair value adjustments on acquired property Loss/(gain) on sale of acquired property 268 (3) (254) Increase in patronage receivable from CoBank (178) (495) (2.332) Stock patronage income from CoBank (398) (290) (305) Decrease in accrued interest receivable 1, Increase in other assets (1,133) (2,129) (1,222) (Decrease)/increase in accrued interest payable (15) (42) 4 (Decrease)/increase in other liabilities (1,130) 1,668 1,082 Net cash provided by operating activities 9,651 14,549 15,187 Cash flows from investing activities (Increase)/decrease in loans, net (44,183) 10,534 (48,994) Recoveries of loans charged off 1, Proceeds from sale of acquired property 1, Acquisition of premises and equipment, net (94) (952) (1,459) Net cash (used in)/provided by investing activities (41,474) 10,147 (49,422) Cash flows from financing activities Net draws/(repayments) on notes payable to the Bank 35,223 (11,667) 32,868 Increase/(decrease) in advance conditional payments 722 (2,953) 2,070 Decrease in unfunded disbursements - (4,866) - Patronage distributions to members (4,737) (4,564) (4,622) Retirement of capital stock and participation certificates, net (17) (14) (8) Net cash provided by/(used in) financing activities 31,191 (24,064) 30,308 Net (decrease)/increase in cash (632) 632 (3,927) Cash Beginning of year 632-3,927 End of year $ - $ 632 $ - Continued on next page The accompanying notes are an integral part of these consolidated financial statements. 42

45 Farm Credit Services Southwest, ACA Consolidated Statements of Cash Flows Years Ended December 31, 2014, 2013 and 2012 Supplemental cash information Cash paid during the year for Interest $ 10,059 $ 10,687 $ 11,338 Income taxes Supplemental schedule of noncash transactions from investing and financing activities Decrease in loans and allowance for loan losses from charge-offs $ 387 $ 1,303 $ 6,002 Financed Sales of OPO Stock Patronage from Bank Patronage Payable - 4,732 4,535 Loans transferred to OPO ,810 The accompanying notes are an integral part of these consolidated financial statements. 43

46 Farm Credit Services Southwest, ACA Notes to Consolidated Financial Statements Years Ended December 31, 2014, 2013 and Organization and Operations Organization Farm Credit Services Southwest, ACA and its subsidiaries, Farm Credit Services Southwest Federal Land Credit Association (FLCA) and Farm Credit Services Southwest Production Credit Association (PCA), (collectively called the Association ) are member-owned cooperatives which provide credit and credit-related services to or for the benefit of eligible borrowers/stockholders for qualified agricultural purposes in Imperial County in the State of California and all counties in the State of Arizona. The Association is a lending institution of the Farm Credit System (System), a nationwide system of cooperatively-owned banks and associations, which was established by Acts of Congress to meet the credit needs of American agriculture and is subject to the provisions of the Farm Credit Act of 1971, as amended (the Farm Credit Act). At December 31, 2014, the System was comprised of three Farm Credit Banks, one Agricultural Credit Bank and 77 associations. Effective January 1, 2012, U.S. AgBank, FCB (AgBank) merged with and into CoBank, FCB, a wholly owned subsidiary of CoBank, ACB (CoBank or Bank). As a result of the merger, CoBank became the funding bank of the Association beginning January 1, CoBank, its related associations and AgVantis, Inc. (AgVantis) are collectively referred to as the District. CoBank provides the funding to associations within the District and is responsible for supervising certain activities of the District Associations. AgVantis, which is owned by the entities it serves, provides technology and other operational services to certain associations and CoBank. As of December 31, 2014, the CoBank District consisted of CoBank, 25 Agricultural Credit Associations (ACA), which each have two wholly owned subsidiaries, (a FLCA and a PCA), one FLCA and AgVantis. ACA parent companies provide financing and related services through their FLCA and PCA subsidiaries. Generally, the FLCA makes secured long-term agricultural real estate and rural home mortgage loans and the PCA makes short- and intermediate-term loans for agricultural production or operating purposes. The Farm Credit Administration (FCA) is delegated authority by Congress to regulate the System banks and associations. The FCA examines the activities of System institutions to ensure their compliance with the Farm Credit Act, FCA regulations and safe and sound banking practices. The Farm Credit Act established the Farm Credit System Insurance Corporation (Insurance Corporation) to administer the Farm Credit Insurance Fund (Insurance Fund). By law, the Insurance Fund is required to be used (1) to ensure the timely payment of principal and interest on Systemwide debt obligations (Insured Debt), (2) to ensure the retirement of protected stock at par or stated value, and (3) for other specified purposes. The Insurance Fund is also available for discretionary use by the Insurance Corporation in providing assistance to certain troubled System institutions and to cover the operating expenses of the Insurance Corporation. Each System bank is required to pay premiums, which may be passed on to the associations, into the Insurance Fund based on its annual average outstanding insured debt adjusted to reflect the reduced risk on loans or investments guaranteed by federal or state governments until the assets in the Insurance Fund reach the secure base amount, which is defined in the Farm Credit Act as 2.0 percent of the aggregate Insured Debt or such other percentage of the Insured Debt as the Insurance Corporation, in its sole discretion, determines to be actuarially sound. When the amount in the Insurance Fund exceeds the secure base amount, the Insurance Corporation is required to reduce premiums, as necessary to maintain the Insurance Fund at the 2.0 percent level. As required by 44

47 Farm Credit Services Southwest, ACA Notes to Consolidated Financial Statements Years Ended December 31, 2014, 2013 and 2012 the Farm Credit Act, as amended, the Insurance Corporation may return excess funds above the secure base amount to System institutions. CoBank passes this premium expense and the return of excess funds as applicable through to each association based on the association s average adjusted note payable with CoBank. Operations The Farm Credit Act sets forth the types of authorized lending activity, persons eligible to borrow, and financial services which can be offered by the Association. The Association is authorized to provide, either directly or in participation with other lenders, credit, credit commitments and related services to eligible borrowers. Eligible borrowers include farmers, ranchers, producers or harvesters of aquatic products, their cooperatives, rural residents and farm-related businesses. The Association also serves as an intermediary in offering credit life insurance, crop hail and fire insurance, advance conditional payment accounts and multi-peril crop insurance. The Association s financial condition may be impacted by factors affecting CoBank. The CoBank Annual Report to Shareholders is available free of charge on CoBank s website, or may be obtained at no charge by calling (602) or writing Farm Credit Services Southwest, 3003 S. Fair Lane, Tempe, AZ Upon request, Association shareholders will be provided with a copy of the CoBank Annual Report. 2. Summary of Significant Accounting Policies The accounting and reporting policies of the Association conform to accounting principles generally accepted in the United States of America (GAAP) and prevailing practices within the banking industry. The preparation of the financial statements in conformity with GAAP requires Association management to make estimates and assumptions that affect amounts reported in the financial statements and accompanying notes. Actual results may differ from these estimates. Significant estimates are discussed in these footnotes as applicable. The consolidated financial statements include the accounts of Farm Credit Services Southwest, ACA; Farm Credit Services Southwest, FLCA; and Farm Credit Services Southwest, PCA. All significant inter-company transactions have been eliminated in consolidation. Restatement of Consolidated Financial Statements During the third quarter of 2014, Association management noted a sudden significant increase in the level of delinquent loans affecting an identifiable portion of the Association s lending portfolio. An in-depth special investigation identified material weaknesses in internal controls relating to credit origination, administration and servicing procedures as well as cash management procedures. Certain loans were made to ineligible borrowers under the Farm Credit Act and/or were inadequately secured. Since these loans would not have met the Association s underwriting standards or regulatory requirements when originated, they should not have been recognized on the Association s consolidated financial statements. During the special investigation, loans originating over a span of several years were identified as subject to significant risk exposure as described above. Some loans with underlying secured collateral that are generally able to support the related outstanding debt have been classified as nonaccrual loans due to uncertainty regarding full collection of the debt. Each of these nonaccrual loans has been individually evaluated for impairment and a specific allowance has been assigned, when necessary, beginning in the year the loan was considered impaired. The remaining loans 45

48 Farm Credit Services Southwest, ACA Notes to Consolidated Financial Statements Years Ended December 31, 2014, 2013 and 2012 identified in the special investigation have been written off in their year of origination. The combination of classifying loans as nonaccrual and writing off loans has resulted in a loss of earnings of $49.7 million. A significant portion of that loss was identified as occurring prior to January 1, Retained earnings at December 31, 2011 have been adjusted to reflect a $38.1 million loss of earnings which is comprised of interest income reversal of $4.2 million and increased provision for loan loss of $34.6 million offset by a tax expense reduction of $0.7 million paid in earlier years. As shown in the following tables, earnings were negatively impacted by interest income reversal of $1.7 million in each of the years 2013 and 2012 and additional provision for loan loss of $1.8 million in 2013 and $3.8 million in This was offset by a tax expense reduction of $9 thousand in 2013 and $654 thousand in Management evaluated the impact of the errors on previously issued financial statements and concluded that such previously issued financial statements were materially misstated. Accordingly, the Association has restated its consolidated statements of condition as of December 31, 2013 and 2012 and its consolidated statements of comprehensive income, changes in members equity and cash flows for the years then ended. As financial statements for periods prior to the year ended December 31, 2012 are not presented here, the impact to those periods is reflected as a reduction to beginning 2012 retained earnings in the amount of $38.1 million. The following tables present the impact of the errors on the Association s previously-issued consolidated statements of condition as of December 31, 2013 and 2012 and consolidated statements of comprehensive income and cash flows for the years then ended. Immaterial corrections were made to the previously reported cash flow statements for 2013 and 2012 due to errors in calculating the amount of stock patronage income and investment in bank. The impact of the tax adjustments referenced above and the stock patronage income are reflected in other assets in the consolidated statements of condition. 46

49 Farm Credit Services Southwest, ACA Notes to Consolidated Financial Statements Years Ended December 31, 2014, 2013 and 2012 Consolidated Statements of Condition 47

50 Farm Credit Services Southwest, ACA Notes to Consolidated Financial Statements Years Ended December 31, 2014, 2013 and 2012 Consolidated Statements of Comprehensive Income 48

51 Farm Credit Services Southwest, ACA Notes to Consolidated Financial Statements Years Ended December 31, 2014, 2013 and 2012 Consolidated Statements of Cash Flows (dollars in thousands) Previously Previously Reported Adjustments As Restated Reported Adjustments As Restated Cash flows from operating activities Net income $ 16,190 $ (3,433) $ 12,757 $ 19,081 $ (4,897) $ 14,184 Adjustments to reconcile net income to net cash provided by operating activities Provision for/(reversal of) loan losses 666 1,765 2,431 (1,122) 3,803 2,681 Depreciation Gain on sale of premises and equipment (57) (57) (31) (31) Fair value adjustments on acquired property Loss/(Gain) on sale of acquired property (3) (3) (254) (254) Increase in patronage receivable from CoBank (5,270) 4,775 (495) (4,766) 2,434 (2,332) Stock patronage income - (290) (290) - (305) (305) Decrease in accrued interest receivable Decrease/I(increase) in other assets 2,654 (4,783) (2,129) 1,509 (2,731) (1,222) (Decrease)/increase in accrued interest payable (42) (42) 4 4 (Decrease)/increase in other liabilities 1,668 1,668 1,082 1,082 Net cash provided by operating activities 16,515 (1,966) 14,549 16,883 (1,696) 15,187 Cash flows from investing activities (Increase)/decrease in loans, net 8,857 1,677 10,534 (50,733) 1,739 (48,994) Recoveries of loans charged off Proceeds from sale of acquired property (Increase)/decrease investment in Bank (289) (43) - Acquisition of premises and equipment, net (952) (952) (1,459) (1,459) Net cash provided by/(used in) investing activities 8,181 1,966 10,147 (51,118) 1,696 (49,422) Cash flows from financing activities Net draws/(repayments) on notes payable to Bank (11,667) (11,667) 32,868 32,868 Increase/(decrease) in advance conditional payments (2,953) (2,953) 2,070 2,070 Decrease in unfunded disbursements (4,866) (4,866) - - Patronage distributions to members (4,564) (4,564) (4,622) (4,622) Retirement of capital stock and participation certificates, net (14) (14) (8) (8) Cash Net cash (used in)/provided by financing activities (24,064) - (24,064) 30,308-30,308 Net increase/(decrease) in cash (3,927) - (3,927) Beginning of year ,927-3,927 End of year $ 632 $ - $ 632 $ - $ - $ - Supplemental schedule of noncash transactions from investing and financing activities Decrease in loans and allowance for loan losses from charge-offs $ 1,300 $ 3 $ 1,303 $ 2,660 $ 3,342 $ 6,002 Stock patronage from Bank $ - $ 290 $ 290 $ 305 $ - $

52 Farm Credit Services Southwest, ACA Notes to Consolidated Financial Statements Years Ended December 31, 2014, 2013 and 2012 Recently Issued Accounting Pronouncements In May 2014, the Financial Accounting Standards Board (FASB) issued guidance entitled, Revenue from Contracts with Customers. The guidance governs revenue recognition from contracts with customers and requires an entity to recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. Financial instruments and other contractual rights within the scope of other guidance issued by the FASB are excluded from the scope of this new revenue recognition guidance. In this regard, a majority of our contracts would be excluded from the scope of this new guidance. In April 2015, this guidance was deferred by one year and results in the new revenue standard becoming effective for interim and annual reporting periods ending after December 15, The Association is in the process of reviewing contracts to determine the effect, if any, on the Association s financial condition or its results of operations. Loans and Allowance for Loan Losses Long-term real estate mortgage loans generally have original maturities ranging from 5 to 40 years. Substantially all short- and intermediate-term loans for agricultural production or operating purposes have maturities of 10 years or less. Loans are carried at their principal amount outstanding adjusted for charge-offs and deferred loan fees or costs. Interest on loans is accrued and credited to interest income based upon the daily principal amount outstanding. Loan origination fees and direct loan origination costs are capitalized and the net fee or cost is amortized over the life of the related loan as an adjustment to yield. Impaired loans are loans for which it is probable that principal and interest will not be collected according to the contractual terms of the loan and are generally considered substandard or doubtful, which is in accordance with the loan rating model, as described below. Impaired loans include nonaccrual loans, restructured loans, and loans past due 90 days or more and still accruing interest. A loan is considered contractually past due when any principal repayment or interest payment required by the loan contract is not received on or before the due date. A loan shall remain contractually past due until it is formally restructured or until the entire amount past due, including principal, accrued interest, and penalty interest incurred in full, is collected or otherwise discharged. Impaired loans are generally placed in nonaccrual status when principal or interest is delinquent for 90 days (unless adequately secured and in the process of collection) or when circumstances indicate that collection of principal and/or interest is in doubt. Additionally, all loans over 180 days past due are placed in nonaccrual status. When a loan is placed in nonaccrual status, accrued interest deemed uncollectible is reversed (if accrued in the current year) and/or included in the recorded nonaccrual balance (if accrued in the prior year). Loans are charged off at the time they are determined to be uncollectible. A restructured loan constitutes a troubled debt restructuring if for economic or legal reasons related to the debtor s financial difficulties the Association grants a concession to the debtor that it would not otherwise consider. When loans are in nonaccrual status, loan payments are generally applied against the recorded nonaccrual balance. A nonaccrual loan may, at times, be maintained on a cash basis. As a cash basis nonaccrual loan, the recognition of interest income from cash payments received is allowed when the collectability of the recorded investment in the loan is no longer in doubt and the loan does not have a remaining unrecovered charge-off associated with it. Nonaccrual loans may be 50

53 Farm Credit Services Southwest, ACA Notes to Consolidated Financial Statements Years Ended December 31, 2014, 2013 and 2012 returned to accrual status when all contractual principal and interest is current, the borrower has demonstrated payment performance, there are no unrecovered prior charge-offs and collection of future payments is no longer in doubt. If previously unrecognized interest income exists at the time the loan is transferred to accrual status, cash received at the time of or subsequent to the transfer is first recorded as interest income until such time as the recorded balance equals the contractual indebtedness of the borrower. In cases where a borrower experiences financial difficulties and the Association makes certain monetary concessions to the borrower through modifications to the contractual term of the loan, the loan is classified as a restructured loan. If the borrowers ability to meet the revised payment schedule is uncertain, the loan is classified as a nonaccrual loan. The Association purchases loan and lease participations from other System entities to generate additional earnings and diversify risk. Additionally, the Association sells a portion of certain loans to other System entities to reduce risk and comply with established lending limits. Loans are accounted for following the accounting requirements for sale treatment. The Association uses a two-dimensional loan rating model based on an internally generated combined System risk rating guidance that incorporates a 14-point risk-rating scale to identify and track the probability of borrower default and a separate scale addressing loss given default over a period of time. Probability of default is the probability that a borrower will experience a default within 12 months from the date of the determination of the risk rating. A default is considered to have occurred if the lender believes the borrower will not be able to pay its obligation in full or the borrower is past due more than 90 days. The loss given default is management s estimate as to the anticipated economic loss on a specific loan assuming default has occurred or is expected to occur within the next 12 months. Each of the probability of default categories carries a distinct percentage of default probability. The 14-point risk rating scale provides for granularity of the probability of default, especially in the acceptable ratings. There are nine acceptable categories that range from a borrower of the highest quality to a borrower of minimally acceptable quality. The probability of default between 1 and 9 is very narrow and would reflect almost no default to a minimal default percentage. The probability of default grows more rapidly as a loan moves from a 9 to other assets especially mentioned and grows significantly as a loan moves to a substandard (viable) level. A substandard (nonviable) rating indicates that the probability of default is almost certain. The credit risk rating methodology is a key component of the Association s allowance for loan losses evaluation, and is generally incorporated into the loan underwriting standards and internal lending limit. The allowance for loan losses is maintained at a level considered adequate by management to provide for probable and estimable losses inherent in the loan portfolio. The allowance is increased through provision for loan losses and loan recoveries and is decreased through loan loss reversals and loan charge-offs. The allowance is based on a periodic evaluation of the loan portfolio by management in which numerous factors are considered, including economic conditions, environmental conditions, loan portfolio composition, collateral value, portfolio quality, current production conditions and prior loan loss experience. The allowance for loan losses encompasses various judgments, evaluations and appraisals with respect to the loans and their underlying collateral that, by their nature, contain elements of uncertainty, imprecision and variability. Changes in the agricultural economy and environment and their impact on borrower repayment capacity will cause various judgments, evaluations and appraisals to change over time. Accordingly, actual circumstances could vary significantly from the Association s expectations and predictions of those circumstances. Management considers the following macro-economic factors 51

54 Farm Credit Services Southwest, ACA Notes to Consolidated Financial Statements Years Ended December 31, 2014, 2013 and 2012 in determining and supporting the level of allowance for loan losses: the concentration of lending in agriculture, combined with uncertainties associated with farmland values, commodity prices, exports, government assistance programs, regional economic effects and weather-related influences. The allowance for loan losses includes components for loans individually evaluated for impairment, loans collectively evaluated for impairment and loans acquired with deteriorated credit quality. Generally, for loans individually evaluated the allowance for loan losses represents the difference between the recorded investment in the loan and the present value of the cash flows expected to be collected discounted at the loan s effective interest rate, or at the fair value of the collateral, if the loan is collateral dependent. For those loans collectively evaluated for impairment, the allowance for loan losses is determined using the risk-rating model, as previously discussed. Cash and Cash Equivalents Cash, as included in the financial statements, represents cash on hand and on deposit at financial institutions. Rabbi Trust money market funds are included in other assets. Investment in the Bank The Association s required investment in CoBank is in the form of Class A Stock. The minimum required investment is 4.00 percent of the prior year s average direct loan volume. The investment in CoBank is comprised of patronage based stock and purchased stock. Premises and Equipment Land is carried at cost. Premises and equipment are carried at cost less accumulated depreciation. Depreciation is provided on a straight-line method over the estimated useful lives of the assets. Useful lives for the building is 40 years and range from 7 to 10 years for furniture, equipment and automobiles. Gains and losses on dispositions are reflected in current operating results. Maintenance and repairs are expensed and improvements above certain thresholds are capitalized. Other Property Owned Other property owned, consisting of real and personal property acquired through foreclosure or deed in lieu of foreclosure, is recorded at fair value less estimated selling costs upon acquisition. Any initial reduction in the carrying amount of a loan to the fair value of the collateral received is charged to the allowance for loan losses. On at least an annual basis, revised estimates to the fair value less cost to sell are reported as adjustments to the carrying amount of the asset, provided that such adjusted value is not in excess of the carrying amount at acquisition. Income and expenses from operations and carrying value adjustments are included in net gains (losses) on other property owned in the Consolidated Statements of Comprehensive Income. Other Assets and Other Liabilities Other assets are comprised primarily of Rabbi Trust assets, pension restoration plan assets, and investments in other Farm Credit institutions and service entities. Significant components of other liabilities primarily include accounts payable, accrued pension liabilities and employee benefits. Advance Conditional Payments The Association is authorized under the Farm Credit Act to accept advance payments from borrowers. Advanced conditional payments are included in liabilities. Advance conditional payments are not insured. Interest is generally paid by the Association on advance conditional payments. 52

55 Farm Credit Services Southwest, ACA Notes to Consolidated Financial Statements Years Ended December 31, 2014, 2013 and 2012 Employee Benefit Plans Substantially all employees of the Association participate in the Eleventh District Defined Benefit Retirement Plan (Defined Benefit Plan) and/or the Farm Credit Foundations Defined Contribution/401(k) Plan (Defined Contribution Plan). The Defined Benefit Plan is a noncontributory plan. Benefits are based on compensation and years of service. The Association recognizes its proportional share of expense and contributes its proportional share of funding. The Defined Benefit Plan was closed to employees hired after December 31, The Defined Contribution Plan has two components. Employees who do not participate in the Defined Benefit Plan may receive benefits through the Employer Contribution portion of the Defined Contribution Plan. In this plan, the Association provides a monthly contribution based on a defined percentage of the employee s salary. Employees may also participate in a Salary Deferral Plan governed by Section 401(k) of the Internal Revenue Code. The Association matches a certain percentage of employee contributions. Employees hired on or after January 1, 1998 are eligible to participate only in the Defined Contribution Plan. All defined contribution costs are expensed in the same period that participants earn employer contributions. The Association also provides certain health and life insurance benefits to eligible current and retired employees through the Farm Credit Foundation Retiree Medical and Retiree Life Plans. Employees may become eligible for those benefits if they reach normal retirement age while working for the Association. The anticipated costs of these benefits are accrued during the period of the employee s active service. The authoritative accounting guidance requires the accrual of the expected cost of providing postretirement benefits during the years that the employee renders service necessary to become eligible for these benefits. The Association also participates in the Eleventh District nonqualified defined benefit Pension Restoration Plan. This plan provides retirement benefits above the Internal Revenue Code compensation limit to certain highly compensated eligible employees. Benefits payable under this plan are offset by the benefits payable from the pension plan. Certain eligible employees may also participate in a nonqualified deferred compensation plan where they are able to defer a portion of their. The Association matches a certain percentage of employee contributions to the plan. Income Taxes As previously described, the ACA holding company conducts its business activities through two wholly owned subsidiaries. Long-term real estate mortgage lending activities are operated through a wholly owned FLCA subsidiary which is exempt from federal and state income tax. Short and intermediate-term lending activities are operated through a wholly owned PCA subsidiary. Operating expenses are allocated to each subsidiary based on estimated relative service. All significant transactions between the subsidiaries and the parent company have been eliminated in consolidation. The ACA, which is the holding company, along with the PCA subsidiary, is subject to income taxes. The Association accounts for income taxes under the liability method. Accordingly, deferred taxes are recognized for estimated taxes ultimately payable or recoverable based on federal, state or local laws. The Association is eligible to operate as a cooperative that qualifies for tax treatment under Subchapter T of the Internal Revenue Code. Accordingly, under specified conditions, the Association can exclude from taxable income amounts distributed as qualified patronage refunds in the form of cash, stock or allocated retained earnings. Provisions for income taxes are made only on those taxable earnings that will not be distributed as qualified patronage distributions. 53

56 Farm Credit Services Southwest, ACA Notes to Consolidated Financial Statements Years Ended December 31, 2014, 2013 and 2012 Deferred taxes are recorded on the tax effect of all temporary differences based on the assumption that such temporary differences are retained by the Association and will therefore impact future tax payments. A valuation allowance is provided against deferred tax assets to the extent that it is more likely than not (over 50% probability), based on management s estimate, the deferred tax assets will not be realized. The consideration of valuation allowances involves various estimates and assumptions as to future taxable earnings, including the effects of the Association s expected patronage program, which reduces taxable earnings. Deferred income taxes have not been provided by the Association on stock patronage distributions received from its funding bank prior to January 1, 1993, the adoption date of the accounting guidance on income taxes. Association management s intent is to permanently invest these and other undistributed earnings in its funding bank, or if converted to cash, to pass through any such earnings to Association borrowers through qualified patronage allocations. The Association has not provided deferred income taxes on amounts allocated to the Association which relate to its funding bank s post-1992 earnings to the extent that such earnings will be passed through to Association borrowers through qualified patronage allocations. Additionally, deferred income taxes have not been provided on its funding bank s post-1992 unallocated earnings. On December 31, 2011, U.S. AgBank FCB in anticipation of its January 1, 2012 merger with CoBank, recapitalized and distributed stock to its Association members. Deferred taxes have not been recorded by the Association on that distribution as management s intent, if that stock is ever converted to cash, is to pass through any related earnings to Association borrowers through qualified patronage allocations. Patronage Distribution from Farm Credit Institutions Patronage distributions from CoBank are accrued by the Association in the year earned. Other Comprehensive Income (Loss) Other comprehensive income refers to revenue, expenses, gains and losses that under GAAP are recorded as an element of members equity and comprehensive income but are excluded from net income. The Association records other comprehensive income or loss associated with the liability under the Pension Restoration Plan. Fair Value Measurements Accounting guidance defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. It describes three levels of inputs that may be used to measure fair value: Level 1 Level 2 Quoted prices in active markets for identical assets or liabilities that the reporting entity has the ability to access at the measurement date. Level 1 assets include assets held in trust funds which relate to the Association s deferred compensation plan and supplemental retirement plan. The trust funds include investments that are actively traded and have quoted net asset values that are observable in the marketplace. Observable inputs other than quoted prices included within Level 1 that are observable for the asset or liability either directly or indirectly. Level 2 inputs include the following: (a) quoted prices for similar assets or liabilities in active markets; (b) quoted prices for identical or similar assets or liabilities in markets that are not active so that they are traded less frequently than exchange-traded instruments, the prices are not current or 54

57 Farm Credit Services Southwest, ACA Notes to Consolidated Financial Statements Years Ended December 31, 2014, 2013 and 2012 principal market information is not released publicly; (c) inputs other than quoted prices that are observable such as interest rates and yield curves, prepayment speeds, credit risks and default rates; and, (d) inputs derived principally from or corroborated by observable market data by correlation or other means. Level 2 investments include various types of bonds. Level 3 Unobservable inputs are those that are supported by little or no market activity and that are significant to the determination of the fair value of the assets or liabilities. These unobservable inputs reflect the reporting entity s own assumptions about factors that market participants would use in pricing the asset or liability. Level 3 assets and liabilities include financial instruments whose values are determined using pricing models, discounted cash flow methodologies, or similar techniques, as well as instruments for which the determination of fair value requires significant management judgment or estimation. Level 3 assets include loans and other property owned. The fair value disclosures are reported in Note 15. Off-Balance-Sheet Credit Exposures Commitments to extend credit are agreements to lend to customers, generally having fixed expiration dates or other termination clauses that may require payment of a fee. Commercial letters of credit are conditional commitments issued to guarantee the performance of a customer to a third party. These letters of credit are issued to facilitate commerce and typically result in the commitment being funded when the underlying transaction is consummated between the customer and third party. The credit risk associated with commitments to extend credit and commercial letters of credit is essentially the same as that involved with extending loans to customers and is subject to normal credit policies. Collateral may be obtained based on management s assessment of the customer s creditworthiness. 3. Loans and Allowance for Loan Losses (restated) A summary of loans follows: December 31, (dollars in thousands) As Restated As Restated Real estate mortgage $ 535,188 $ 534,030 $ 533,806 Production and intermediate-term 354, , ,400 Agribusiness: Farm related business 61,515 45,026 36,180 Processing and marketing 18,248 4,550 8,365 Cooperatives 8,998 13,405 5,581 Lease receivables 15,977 18,929 17,290 Rural residential real estate Total loans $ 994,342 $ 950,888 $ 962,781 55

58 Farm Credit Services Southwest, ACA Notes to Consolidated Financial Statements Years Ended December 31, 2014, 2013 and 2012 The Association purchases or sells loan participations with other parties in order to diversify risk, manage loan volume and comply with FCA regulations. At December 31, 2014, all participations sold and purchased were with other Farm Credit Institutions. The following table presents information regarding participations purchased and sold as of December 31, 2014: Total (dollars in thousands) Purchased Sold Real estate mortgage $ 15,843 $ 95,379 Production and intermediate-term 26, ,018 Agribusiness 72,464 7,463 Lease receivables 17,361 - $ 131,913 $ 257,860 The Association s concentration of credit risk in various agricultural commodities is shown in the following table: (dollars in thousands) December 31, Commodity Amount Percentage Amount Percentage Amount Percentage As Restated As Restated Dairy $ 249,895 25% $ 271,110 28% $ 296,591 31% Hay 173, , , Livestock 99, , , Field crops 74, , ,310 6 Vegetables 74, , ,881 8 Fruit 57, , ,857 4 Cotton 56, , ,608 6 Farm related business 52, , ,908 4 Cash rent 51, , ,535 4 Feed grains 46, , ,328 4 Nuts 26, , ,301 2 Other 31, , ,421 3 $ 994, % $ 950, % $ 962, % While the amounts represent the Association s maximum potential credit risk as it relates to recorded loan principal, a substantial portion of the Association s lending activities are collateralized. Accordingly, the Association s exposure to credit loss associated with lending activities is considerably less than the recorded loan balances. An estimate of the Association s credit risk exposure is indicated in the consolidated Statements of Condition in the allowance for loan losses. The amount of collateral obtained, if deemed necessary upon extension of credit, is based on management s credit evaluation of the borrower. Collateral held varies, but typically includes farmland and income-producing property, such as crops and livestock, as well as receivables. Long-term real estate mortgage loans are secured by first liens on the underlying real property. Federal regulations state that long-term real estate mortgage loans are not to exceed 85 percent 56

59 Farm Credit Services Southwest, ACA Notes to Consolidated Financial Statements Years Ended December 31, 2014, 2013 and 2012 (97 percent if guaranteed by a government agency) of the property s appraised value. However, a decline in a property s market value subsequent to loan origination or advances, or other actions necessary to protect the financial interest of the Association in the collateral, may result in loan to value ratios in excess of the regulatory maximum. The Association has obtained credit enhancements by entering into Standby Commitment to Purchase Agreements (Agreements) with the Federal Agricultural Mortgage Corporation (Farmer Mac), covering loans with principal balance outstanding of $240 million, $232 million and $246 million at December 31, 2014, 2013 and 2012, respectively. Under the Agreements, Farmer Mac agrees to purchase loans from the Association in the event of default (typically four months past due), subject to certain conditions, thereby mitigating the risk of loss from covered loans. In return, the Association pays Farmer Mac commitment fees based on the outstanding balance of loans covered by the Agreements. Such fees, totaling $1.0 million for 2014 and $1.1 million for 2013 and 2012, are reflected as a reduction to interest income. Credit enhancements with federal government agencies of $29 million at year-end 2014, $36 million at year-end 2013 and $33 million at year-end 2012 were outstanding. One credit quality indicator utilized by the Association is the FCA Uniform Loan Classification System that categorizes loans into five categories. The categories are defined as follows: Acceptable assets are expected to be fully collectible and represent the highest quality, Other assets especially mentioned (OAEM) assets are currently collectible but exhibit some potential weakness, Substandard assets exhibit some serious weakness in repayment capacity, equity, and/or collateral pledged on the loan, Doubtful assets exhibit similar weaknesses to substandard assets; however, doubtful assets have additional weaknesses in existing factors, conditions and values that make collection in full highly questionable, and Loss assets are considered uncollectible. 57

60 Farm Credit Services Southwest, ACA Notes to Consolidated Financial Statements Years Ended December 31, 2014, 2013 and 2012 The following table shows loans and related accrued interest classified under the FCA Uniform Loan Classification system as a percentage of total loans and related accrued interest receivable by loan type as of December As Restated As Restated Real estate mortgage Acceptable 91.9 % 93.6 % 92.3 % OAEM Substandard % % % Production and intermediate-term Acceptable 90.7 % 92.8 % 90.9 % OAEM Substandard Doubtful % % % Agribusiness Acceptable 99.6 % 97.9 % 96.8 % OAEM Substandard % % % Lease receivables Acceptable 99.3 % 98.7 % 97.6 % OAEM Substandard % % % Rural residential real estate Acceptable % % % % % % Total loans Acceptable 92.3 % 93.7 % 92.1 % OAEM Substandard Doubtful % % % 58

61 Farm Credit Services Southwest, ACA Notes to Consolidated Financial Statements Years Ended December 31, 2014, 2013 and 2012 Impaired loans are loans for which it is probable that all principal and interest will not be collected according to the contractual terms of the loan. The following table presents information concerning impaired loans including accrued interest: December 31, (dollars in thousands) As Restated As Restated Nonaccrual loans Current as to principal and interest $ 34,752 $ 20,466 $ 23,610 Past due 6,988 1, Total nonaccrual loans 41,740 22,218 23,757 Impaired accrual loans Restructured 7,286 9,882 10,068 Ninety days or more past due Total impaired accrual loans 7,286 9,987 10,068 Total impaired loans $ 49,026 $ 32,205 $ 33,825 Commitments to lend additional funds to debtors whose loans were classified as impaired at December 31, 2014 totaled $1.5 million. High risk assets consist of impaired loans and other property owned. The following table presents these in a more detailed manner than the previous table. These nonperforming assets (including related accrued interest) are as follows: (dollars in thousands) As Restated As Restated Nonaccrual loans Real estate mortgage $ 23,688 $ 15,433 $ 16,943 Production and intermediate-term 18,052 6,785 6,814 Total nonaccrual loans 41,740 22,218 23,757 Accruing restructured loans Real estate mortgage 7,286 9,882 10,068 Total accruing restructured loans 7,286 9,882 10,068 Accruing loans 90 days past due Production and intermediate-term Total accruing loans 90 days past due Total impaired loans 49,026 32,205 33,825 Other property owned - 1,130 1,130 Total high risk assets $ 49,026 $ 33,335 $ 34,955 59

62 Farm Credit Services Southwest, ACA Notes to Consolidated Financial Statements Years Ended December 31, 2014, 2013 and 2012 Additional impaired loan information is as follows: (dollars in thousands) Recorded Investment at Unpaid Average Interest December 31, Principal Related Impaired Income 2014 Balance Allowance Loans Recognized Impaired loans with a related allowance for credit losses Real estate mortgage $ 7,694 $ 7,849 $ 1,409 $ 7,735 $ 94 Production and intermediate-term 13,772 14,654 7,900 12,883 - Total $ 21,466 $ 22,503 $ 9,309 $ 20,618 $ 94 Impaired loans with no related allowance for credit losses Real estate mortgage $ 23,274 $ 30,182 $ - $ 23,256 $ 188 Production and intermediate-term 4,286 5,994-5,445 - Total $ 27,560 $ 36,176 $ - $ 28,701 $ 188 Total impaired loans Real estate mortgage $ 30,968 $ 38,031 $ 1,409 $ 30,991 $ 282 Production and intermediate-term 18,058 20,648 7,900 18,328 - Total $ 49,026 $ 58,679 $ 9,309 $ 49,319 $ 282 (dollars in thousands) Recorded Investment at Unpaid Average Interest December 31, Principal Related Impaired Income 2013 Balance Allowance Loans Recognized As Restated As Restated As Restated As Restated Impaired loans with a related allowance for credit losses Real estate mortgage $ 11,582 $ 12,139 $ 1,456 $ 12,231 $ 95 Production and intermediate-term 5,925 5,951 4,029 5,044 - Total $ 17,507 $ 18,090 $ 5,485 $ 17,275 $ 95 Impaired loans with no related allowance for credit losses Real estate mortgage $ 13,732 $ 20,024 $ - $ 20,065 $ 445 Production and intermediate-term 966 1,302-1, Total $ 14,698 $ 21,326 $ - $ 21,484 $ 512 Total impaired loans Real estate mortgage $ 25,314 $ 32,163 $ 1,456 $ 32,296 $ 540 Production and intermediate-term 6,891 7,253 4,029 6, Total $ 32,205 $ 39,416 $ 5,485 $ 38,759 $

63 Farm Credit Services Southwest, ACA Notes to Consolidated Financial Statements Years Ended December 31, 2014, 2013 and 2012 (dollars in thousands) Recorded Investment at Unpaid Average Interest December 31, Principal Related Impaired Income 2012 Balance Allowance Loans Recognized As Restated As Restated As Restated As Restated Impaired loans with a related allowance for credit losses Real estate mortgage $ 16,048 $ 19,615 $ 1,419 $ 18,479 $ 97 Production and intermediate-term 4,313 4,357 2,432 3, Total $ 20,361 $ 23,972 $ 3,851 $ 22,032 $ 120 Impaired loans with no related allowance for credit losses Real estate mortgage $ 12,267 $ 12,579 $ - $ 12,184 $ 288 Production and intermediate-term 1,197 1,485-1, Total $ 13,464 $ 14,064 $ - $ 13,621 $ 303 Total impaired loans Real estate mortgage $ 28,315 $ 32,194 $ 1,419 $ 30,663 $ 385 Production and intermediate-term 5,510 5,842 2,432 4, Total $ 33,825 $ 38,036 $ 3,851 $ 35,653 $ 423 Interest income is recognized and cash payments are applied on nonaccrual impaired loans as described in Note 2. The following table presents interest income recognized on impaired loans and average impaired loans: Years Ended December 31, (dollars in thousands) Interest income recognized on Nonaccrual loans $ 28 $ 222 $ 46 Restructured accrual loans Accrual loans 90 days or more past due Interest income recognized on impaired loans $ 282 $ 607 $ 423 Average impaired loans (As restated for 2013 and 2012) $ 49,319 $ 38,759 $ 35,653 Interest income on nonaccrual and accruing restructured loans that would have been recognized under the original terms of the loans as follows: Years Ended December 31, (dollars in thousands) As Restated As Restated Interest income which would have been recognized under the original loan terms $ 2,071 $ 2,600 $ 2,783 Less: Interest income recognized (282) (606) (423) Foregone interest income $ 1,789 $ 1,994 $ 2,360 61

64 Farm Credit Services Southwest, ACA Notes to Consolidated Financial Statements Years Ended December 31, 2014, 2013 and 2012 The following table provides an age analysis of past due loans (including accrued interest): Not Past Recorded (dollars in thousands) Days Due or less Investment Days Past or More Total Past than 30 Days > 90 Days December 31, 2014 Due Past Due Due Past Due Total Loans and Accruing Real estate mortgage $ 4,103 $ 4,464 $ 8,567 $ 531,834 $ 540,401 $ - Production and intermediate-term 2,013 2,014 4, , ,947 - Agribusiness ,859 88,859 - Rural residential real estate Lease receivables ,977 15,977 - Total $ 6,228 $ 6,478 $ 12,706 $ 988,590 $ 1,001,296 $ - Not Past Recorded (dollars in thousands) Days Due or less Investment Days Past or More Total Past than 30 Days > 90 Days December 31, 2013 Due Past Due Due Past Due Total Loans and Accruing As Restated As Restated Real estate mortgage $ 1,413 $ - $ 1,413 $ 538,522 $ 539,935 $ - Production and intermediate-term , , , Agribusiness ,154 63,154 - Rural residential real estate Lease receivables ,930 18,930 - Total $ 2,281 $ 444 $ 2,725 $ 956,768 $ 959,493 $ 105 Not Past Recorded (dollars in thousands) Days Due or less Investment Days Past or More Total Past than 30 Days > 90 Days December 31, 2012 Due Past Due Due Past Due Total Loans and Accruing As Restated As Restated Real estate mortgage $ - $ - $ - $ 539,532 $ 539,532 $ - Production and intermediate-term , ,470 - Agribusiness ,079 50,314 - Rural residential real estate Lease receivables ,290 17,290 - Total $ 873 $ 147 $ 1,020 $ 970,746 $ 971,766 $ - 62

65 Farm Credit Services Southwest, ACA Notes to Consolidated Financial Statements Years Ended December 31, 2014, 2013 and 2012 Note: The recorded investment in the loan receivable is the face amount increased or decreased by applicable accrued interest and unamortized premium, discount, finance charges, or acquisitions costs and may also reflect a previous direct write-down of the loan receivable. A restructuring of a debt constitutes a troubled debt restructuring if the creditor for economic or legal reasons related to the debtor s financial difficulties grants a concession to the debtor that it would not otherwise consider. There were no new troubled debt restructurings as of December 31, 2013 and The following table presents additional information regarding troubled debt restructurings (whether accrual or nonaccrual) that occurred during the year ended: (dollars in thousands) Year ended: December 31, 2012 Pre-modification Post-modification Outstanding Outstanding Recorded Recorded Investment* Investment* Troubled debt restructurings Real Estate Mortgage $ 12,090 $ 9,727 $ 12,090 $ 9,727 *Pre-modification represents the recorded investment in the loan receivable just prior to restructuring and post-modification represents the recorded investment in the loan receivable immediately following the restructuring. The recorded investment is the face amount of the loan receivable increased or decreased by applicable accrued interest and unamortized premium, discount, finance charges, or acquisition costs and may also reflect a previous direct write-down of the loan receivable. There were no troubled debt restructurings that occurred within the previous 12 months for which there was a payment default during the period. The following table provides information on outstanding loans restructured in troubled debt restructurings at period end. These loans are included as impaired loans in the impaired table. Loans modified as TDRs (dollars in thousands) December 31, December 31, December 31, Troubled debt restructurings Real Estate Mortgage $ 11,508 $ 14,305 $ 15,620 Production and intermediate term $ 11,541 $ 14,305 $ 15,768 63

66 Farm Credit Services Southwest, ACA Notes to Consolidated Financial Statements Years Ended December 31, 2014, 2013 and 2012 TDRs in Nonaccrual Status (dollars in thousands) December 31, December 31, December 31, Troubled debt restructurings Real Estate Mortgage $ 4,222 $ 4,423 $ 5,552 Production and intermediate term $ 4,255 $ 4,423 $ 5,700 A summary of the changes in the allowance for loan losses and period end recorded investment in loans is as follows: Provision for Balance at Loan Losses Balance at December 31, Charge- (Loan Loss December 31, (dollars in thousands) 2013 offs Recoveries Reversals) 2014 As Restated Real estate mortgage $ 2,522 $ (30) $ 67 $ (711) $ 1,848 Production and intermediate-term 5,638 (357) 1,704 5,851 12,836 Agribusiness Lease receivables (10) 40 Total $ 8,296 $ (387) $ 1,771 $ 5,148 $ 14,828 Provision for Balance at Loan Losses/ Balance at December 31, Charge- (Loan Loss December 31, (dollars in thousands) 2012 offs Recoveries Reversals) 2013 As Restated Real estate mortgage $ 2,581 $ (1,126) $ 13 $ 1,054 $ 2,522 Production and intermediate-term 3,920 (177) 510 1,385 5,638 Agribusiness Lease receivables (23) 50 Total $ 6,645 $ (1,303) $ 523 $ 2,431 $ 8,296 Provision for Balance at Loan Losses/ Balance at December 31, Charge- (Loan Loss December 31, (dollars in thousands) 2011 offs Recoveries Reversals) 2012 As Restated Real estate mortgage $ 5,083 $ (2,631) $ 72 $ 57 $ 2,581 Production and intermediate-term 3,906 (3,371) 799 2,586 3,920 Agribusiness Rural residential real estate (1) - Lease receivables Total $ 9,095 $ (6,002) $ 871 $ 2,681 $ 6,645 64

67 Farm Credit Services Southwest, ACA Notes to Consolidated Financial Statements Years Ended December 31, 2014, 2013 and 2012 Allowance for Credit Losses Recorded Investments in Ending Balance at December 31, 2014 Ending Balance at December 31, 2014 Individually Collectively Individually Collectively Evaluated for Evaluated for Evaluated for Evaluated for (dollars in thousands) Impairment Impairment Impairment Impairment Real estate mortgage $ 1,409 $ 439 $ 30,968 $ 508,680 Production and intermediate-term 7,900 4,936 18, ,642 Agribusiness ,859 Rural residential real estate Lease receivables ,977 Total $ 9,309 $ 5,519 $ 49,026 $ 952,270 Allowance for Credit Losses Recorded Investments in Ending Balance at December 31, 2013 Ending Balance at December 31, 2013 Individually Collectively Individually Collectively Evaluated for Evaluated for Evaluated for Evaluated for (dollars in thousands) Impairment Impairment Impairment Impairment As Restated As Restated As Restated Real estate mortgage $ 1,456 $ 1,066 $ 25,314 $ 514,621 Production and intermediate-term 4,029 1,609 6, ,470 Agribusiness ,154 Rural residential real estate Lease receivables ,930 Total $ 5,485 $ 2,811 $ 32,205 $ 927,289 Allowance for Credit Losses Recorded Investments in Ending Balance at December 31, 2012 Ending Balance at December 31, 2012 Individually Collectively Individually Collectively Evaluated for Evaluated for Evaluated for Evaluated for (dollars in thousands) Impairment Impairment Impairment Impairment As Restated As Restated As Restated Real estate mortgage $ 1,419 $ 1,162 $ 28,315 $ 512,521 Production and intermediate-term 2,432 1,488 5, ,656 Agribusiness ,314 Rural residential real estate Lease receivables ,290 Total $ 3,851 $ 2,794 $ 33,825 $ 937, Investment in the Bank The Association is required to maintain an investment in CoBank equal to 4.00 percent of the prior year s average direct loan volume. The investment in CoBank is composed of patronage based stock and purchased stock. 65

68 Farm Credit Services Southwest, ACA Notes to Consolidated Financial Statements Years Ended December 31, 2014, 2013 and Premises and Equipment Premises and equipment consisted of the following: December 31, (dollars in thousands) Land and building and improvements $ 5,642 $ 5,607 $ 4,775 Furniture and equipment 1,415 1,450 1,392 Automobiles Construction in process ,139 7,242 6,521 Less: Accumulated depreciation (2,476) (2,420) (2,396) Total premises and equipment $ 4,663 $ 4,822 $ 4,125 The Association is obligated under various non-cancelable operating leases primarily for vehicles. At December 31, 2014, future minimum payments for these non-cancelable leases are as follows: (dollars in thousands) Total minimum lease payments $ Other Property Owned Losses on other property owned, net as reflected on the Consolidated Statements of Comprehensive Income consisted of the following: (dollars in thousands) Losses/(gains) on sale, net $ 268 $ (13) $ (254) Carrying value adjustments Operating (income) expense, net 15 (2) - Losses on other property owned, net $ 455 $ 2 $ Notes Payable to the Bank The Association s indebtedness to CoBank represents borrowings by the Association to fund its loan portfolio. This indebtedness is collateralized by a pledge of substantially all of the Association s assets and is governed by a General Financing Agreement (GFA), which provides a $1.0 billion line of credit. The GFA and promissory note require the Association to comply with certain covenants and are subject to periodic renewals in the normal course of business. The GFA matures on May 31, Management expects renewal of the GFA at that time. The Association was in compliance with the terms and conditions of the GFA as of December 31, Substantially, all borrower loans are match-funded with CoBank. Payments and disbursements are 66

69 Farm Credit Services Southwest, ACA Notes to Consolidated Financial Statements Years Ended December 31, 2014, 2013 and 2012 made on the note payable to CoBank on the same basis the Association collects payments from and disburses on borrower loans. The interest rate may periodically be adjusted by CoBank based on the terms and conditions of the borrowing. The weighted average interest rate was 1.19% percent for the year ended December 31, 2014, compared with 1.28% at December 31, 2013 and 1.40% at December 31, The Association has the opportunity to commit loanable funds with CoBank under a variety of programs at either fixed or variable rates for specified timeframes. Participants in the program receive a credit on the committed loanable funds balance that is classified as a reduction of interest expense. These committed funds are netted against the note payable to the Bank as of December 31 follow: (dollars in thousands) Committed funds $ 3,500 $ 9,700 $ 14,200 Average rates 1.99 % 2.72 % 2.39 % Under the Farm Credit Act, the Association is obligated to borrow only from CoBank, unless CoBank approves borrowing elsewhere. CoBank, consistent with FCA regulations, has established limitations on the Association s ability to borrow funds based on specified factors or formulas relating primarily to credit quality and financial condition. At December 31, 2014, the Association s notes payable was within the specified limitations. 8. Members Equity Descriptions of the Association s capitalization requirements, capital protection mechanisms, regulatory capitalization requirements and restrictions, and equities are provided below. Capital Stock and Participation Certificates In accordance with the Farm Credit Act, each borrower is required to invest in the Association as a condition of borrowing. The borrower normally acquires ownership of the stock or participation certificates at the time the loan is made. The Association has a first lien on the stock or participation certificates owned by its borrowers. At the discretion of the Board of Directors, retirement of such equities will generally be at the lower of par or book value, and repayment of a loan does not automatically result in retirement of the corresponding stock or participation certificates. In accordance with the Association s capitalization bylaws, each borrower is required to invest in the Association as a condition of borrowing. Capitalization bylaws allow stock requirements to range from the lesser of one thousand dollars or 2.0% of the amount of the loan up to but not greater than 10.0% of the loan. The Board of Directors has the authority to change the minimum required stock level of a shareholder as long as the change is within this range. Currently, the Association has a stock requirement of the lesser of 2 percent of the borrower s combined loan volume or $1,000. Description of Equities Each owner of class C capital stock is entitled to a single vote. Other classes of borrower equities do not provide voting rights to their owners. Voting stock may not be transferred to another person unless such person is eligible to hold voting stock. 67

70 Farm Credit Services Southwest, ACA Notes to Consolidated Financial Statements Years Ended December 31, 2014, 2013 and 2012 The Association has the authority to issue the following classes of stock, some of which have no shares outstanding: Class A Preferred Stock (Nonvoting) may be issued to investors who need not be eligible to borrow from the Association. The Association currently has no intention of issuing this class of stock. Class A Common Stock (Nonvoting) issued to eligible borrowers who previously held Class C or Class F Stock but have not had a borrowing relationship with the Association for more than two years. Class C Common Stock (Voting) issued to eligible borrowers except for those that are only eligible for Class F Stock. Class D Common Stock (Nonvoting) issued to a Farm Credit Bank or other Farm Credit institution. Class F Participation Certificates (Nonvoting) issued to those eligible borrowers who are not eligible to hold Class C Voting Stock under the regulations of the Farm Credit System. At December 31, 2014, the Association had 116 shares of Class A common stock, 156,600 shares of Class C common stock, 600 shares of Class D common stock and 5,384 shares Class F participation certificates outstanding, all at a par value of $5.00 per share. Losses that result in impairment of capital stock and participation certificates will be allocated to the classes of equity described above on a pro-rata basis. Upon liquidation of the Association, any assets remaining after the settlement of all liabilities will be distributed first to redeem the par value of protected equities and then to redeem the par value of unprotected equities. Any assets remaining after such distribution will be shared, pro-rata, by all stock and certificate holders of record immediately before the liquidation distribution. Regulatory Capitalization Requirements and Restrictions The FCA s capital adequacy regulations require the Association to maintain permanent capital of 7% of average risk-adjusted assets. Failure to meet the requirement can initiate certain mandatory and possibly additional discretionary actions by FCA that, if undertaken, could have a direct material effect on the Association s consolidated financial statements. The Association is prohibited from reducing permanent capital by retiring stock or making certain other distributions to shareholders unless the prescribed capital standard is met. The FCA regulations also require other additional minimum standards for capital be maintained. These standards require all System institutions to achieve and maintain ratios of total surplus as a percentage of average risk-adjusted assets of 7% and of core surplus (generally unallocated surplus) as a percentage of average riskadjusted assets of 3.5%. The Association s permanent capital, total surplus and core surplus ratios at December 31, 2014, were 13.73%, 13.63% and 12.90%, respectively. An existing regulation empowers FCA to direct a transfer of funds or equities by one or more System institutions to another System institution under specified circumstances. This regulation has not been utilized to date. The Association has not been called upon to initiate any transfers and is not aware of any proposed action under this regulation. 68

71 Farm Credit Services Southwest, ACA Notes to Consolidated Financial Statements Years Ended December 31, 2014, 2013 and 2012 Patronage Distributions The Association s bylaws provide for the payment of patronage distributions. Prior to the beginning of any fiscal year, the Board of Directors, by adoption of a resolution, may obligate the Association to distribute to stockholders on a patronage basis, all or any portion of available net earnings for such fiscal year. All patronage distributions to borrowers shall be on such proportionate patronage basis as may be approved by the Association s Board of Directors, consistent with the requirement of Subchapter T of the Internal Revenue Code. That portion of patronage-sourced net income not distributed in cash is also allocated to patrons. In accordance with Internal Revenue Service requirements, each customer is sent a nonqualified written notice of allocation. Allocated, but not distributed patronage refunds, are included in the unallocated retained earnings account. Such allocations may provide a future basis for a distribution of capital. The Board of Directors considers these unallocated retained earnings to be permanently invested in the Association. As such, there is no current plan to revolve or redeem these amounts. No express or implied right to have such capital retired or revolved at any time is granted. For 2014, the Board did not approve a cash patronage distribution. The Board approved patronage distributions of $4.7 million during 2013 and $4.5 million during 2012, which were paid in cash to shareholders in 2014 and 2013, respectively. Accumulated Other Comprehensive Income (Loss) The Association reports other comprehensive income (loss) in its Consolidated Statements of Comprehensive Income. As more fully described in Note 2, other comprehensive income/loss results from the recognition of the Pension Restoration Plan s net unamortized gains and losses and prior service credits of ($193) thousand in 2014, ($42) thousand in 2013 and $29 thousand in There were no other items affecting comprehensive income or loss. 9. Patronage Distribution from Farm Credit Institutions Patronage income recognized from Farm Credit Institutions to the Association follows. Years Ended December 31, (dollars in thousands) CoBank $ 5,487 $ 5,261 $ 5,638 Farm Credit Foundations Other Total $ 5,487 $ 5,270 $ 5,714 Patronage distributed from CoBank was in cash and stock. There were $398 thousand in stock distributions in 2014, $290 thousand in 2013, and $305 thousand in The amount earned in 2014 was accrued and will be paid by CoBank in March The amount earned and accrued in 2013 and 2012 was paid by CoBank in March 2014 and 2013, respectively.. 69

72 Farm Credit Services Southwest, ACA Notes to Consolidated Financial Statements Years Ended December 31, 2014, 2013 and Income Taxes (restated) As a result of the restatement of prior years income as described in Note 2, there was no provision for income taxes in years 2014, 2013 or The following table quantifies the differences between the provision for income taxes and the amount of income tax determined by applying the applicable U.S. statutory federal income tax rate to pretax book income: Years Ended December 31, As Restated As Restated (dollars in thousands) Amount Amount Amount Federal tax at statutory rate $ 1,704 $ 4,337 $ 4,292 Effect of nontaxable FLCA subsidiary (3,481) (4,046) (4,610) Patronage distribution - (1,120) - State tax, net Adjustments to federal deferred tax asset valuation allowance 1, Prior year tax adjustment Other (66) Provision for income taxes $ - $ - $ - Deferred tax assets and liabilities are comprised of the following: December 31, (dollars in thousands) As Restated As Restated Deferred tax assets Allowance for loan losses $ 5,120 $ 2,800 $ 1,926 Postretirement benefits other than pensions Pension liability Basis difference on acquired property Loss carryforward 1,000 1,213 1,213 Nonaccural income Gross deferred tax asset 6,940 4,927 4,005 Less: Valuation allowance (5,868) (3,794) (2,906) Deferred tax assets, net of valuation allowance 1,072 1,133 1,099 Deferred tax liability Deferred loan origination fees (449) (536) (520) Patronage receivable from CoBank (509) (500) (488) Pension asset (114) (97) (91) Net deferred tax asset $ - $ - $ - The calculation of deferred tax assets and liabilities involve various management estimates and assumptions as to future taxable earnings including the amount of non-patronage income and patronage income retained. The expected future tax rates are based upon enacted tax laws. 70

73 Farm Credit Services Southwest, ACA Notes to Consolidated Financial Statements Years Ended December 31, 2014, 2013 and 2012 The Association recorded a valuation allowance of $2.1 million, $889 thousand and $334 thousand during 2014, 2013 and 2012, respectively. The Association will continue to evaluate the realizability of its deferred tax assets and adjust the valuation allowance accordingly. At December 31, 2014, the Association had federal net operating loss carry-forwards of $2.8 million that expire from 2031 to The Association recognizes interest and penalties related to unrecognized tax positions as an adjustment to income tax expense. The Association did not have any positions for which it is reasonably possible that the total amounts of unrecognized tax positions will significantly increase or decrease within the next 12 months. The Association accounts for income taxes in accordance with ASC 740, which provides guidance for how uncertain tax positions should be recognized, measured, presented and disclosed in the financial statements. ASC 740 requires the evaluation of tax positions taken or expected to be taken in the course of preparing the Association's tax returns to determine whether the tax positions are more likely than not of being sustained upon examination by the applicable tax authority, based on the technical merits of the tax position, and then measuring the tax benefit that is more-likely-than-not to be realized. Tax positions not deemed to meet the more-likely-than-not threshold would be recorded as a tax expense in the current reporting period. The Association has no uncertain tax positions to be recognized as of December 2014, 2013 or The tax years that remain open for federal and major state income tax jurisdictions are 2011 and forward. 11. Employee Benefit Plans Certain employees participate in the Eleventh Retirement Plan, a multi-employer defined benefit retirement plan. The Department of Labor has determined the plan to be a governmental plan; therefore, the plan is not subject to the provisions of the Employee Retirement Income Security Act of 1974, as amended (ERISA). As the plan is not subject to ERISA, the plan s benefits are not insured by the Pension Benefit Guaranty Corporation. Accordingly, the amount of accumulated benefits that participants would receive in the event of the plan s termination is contingent on the sufficiency of the plan s net assets to provide benefits at that time. This Plan is noncontributory and covers eligible employees. The assets, liabilities, and costs of the plan are not segregated by participating entities. As such, plan assets are available for any of the participating employers retirees at any point in time. Additionally, if a participating employer stops contributing to the plan, the unfunded obligations of the plan may be borne by the remaining participating employers. Further, if the Association chooses to stop participating in the plan, the Association may be required to pay an amount based on the underfunded status of the plan, referred to as a withdrawal liability. Because of the multi-employer nature of the plan, any individual employer is not able to unilaterally change the provisions of the plan. If an employee moves to another employer within the same plan, the employee benefits under the plan transfer. Benefits are based on salary and years of service. There is no collective bargaining agreement in place as part of this plan. The defined benefit pension plan reflects an unfunded liability totaling $85.2 million at December 31, The pension benefits funding status reflects the net of the fair value of the plan assets and the projected benefit obligation at the date of these consolidated financial statements. The projected benefit obligation is the actuarial present value of all benefits attributed by the pension benefit formula to employee service rendered prior to the measurement date based on assumed future compensation levels. The projected benefit obligation of the plan was $247.2 million at December 31, 2014, $207.8 million at December 31, 2013 and $219.4 million at December 31, The fair value of the plan assets was $162.0 million at December 31, 2014 and $141.0 million at both December 31, 2013 and December 31, The amount of the pension benefits funding status is subject to many variables including performance of plan assets 71

74 Farm Credit Services Southwest, ACA Notes to Consolidated Financial Statements Years Ended December 31, 2014, 2013 and 2012 and interest rate levels. Therefore, changes in assumptions could significantly affect these estimates. Costs are determined for each individual employer based on costs directly related to their current employees as well as an allocation of the remaining costs based proportionately on the estimated projected liability of the employer under this plan. The Association recognizes its proportional share of expense and contributes a proportional share of funding. Total plan expense for participating employers was $2.5 million in 2014, $3.3 million in 2013, and $8.8 million in The Association's allocated share of plan expenses included in salaries and employee benefits was $61 thousand in 2014, $123 thousand in 2013, and $159 thousand in Participating employers contributed $5.1 million in 2014, $4.0 million in 2013, and $5.7 million in 2012 to the plan. The Association's allocated share of these pension contributions was $124 thousand in 2014, $149 thousand in 2013, and $264 thousand in While the plan is a governmental plan and is not subject to minimum funding requirements, the employers contribute amounts necessary on an actuarial basis to provide the plan with sufficient assets to meet the benefits to be paid to participants. The amount of the total employer contributions expected to be paid into the pension plans during 2015 is $6.7 million. The Association's allocated share of these pension contributions is expected to be $327 thousand. The amount ultimately to be contributed and the amount ultimately recognized as expense as well as the timing of those contributions and expenses, are subject to many variables including performance of plan assets and interest rate levels. These variables could result in actual contributions and expenses being greater than or less than anticipated. Postretirement benefits other than pensions are also provided through the Farm Credit Foundations Retiree Medical and Retiree Life Plans to eligible current and retired employees of the Association. Benefits provided are determined on a graduated scale, based on years of service. The anticipated costs of these benefits are accrued during the period of the employee s active service. Postretirement benefits expense (primarily health care benefits and life insurance) included in salaries and employee benefits expense were $34 thousand for 2014 and 2013, and $30 thousand for The Association participates in a non-qualified defined benefit Pension Restoration Plan that is unfunded. The plan provides retirement benefits above the Internal Revenue Code compensation limit to certain highly compensated eligible employees. Benefits payable under the Pension Restoration Plan are offset by the benefits payable from the Pension Plan. Pension Restoration Plan expenses included in salaries and employee benefits were $424 thousand for 2014, $336 thousand for 2013 and $350 thousand for These expenses are equal to the Association's cash contributions for each year. 72

75 Farm Credit Services Southwest, ACA Notes to Consolidated Financial Statements Years Ended December 31, 2014, 2013 and 2012 The funding status and the amounts recognized in the Consolidated Statements of Condition for the Association s participation in the Pension Restoration Plan follows: Nonqualified Pension Benefits (dollars in thousands) Change in projected benefit obligation Benefit obligation at beginning of year $ 2,693 $ 2,314 $ 1,993 Service cost Interest cost Actuarial loss Benefit obligation at end of year $ 3,309 $ 2,693 $ 2,314 Funded Status Net amount recognized $ 3,309 $ 2,693 $ 2,314 The Association has placed assets of $2.4 million in a grantor trust for expected payment of related benefits. Amounts recognized in the Consolidated Statements of Condition consist of: (dollars in thousands) Accumulated other comprehensive loss $ 967 $ 774 $ 732 Liabilities (3,309) (2,693) (2,314) Net amount recognized-december 31 $ (2,342) $ (1,919) $ (1,582) At December 31, 2014, there were no prior service costs for the respective years below. The following represent the amounts included in accumulated other comprehensive loss (pre-tax) at December 31: (dollars in thousands) Net actuarial loss $ 967 $ 774 $ 732 Total amount recognized in AOCI $ 967 $ 774 $ 732 An estimated net actuarial loss of $153 thousand for the Pension Restoration Plan will be amortized into income over the next year. 73

76 Farm Credit Services Southwest, ACA Notes to Consolidated Financial Statements Years Ended December 31, 2014, 2013 and 2012 The projected and accumulated benefit obligations for the pension restoration plan at December 31 were: (dollars in thousands) Projected benefit obligation $ 3,309 $ 2,693 $ 2,314 Accumulated benefit obligation 3,309 2,639 1,842 The net periodic pension expense for the Pension Restoration Plan included in the Consolidated Statements of Comprehensive Income is comprised of the following for the year ended December 31: (dollars in thousands) Components of net periodic benefit (income) cost Service cost $ 147 $ 138 $ 123 Interest cost Net amortization Net periodic benefit cost $ 423 $ 337 $ 350 Changes in plan assets and benefit obligations recognized in accumulated other comprehensive loss are included in the following table: (dollars in thousands) Current year net actuarial loss $ (339) $ (147) $ (97) Amortization of net actuarial loss Total adjustment to accumulated other comprehensive (loss) gain $ (193) $ (42) $ 29 Weighted average assumptions used to determine benefit obligation at December 31: Discount rate 4.10 % 4.85 % 4.05 % Rate of compensation increase 4.50 % 4.50 % 4.50 % Weighted average assumptions used to determine net periodic benefit cost for the year ended December 31: Discount rate 4.85 % 4.05 % 5.05 % Rate of compensation increase 4.50 % 4.50% 4.50 % The Association expects to contribute $404 thousand to the Pension Restoration Plan in

77 Farm Credit Services Southwest, ACA Notes to Consolidated Financial Statements Years Ended December 31, 2014, 2013 and 2012 Estimated Future Benefit Payments The following benefit payments, which reflect expected future service, as appropriate, are expected to be paid: (dollars in thousands) 2015 $ Years ,021 $ 4,041 The Association also participates in the Farm Credit Foundations Defined Contribution/401(k) Plan (Contribution Plan). The Contribution Plan has two components. Employees who do not participate in the Pension Plan may receive benefits through the Employer Contribution portion of the Contribution Plan. In this plan, the Association provides a monthly contribution based on a defined percentage of the employee s salary. Employees may also participate in a Salary Deferral Plan governed by Section 401(k) of the Internal Revenue Code. The Association matches a certain percentage of employee contributions. Employer contributions to these plans were $815 thousand, $719 thousand and $649 thousand for the years ended December 31, 2014, 2013 and 2012, respectively. The Association has initiated employee deferred compensation arrangements. The Association has established Rabbi Trusts for these plans. In its sole discretion, the Association may make contributions to the trusts in amounts and at times to be determined by the Board of Directors, however, the Association shall not be obligated to make any further contributions except as provided in the respective plan documents. The Rabbi Trusts are included in other assets in the Consolidated Statements of Condition and the offsetting payable is included in other liabilities. 12. Related Party Transactions In the ordinary course of business, the Association enters into loan transactions with officers and directors of the Association, their immediate families, and other organizations with which such persons may be associated. Such loans are subject to special approval requirements contained in the FCA regulations and are made on the same terms, including interest rates, amortization schedules and collateral, as those prevailing at the time for comparable transactions with unrelated borrowers. The Association has a policy that loans to directors and senior officers must be maintained at an Acceptable or Other Assets Especially Mentioned (OAEM) credit classification. If the loan falls below the OAEM credit classification, corrective action must be taken and the loan brought back to either Acceptable or OAEM within eighteen months. If not, the director or senior officer must resign from the Board or employment. 75

78 Farm Credit Services Southwest, ACA Notes to Consolidated Financial Statements Years Ended December 31, 2014, 2013 and 2012 Related party loan information is shown below: December 31, (dollars in thousands) New loans and advances $ 103,961 $ 91,580 $ 144,911 Repayments 104,594 86, ,411 Ending balance 81,298 81,931 76,482 In the opinion of management, none of the related party loans outstanding to officers and directors at December 31, 2014, involved more than a normal risk of collectability. The Association also has business relationships with certain other System entities. The Association paid $1.5 million in 2014, $1.1 million in 2013 and $1.3 million in 2012 to Financial Partners, Inc. (FPI) for technology services. In 2014, the Association transitioned from an ownership investment in FPI to a vendor services relationship as the result of an FPI ownership restructure. This is not expected to significantly change the Association s cost of technology services. The Association paid $120 thousand in 2014, $108 thousand in 2013, and $109 thousand in 2012 to Foundations for human resource services. 13. Regulatory Enforcement Matters During the third and fourth quarters of 2014, the FCA issued supervisory letters to the Association as a result of the events described in Note 2, Restatement, and the issuance of an FCA examination report. Special Supervision is an elevated state of regulatory supervision and oversight activities. The 2014 supervisory letters directed the Board of Directors to initiate prompt actions to address such events, including remediation of the weaknesses summarized in the examination report to adequately address the cause of those weaknesses. The letters required the Association to take certain corrective actions and increase regulatory reporting, including: Forming a special Board committee to investigate the increase in the level of delinquent loans affecting an identifiable portion of the Association s lending portfolio, Submitting for approval strategies and action plans to return the Association s lending portfolio risk to a safe and sound level, Evaluating internal control and audit processes and expanding the Association s risk assessment process, Reporting loan servicing plans on a certain portion of the Association s assets, Reporting certain employee and compensation matters, Submitting for approval planned actions regarding the Association s financial statements, Regularly reporting on the Association s operating results, financial condition and regulatory capital level, and Prohibiting payment of patronage or dividend distributions without the prior written consent of the FCA. 76

79 Farm Credit Services Southwest, ACA Notes to Consolidated Financial Statements Years Ended December 31, 2014, 2013 and 2012 In February 2015, the FCA issued a supervisory letter to the Association which replaced the 2014 supervisory letters in their entirety. The February 2015 supervisory letter referenced the events described in Note 2, Restatement, and the issuance of an FCA examination report. The 2015 supervisory letter directed the Board of Directors to initiate prompt actions to remediate weaknesses summarized in the examination report to adequately address the cause of those weaknesses. It requires the Association to take certain corrective actions and increase regulatory reporting, including: Addressing the results and recommendations of the special investigation of the increase in the level of delinquent loans affecting an identifiable portion of the Association s lending portfolio, Submitting to FCA restated financial statements, call reports and a business plan for 2015, Reporting certain employee and compensation matters, Reporting loan servicing plans on a certain portion of the Association s assets, Complying with all applicable merger-related regulations in the Association s proposed merger with Farm Credit West, Utilizing specified third parties to conduct the Association s internal credit reviews, and Prohibiting the payment of patronage or dividend distributions without the prior written consent of the FCA. 14. Commitments and Contingencies The Association has various commitments outstanding and contingent liabilities. The Association may participate in financial instruments with off-balance-sheet risk to satisfy the financing needs of its borrowers and to manage their exposure to interest-rate risk. These financial instruments include commitments to extend credit and commercial lines of credit. The instruments involve, to varying degrees, elements of credit risk in excess of the amount recognized in the financial statements. Commitments to extend credit are agreements to lend to a borrower as long as there is not a violation of any condition established in the contract. Commercial letters of credit are agreements to pay a beneficiary under conditions specified in the letter of credit. Commitments and letters of credit generally have fixed expiration dates or other termination clauses and may require payment of a fee by the borrower. At December 31, 2014, $328.4 million of commitments to extend credit were outstanding. Since many of these commitments are expected to expire without being drawn upon, the total commitments do not necessarily represent future cash requirements. However, these credit related financial instruments have off-balance-sheet credit risk because their amounts are not reflected on the Consolidated Statements of Condition until funded or drawn upon. The credit risk associated with issuing commitments and letters of credit is substantially the same as that involved in extending loans to borrowers and management applies the same credit policies to these commitments. Upon fully funding a commitment, the credit risk amounts are equal to the contract amounts, assuming that borrowers fail completely to meet their obligations and the collateral or 77

80 Farm Credit Services Southwest, ACA Notes to Consolidated Financial Statements Years Ended December 31, 2014, 2013 and 2012 other security is of no value. The amount of collateral obtained, if deemed necessary upon extension of credit, is based on management s credit evaluation of the borrower. The Association also participates in standby letters of credits to satisfy the financing needs of its borrowers. These letters of credit are irrevocable agreements to guarantee payments of specified financial obligations. At December 31, 2014, $1.5 million of standby letters of credit were outstanding with a nominal fair value. Outstanding standby letters of credit have expiration dates ranging from 2015 to The maximum potential amount of future payments the Association is required to make under the guarantees is $1.5 million. In October 2014, certain plaintiffs filed complaints against the Association and a former employee of the Association seeking unspecified monetary damages and/or reformation or rescission of their loan and guaranty obligations. Some of these plaintiffs also filed bankruptcies and a related adversary complaint in bankruptcy court against the Association in October 2014 seeking to reform, modify or subordinate the Association s loans and security interests in assets and to recover alleged preferential and fraudulent transfers. In January 2015, the Association filed answers and asserted counterclaims against the plaintiffs in these actions. The parties have exchanged initial disclosure statements and discovery is ongoing. The parties also engaged in mediation sessions in June FCSSW cannot at this time estimate potential losses which may be associated with the litigation. In June 2015, certain plaintiffs and the Association settled claims arising out of alleged wrongdoing in connection with the sale of dairy cows in a dairy farm owned by certain plaintiffs. In July 2015, certain plaintiffs and the Association conditionally settled certain disputes which require approval of the bankruptcy court. In January 2015, the Association filed complaints against certain related borrowers for monetary damages aggregating approximately $4.5 million plus interest, fees and costs for failure to repay loans made by the Association to such borrowers. These complaints were not served on the borrowers and were voluntarily dismissed by the Association without prejudice. In February 2015, the Association filed related complaints against third parties regarding payments owed to the Association for the benefit of certain plaintiffs named in the October 2014 complaint. In July 2015, the Association filed an application for entry of default and the defendants filed a motion to dismiss the action. 15. Fair Value Measurements (restated) Accounting guidance defines fair value as the exchange price that would be received for an asset or paid to transfer a liability in an orderly transaction between market participants in the principal or most advantageous market for the asset or liability. The fair value measurement is not an indication of liquidity. See Note 2 for additional information. Quoted market prices may not be available for the instruments presented below. Accordingly, fair values are based on internal models that consider judgments regarding anticipated cash flows, future expected loss experience, current economic conditions, risk characteristics of various financial instruments, and other factors. These estimates involve uncertainties and matters of judgment, and therefore cannot be determined with precision. Changes in assumptions could significantly affect the estimates. 78

81 Farm Credit Services Southwest, ACA Notes to Consolidated Financial Statements Years Ended December 31, 2014, 2013 and 2012 Quantitative Information about Recurring and Nonrecurring Level 3 Fair Value Measurements Assets measured at fair value on a recurring basis for each of the fair value hierarchy values are summarized below as of December 31: Fair Value Measurement Using Total Fair (dollars in thousands) Level 1 Level 2 Level 3 Value Assets held in nonqualified benefit plans 2014 $ 4,117 $ - $ - $ 4, , , , ,751 The Association has no liabilities measured at fair value on a recurring basis for the periods presented. During the three years presented, the Association recorded no transfers in or out of levels 1, 2, or 3. Assets measured at fair value on a nonrecurring basis for the period ended December 31 for each of the fair value hierarchy value types are summarized below: Fair Value Measurement Total Losses Using Incurred Unobservable Total Fair During (dollars in thousands) Inputs (Level 3) Value the Year Assets Nonaccrual loans December 31, 2014 $ 23,106 $ 23,106 $ 5,134 December 31, 2013 (as restated) 14,282 14,282 2,934 December 31, 2012 (as restated) 15,307 15,307 3,181 Other property owned, appraised value December 31, 2014 $ - $ - $ - December 31, 2013 (as restated) 1,331 1, December 31, 2012 (as restated) 1,331 1, The Association has no liabilities measured at fair value on a non-recurring basis for any of the periods presented. 79

82 Farm Credit Services Southwest, ACA Notes to Consolidated Financial Statements Years Ended December 31, 2014, 2013 and 2012 The estimated fair values of the Association s financial instruments follow. December 31, Carrying Fair Carrying Fair Carrying Fair (dollars in thousands) Amount Value Amount Value Amount Value Financial assets Loans, net of allowance (as restated) $ 979,514 $ 981,972 $ 942,592 $ 944,090 $ 956,136 $ 968,550 Assets held in nonqualified benefit plans 4,117 4,117 4,250 4,250 3,751 3,751 Financial liabilities Notes payable to CoBank 890, , , , , ,272 Commitments to extend credit Stand-by letters of credit Valuation Techniques As more fully discussed in Note 2, accounting guidance establishes a fair value hierarchy, which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The following represent a brief summary of the valuation techniques used by the Association for assets and liabilities subject to fair value measurements. During the three years presented the Association recorded no transfers in or out of Levels 1, 2, or 3. Loans, Net of Allowance Fair value is estimated by discounting the expected future cash flows using the Association s current interest rates at which similar loans would be made to borrowers with similar credit risk. The discount rates are based on the District s current loan and organization rates as well as management estimates of credit risk. Management has no basis to determine whether the estimated fair values presented would be indicative of the assumptions and adjustments that a purchaser of the Association s loans would seek in an actual sale which would be less. For purposes of determining the fair value of accruing loans, the loan portfolio is segregated into pools of loans with homogeneous characteristics. Expected future cash flows and interest rates reflecting appropriate credit risk are separately determined for each individual pool. Fair value of loans in a nonaccrual status is estimated as described above, with appropriately higher interest rates, which reflect the uncertainty of continued cash flows. For noncurrent nonaccrual loans, it is assumed that collection will result only from the disposition of the underlying collateral. Fair value of these loans is estimated to equal the aggregate net realizable value of the underlying collateral, discounted at an interest rate, which appropriately reflects the uncertainty of the expected future cash flows over the average disposal period. Where the net realizable value of the collateral exceeds the legal obligation for a particular loan the legal obligation is generally used in place of the net realizable value. Assets Held in Nonqualified Benefit Plans Assets held in nonqualified benefit plans are related to deferred compensation and supplemental retirement plans and are classified within Levels 1 and 2. The assets include cash, money market 80

83 Farm Credit Services Southwest, ACA Notes to Consolidated Financial Statements Years Ended December 31, 2014, 2013 and 2012 funds and mutual funds that have quoted market prices in an active market for identical assets and are therefore classified within Level 1. These assets relate to employee deferred compensation and supplemental retirement plans. Other Property Owned Other property owned is generally classified as Level 3. The process for measuring the fair value of other property owned involves the use of appraisals or other market-based information. As a result, these fair value measurements fall within Level 3 of the hierarchy. Costs to sell represent transaction costs and are not included as a component of the asset s fair value. Notes Payable to CoBank The notes payable are segregated into pricing pools according to the types and terms of the loans (or other assets) which they fund. Fair value of the notes payable is estimated by discounting the anticipated cash flows of each pricing pool using the current rate that would be charged for borrowings. For purposes of this estimate, it is assumed the cash flow on the notes payable is equal to the principal payments on the Association s loan receivables plus accrued interest on the notes payable. Commitments to Extend Credit and Standby Letters of Credit The fair value of commitments is estimated using the fees currently charged for similar agreements, taking into account the remaining terms of the agreements and the creditworthiness of the counterparties. For fixed-rate loan commitments, estimated fair value also considers the difference between current levels of interest rates and the committed rates. The fair value of letters of credit approximate the fees currently charged for similar agreements or the estimated cost to terminate or otherwise settle similar obligations. 16. Subsequent Events The Association has evaluated subsequent events through July 29, 2015, which is the date the financial statements were issued. The following material subsequent events occurred: Merger Agreement - In January 2015, the Association entered into a letter of intent to merge with Farm Credit West (FCW). The Association and FCW completed due diligence and signed a definitive merger agreement in April The merger agreement is subject to the approval of the FCA, CoBank and the voting shareholders of the Association and FCW. The parties currently anticipate an effective date for the merger in the fourth quarter of Transition Management Agreement - In February 2015, the Association and FCW entered into a transition management agreement and FCW s President/CEO Mark Littlefield was appointed as the President/CEO of the Association. Please also see Senior Officers and Certain Key Employees in the annual report. Eight additional FCW employees have been designated as joint employees as of June 2015 to provide services to the Association. Litigation See Note 14 Commitments and Contingencies for discussion of Association litigation. 81

84 FARM CREDIT SERVICES SOUTHWEST FCA REQUIRED DISCLOSURES DESCRIPTION OF BUSINESS The description of the territory served, persons eligible to borrow, types of lending activities engaged in and financial services offered, and related Farm Credit organizations required to be disclosed in this section is incorporated by reference from Note 1 to the financial statements, "Organization and Operations," included in this annual report to shareholders. The description of significant developments that had or could have a material impact on earnings or interest rates to borrowers, acquisitions or dispositions of material assets, material changes in the manner or conduct of the business, seasonal characteristics, and concentrations of assets, if any, required to be disclosed in this section is incorporated by reference from "Management's Discussion and Analysis of Financial Condition and Results of Operations," included in this annual report to shareholders. DESCRIPTION OF PROPERTY The Association owns offices in Tempe, Safford and Yuma, Arizona and Imperial, California. Office space is used by the administrative staff and for lending operations. LEGAL PROCEEDINGS Disclosure information required in this section is incorporated herein by reference from Note 14 to the financial statements, "Commitments and Contingencies," included in this annual report to shareholders. REGULATORY ENFORCEMENT ACTIONS Disclosure information required in this section is incorporated herein by reference from Note 13 to the financial statements, "Regulatory Enforcement Matters," included in this annual report to shareholders. DESCRIPTION OF CAPITAL STRUCTURE Information pertaining to the capital stock and participation certificates required to be disclosed in this section is incorporated herein by reference from Note 8 to the financial statements, "Members Equity," included in this annual report to shareholders. DESCRIPTION OF LIABILITIES The description of debt outstanding required to be disclosed in this section is incorporated herein by reference from Note 7 to the financial statements, "Notes Payable to the Bank," included in this annual report to shareholders. The description of contingent liabilities, intra-system financial assistance rights, and obligations required to be disclosed in this section is incorporated herein by reference from Note 14 to the financial statements, "Commitments and Contingencies," included in this annual report to shareholders. RELATIONSHIP WITH COBANK The Association s statutory obligation to borrow from CoBank is discussed in Note 7. The Bank s access to Association capital is discussed in Note 4 to the financial statements, Investment in the Bank included in this annual report to shareholders. The Bank s role in mitigating the Association s exposure to interest rate risk is described in the Interest Rate Risk section of Management s Discussion and Analysis. 82

85 FARM CREDIT SERVICES SOUTHWEST FCA REQUIRED DISCLOSURES SELECTED FINANCIAL DATA The selected financial data for the five years ended December 31, 2014 required to be disclosed in this section are incorporated herein by reference from the "Five Year Summary of Selected Financial Data" included in this annual report to shareholders. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS "Management's Discussion and Analysis of Financial Condition and Results of Operations," which appears separately in the annual report to shareholders and is required to be disclosed in this section, is incorporated herein by reference. DIRECTORS Farm Credit Administration regulations require the disclosure of directors' business experience for the past five years, other entities on whose board the director serves and/or as a senior officer, compensation received as a Farm Credit Services Southwest director, and certain other information. Compensation amounts are presented in whole dollars. John O. Grizzle, Chairman of the Board of Directors Term of Office: Mr. Grizzle has served on the Board since His current term ends in He is 75 years of age and resides in El Centro, California. During the past five years, Mr. Grizzle has been a farmland owner and retired farmer. He is co-owner of a dairy heifer feeding operation near Brawley, California. Mr. Grizzle serves as chairman of the Farm Credit Services Southwest Board and as a member of the Farm Credit Services Southwest Compensation Committee. In 2014, Mr. Grizzle served 18 days at Board and Board committee meetings, and 14 days in other official activities on behalf of the Board for which he was compensated $24,250* (*this amount also includes compensation for extensive duties as a member of a Special Investigation Board Committee from August through November in the amount of $7,500). J. Dick Eastman, Vice Chairman of the Board of Directors Term of Office: Mr. Eastman has served on the Board since His current term ends in He is 66 years of age and resides in Bowie, Arizona. During the past five years, Mr. Eastman has been president of Lesco Enterprises Inc., First Pecan Company, and Fort Bowie Vineyards, all his family-owned farming operations growing a variety of crops including pecans, pistachios, grapes and alfalfa. He is also a director of ACE, LLC (land ownership entity), Four Star (farming entity) Coronado Vineyards (winery), and Pita, LLC (farm ownership lease land). Mr. Eastman serves as vice chairman of the Farm Credit Services Southwest Board and as a member of the Farm Credit Services Southwest Compensation Committee and Audit Committee. In 2014, Mr. Eastman served 18 days at Board and Board committee meetings and 15.5 days in other official activities on behalf of the Board for which he was compensated $29,000* (*this amount also includes compensation for extensive duties as a member of a Special Investigation Board Committee from August through November in the amount of $7,500). Norman Brown, Director Term of Office: Mr. Brown has served on the Board since His current term ends in He is 59 years of age and resides in St. Johns, Arizona. During the past five years, Mr. Brown has been a cattleman, farms hay and is president of J. Albert Brown Ranches, Inc. He is a board member of Lyman Water County Irrigation and Apache County Farm Bureau, and is a committee member of the Farm Service Agency. Mr. Brown is a member of the Farm Credit Services Southwest Compensation Committee. In 2014, Mr. Brown served 18 days at Board and 83

86 FARM CREDIT SERVICES SOUTHWEST FCA REQUIRED DISCLOSURES Board committee meetings and 9.5 days in other official activities on behalf of the Board for which he was compensated $18,000. Thomas P. Gargiulo, Appointed Director Term of Office: Mr. Gargiulo has served on the Board since His current term ends in 2015 as an outside director appointed by the Board under provisions of the Agricultural Act of He is 83 years of age and resides in Brawley, California. During the past five years, Mr. Gargiulo has owned a diversified agricultural operation and is a director of Imperial Grain Growers. Mr. Gargiulo is a member of the Farm Credit Services Southwest Audit Committee. In 2014, Mr. Gargiulo served 15 days at Board and Board committee meetings and 2.5 days in other official activities on behalf of the Board for which he was compensated $9,500. Mr. Gargiulo attended fewer than 75% of the meetings of the Board committees on which he served during the last fiscal year attending 8 of the 11 Audit Committee meetings in 2014 resulting in 73% attendance. Ben Gingg, Director Term of Office: Mr. Gingg has served on the Board since His current term ends in He is 62 years of age and resides in Litchfield Park, Arizona. During the past five years, Mr. Gingg has been a dairyman and treasurer of Triple G Dairy. He has also served as a director and treasurer/secretary of United Dairymen of Arizona, an agricultural milk marketing cooperative. Mr. Gingg is a member of the Farm Credit Services Southwest Compensation Committee and Audit Committee. In 2014, Mr. Gingg served 16 days at Board and Board committee meetings and 3 days in other official activities on behalf of the Board for which he was compensated $10,000. Leslie Les Heiden, Director Term of Office: Mr. Heiden has served on the Board since His current term ends in He is 59 years of age and resides in Litchfield Park, Arizona. During the past five years, Mr. Heiden has owned and managed a cattle/feedlot operation and a diversified cotton, alfalfa, wheat, oats and silage farming operation. He is a director of the Arizona Cattle Feeders Association, an organization that assists cattlemen in marketing. Mr. Heiden is a member of the Farm Credit Services Southwest Compensation Committee. In 2014, Mr. Heiden served 18 days at Board and Board committee meetings and 8.5 days in other official activities on behalf of the Board for which he was compensated $13,750. Louis Otis Kramer, Director Term of Office: Mr. Kramer has served on the Board since His current term ends in He is 67 years of age and resides in Brawley, California. During the past five years, Mr. Kramer has owned and managed a wheat/alfalfa diversified farming operation. He is a director of Jordan/Central Implement Company, a retail farm equipment dealership, and is a director of the California Beet Growers Association. He is also treasurer of Planter s Hay, Inc., a grower-owned business that compresses and exports dry forage products from the Imperial Valley. Mr. Kramer serves as chairman of the Farm Credit Services Southwest Audit Committee. In 2014, Mr. Kramer served 17 days at Board and Board committee meetings and 4.5 days in other official activities on behalf of the Board for which he was compensated $19,000* (*this amount also includes compensation for extensive duties as a member of a Special Investigation Board Committee from August through November in the amount of $7,500). Timothy J. LaBrucherie, Director Term of Office: Mr. LaBrucherie has served on the Board since His current term ends in He is 68 years of age and resides in El Centro, California. 84

87 FARM CREDIT SERVICES SOUTHWEST FCA REQUIRED DISCLOSURES During the past five years, Mr. LaBrucherie has owned and managed diversified livestock and alfalfa farming operations. He is a director of the Farm Bureau of Imperial County and secretary of El Toro Land and Cattle Company. Mr. LaBrucherie serves as a member and vice chairman of the Farm Credit Services Southwest Compensation Committee and as a member of the Audit Committee. In 2014, Mr. LaBrucherie served 18 days at Board and Board committee meetings and 7 days in other official activities on behalf of the Board for which he was compensated $13,250. Colin Mellon, Director Term of Office: Mr. Mellon has served on the Board since His current term ends in He is 46 years of age and resides in Yuma, Arizona. During the past five years, Mr. Mellon has owned and managed a diversified produce operation. He is a director of Yuma County Water Users Association. Mr. Mellon serves as a member of the Farm Credit Services Southwest Compensation Committee. In 2014, Mr. Mellon served 18 days at Board and Board committee meetings and 8.5 days in other official activities on behalf of the Board for which he was compensated $14,000. Keith Murfield, Appointed Director Term of Office: Mr. Murfield has served on the Board since His current term ends in 2018 as an outside director appointed by the Board under provisions of the Agricultural Act of He is 61 years of age and resides in Chandler, Arizona. During the past five years, Mr. Murfield has served as chief executive officer of United Dairymen of Arizona, an agricultural milk marketing cooperative. Mr. Murfield is a director of DairyAmerica, Inc. (a dairy marketing cooperative), a director of National Milk Producer Federation (an organization in which dairy cooperatives formulate policy on national issues that affect milk production and marketing), a director of Dairy Producers of Arizona (dairy advertising) and a director of American Dairy Products Institute (manufactures and markets milk-based and whey-based ingredients). He is also an alternate director of Seco Golden 100, a buying group. Mr. Murfield serves as chairman of the Farm Credit Services Southwest Compensation Committee and is a member of the Audit Committee. In 2014, Mr. Murfield served 14 days at Board and Board committee meetings and 3 days in other official activities on behalf of the Board for which he was compensated $16,500* (*this amount also includes compensation for extensive duties as a member of a Special Investigation Board Committee from August through November in the amount of $7,500). Jon L. Nickerson, Director Term of Office: Mr. Nickerson has served on the Board since 2001 (and previously served on the Board from ). His current term ends in He is 81 years of age and resides in Wellton, Arizona. During the past five years, Mr. Nickerson has owned and managed a diversified produce operation and served as president of Nickerson Ranches, Inc., and of Dome Valley Investments (his family-owned farming and land ownership entities). He is a director of the Wellton Mohawk Irrigation District. Mr. Nickerson serves as vice chairman of the Farm Credit Services Southwest Audit Committee. In 2014, Mr. Nickerson served 14 days at Board and Board committee meetings and 1.5 days in other official activities on behalf of the Board for which he was compensated $9,250. Mr. Nickerson attended fewer than 75% of the meetings of the Board committees on which he served during the last fiscal year attending 8 of the 11 Audit Committee meetings in 2014 resulting in 73% attendance. Gregory Pierce, Director Term of Office: Mr. Pierce has served on the Board since His current term ends in He is 59 years of age and resides in Buckeye, Arizona. During the past five years, Mr. Pierce has owned and managed a diversified hay, cotton, silage wheat and dairy operation. He is a director of Electrical District-8 and the Paloma Irrigation Board. He is a member of the Farm Credit Services Southwest Audit Committee. In 2014, Mr. Pierce served 18 days at 85

88 FARM CREDIT SERVICES SOUTHWEST FCA REQUIRED DISCLOSURES Board and Board committee meetings and 2.5 days in other official activities on behalf of the Board for which he was compensated $10,750. DIRECTOR COMPENSATION During 2014, each Farm Credit Services Southwest director was compensated based on a daily honorarium of $500 for attendance at Board meetings, including additional special board meetings, and $250 per each half day for other official functions including committee meetings. Directors living outside the local area also are compensated for travel time to attend official Board functions. Directors serving on the Audit and Compensation Committees are not paid additional compensation for such service unless a committee meeting is held outside of a scheduled Board meeting date. Director compensation totaled $187,484 in 2014, $103,000 in 2013, and $105,250 in Directors are reimbursed for mileage and documented business expenses while serving in an official capacity. Travel and subsistence expense paid to directors totaled $14,153 in 2014, $11,497 in 2013, and $11,921 in Directors also were reimbursed $6,163 in 2014 for miscellaneous non-travel expenses ($7,205 in 2013 and $7,461 in 2012). A copy of the Association's travel policy is available to stockholders upon request. *As referenced in the individual director disclosures, the following Farm Credit Services Southwest directors were compensated for their duties on a Special Investigative Committee commencing on August 11, 2014 through November 21, 2014: John Grizzle, J. Dick Eastman, Louis Kramer and Keith Murfield. These duties included a minimum of two conference calls per week, additional calls as needed and review of extensive materials in preparation for the calls and each director was compensated $500 per week. SENIOR OFFICERS AND CERTAIN KEY EMPLOYEES FCA regulations also require the following disclosures for each senior officer. For the purposes of business experience and position title, previous employment with Imperial-Yuma Production Credit Association and the Federal Land Bank Association of El Centro are considered continuous employment with their successor, Farm Credit Services Southwest (Association). MARK D. LITTLEFIELD, PRESIDENT AND CHIEF EXECUTIVE OFFICER Mr. Littlefield became President/CEO of the Association in February 2015 pursuant to a joint management agreement between the Association and Farm Credit West. Mr. Littlefield has served as President/CEO of Farm Credit West since He serves as a director of Financial Partners Inc., a Farm Credit technology service provider, where he also serves as the chairman of its audit committee. MARC H. EHLERS, EXECUTIVE VICE PRESIDENT Mr. Ehlers has served as Executive Vice President Chief Lending and Relationship Officer of the Association since May Prior to that, Mr. Ehlers served as the Northeast Regional Senior Vice President Designate from 2013, when he joined the Association, until May Immediately prior to joining the Association, Mr. Ehlers was employed in a lending capacity for a commercial bank. Mr. Ehlers has 20 years of prior experience at associations within the Farm Credit System in various roles. CRAIG R. TYLER, EXECUTIVE VICE PRESIDENT Mr. Tyler has served as Executive Vice President Chief Risk Management Officer of the Association since May Prior to that, he served as Senior Vice President and Risk Management Officer from 2013 until May 2014, and Vice President and Branch Manager of the Rural Arizona Branch from 2002 until Mr. Tyler joined the Association in JEAN L. KOENCK, EXECUTIVE VICE PRESIDENT AND CFO Ms. Koenck has served as Executive Vice President/CFO of the Association since January Prior to that, she served as Senior Vice President from September 2014, when she joined the Association, until January Ms. Koenck began her career with the Farm Credit System in 2004 as Controller for U.S. 86

89 FARM CREDIT SERVICES SOUTHWEST FCA REQUIRED DISCLOSURES AgBank and continued with CoBank, ACB after the banks merger. Prior to joining U.S. AgBank, she worked in public accounting and commercial banking. DENISE E. WARKOMSKI, ACTING CHIEF OPERATING OFFICER Ms. Warkomski has served as Acting Chief Operating Officer of the Association since Mid-November Prior to that, she served as Senior Vice President Capital Markets and Financial Services from May 2014 until November 2014 and as Vice President and Branch Manager of the Capital Markets Branch from June 2009 until April Ms. Warkomski joined the Association in July DANIEL R. CLAWSON, ACTING CHIEF CREDIT OFFICER Mr. Clawson became Acting Chief Credit Officer of the Association in April 2015 pursuant to a joint management agreement between the Association and Farm Credit West. Mr. Clawson has served as Executive Vice President-Chief Credit Officer of Farm Credit West since January Prior to that, he served as a regional vice president or senior vice president in credit operations since ROGER V. BECKER, FORMER PRESIDENT AND CHIEF EXECUTIVE OFFICER Mr. Becker served as President/CEO of the Association from May 2014 until February Prior to that, he served as President/CEO Designate from August 2013 through April 2014, Senior Vice President and Risk Management Officer from January 2013 to August 2013, and Vice President Credit Programs from 2007 through Mr. Becker joined the Association in Mr. Becker also served as a director of Financial Partners Inc. from May 2014 until February GARY R. DYER, FORMER PRESIDENT AND CHIEF EXECUTIVE OFFICER Mr. Dyer served as President/CEO of the Association from 1990 through April Mr. Dyer also served as a director of Financial Partners Inc. through April Mr. Dyer is a member of the Arizona State University Advisory Board of the School of Agri-Business and Environmental Sciences. Mr. Dyer joined the Association in August JOHN E. BARKELL, FORMER EXECUTIVE VICE PRESIDENT AND CFO Mr. Barkell served as Executive Vice President/CFO of the Association from May 2014 through December Prior to that, he served as Senior Vice President/CFO from 1990 until May Mr. Barkell joined the Association in October MARK L. BROWNING, FORMER EXECUTIVE VICE PRESIDENT Mr. Browning served as Executive Vice President Credit Development of the Association from May 2014 through October Prior to that, he served as Regional Senior Vice President of the Northeast region from 2011 until May 2014 and Chief Credit Officer from 1992 to He rejoined the Association in June J. JASON LAWRENCE, ACTING CHIEF CREDIT OFFICER Mr. Lawrence served as Acting Chief Credit Officer of the Association from November 2014 until April 2015 pursuant to a contract between the Association and CoBank, ACB. Prior to joining the Association, he was Vice President of Credit for the Regional Agribusiness Banking Group of CoBank. Mr. Lawrence served in various credit approval and management roles at CoBank between 2012 and From 2010 to 2012, Mr. Lawrence was the Chief Business Officer of ProValue, LLC. From 2000 to 2010, Mr. Lawrence served in various credit and relationship manager roles at CoBank. JOEL L. LORENZEN, FORMER EXECUTIVE VICE PRESIDENT Mr. Lorenzen served as Executive Vice President Chief Credit and Operations Officer of the Association from May 2014 through October Prior to that, he served as Senior Vice President and Chief Credit and Operations Officer from 1998 through May Mr. Lorenzen joined the Association in June C. RICHARD COOK, FORMER SENIOR VICE PRESIDENT Mr. Cook served as Regional Senior Vice President of the Association s Southwest region from 1993 through June Mr. Cook joined the Association in January

90 FARM CREDIT SERVICES SOUTHWEST FCA REQUIRED DISCLOSURES SENIOR OFFICER COMPENSATION The Compensation Committee of the Board of Directors follows a comprehensive compensation philosophy where the objectives of the Association s compensation plans (Plans) are to: Provide market-based compensation through base salary, short-term annual incentive and longterm incentive components that will allow the Association to attract, motivate and retain superior executive talent; Place a portion of total compensation for the executive at risk and contingent upon the Association remaining sound financially and meeting established performance goals; and Ensure that long-term financial stability of the Association is emphasized over short-term results and decisions. The Plans were designed to: Reward successful business year results through an Annual Incentive Plan; Foster long-term financial stability through a Long-Term Incentive Plan; and Significantly contribute to the retention of the CEO and other senior officers. The Compensation Committee annually reviews market information prepared by an independent outside consulting firm to determine the level and mix of salaries, benefits, and incentive plans for the CEO and other senior officers. Due to the cooperative business structure of the Association, the Plans do not contain stock-based compensation components. Summary Compensation Table The following Summary Compensation Table reflects individual compensation earned by the CEO and aggregate compensation earned by the other senior officers and highly-compensated employees for the years ended December 31, 2014, 2013 and 2012, even if payment of some amounts have been deferred by the CEO or other senior officers elections pursuant to the Association s defined contribution/401(k) plan ( 401(k) Plan ) or nonqualified deferred compensation plan ( NQDC Plan ). Senior Officers in their roles beginning after December 31, 2014, as well as contract employees, are not included in the Summary Compensation Table. Summary Compensation Table 1 ($ in Thousands) Name of CEO Year Salary Annual Incentive Compensation 4 Long-Term Incentive Compensation 4 Change in Pension Value 7 Deferred/ Other 9 Total Perquisites 8 Becker $200 $0 $0 $0 $33 $0 $233 Dyer $161 $0 $0 $2,468 $14 $ $2,769 Dyer 2013 $478 $155 $605 5 $52 $76 $1 $1,367 Dyer 2012 $478 $150 $0 $0 $25 $23 $675 Aggregate number of senior officers and highly compensated employees (excluding CEO) $1,285 $0 $132 6 $359 $180 $ $2, $1,391 $331 $708 $15 $288 $155 $2, $914 $159 $0 $0 $95 $1 $1,169 88

91 FARM CREDIT SERVICES SOUTHWEST FCA REQUIRED DISCLOSURES 1. Disclosure of total compensation earned by any designated senior officer or highly compensated employee is available to shareholders upon written request. Compensation amounts do not include earnings on nonqualified deferred compensation as such earnings are not considered above-market or preferential. 2. Reflects four months of compensation for Mr. Dyer and eight months of compensation for Mr. Becker. 3. Reflects three employees for twelve months and six employees for a partial year, including Mr. Becker for four months. 4. Incentive compensation amounts are reported in the year when earned even if paid in a subsequent year. Annual incentive compensation amounts are calculated based on relevant performance factors for the reported fiscal year, while long-term incentive compensation amounts are based on salary and achieving the performance and employment requirements of the long-term retention plan. 5. Includes $119,000 earned in 2013 under the additional long-term incentive plan described below. 6. Includes benefits vested and paid to one senior officer in 2014 under the long-term incentive compensation plan. 7. Change in Pension Value increased significantly in 2014 primarily due to known retirement dates and distribution elections as well as changes in actuarial assumptions such as the discount rate and updated life expectancy actuarial tables. No such measurement was required for disclosure in Includes Association contributions to the 401(k) Plan, the Employer Contribution Plan and matches under the NQDC Plan in the same year as related incentive compensation was earned, and payments for certain other expenses such as certain travel-related costs, long-term disability premium reimbursements and life insurance benefits. In 2014, the Association s employer matching contributions to Mr. Dyer s account in the 401(k) Plan was $797 and to Mr. Dyer s account in the NQDC Plan to restore the employer match that was limited due to restrictions in the Internal Revenue Code and compensation deferred was $4,855. In 2014, the Association s contributions to Mr. Becker s account in the Employer Contribution Plan and the NQDC Plan totaled $28,000. In 2014, the Association s employer matching and non-elective contributions for the other senior officers accounts in the 401(k) Plan were $111,755 and contributions to their accounts in the NQDC Plan totaled $34, Includes de minimis amounts paid or payable by the Association for holiday gift cards, wellness benefits, as well as relocation payments of $11,726 and other miscellaneous payments. Also includes for Mr. Dyer an earned benefit under an executive deferred compensation agreement ( SERP ) described below of $25,000 in 2014, $24,000 in 2013 and $23,000 in Includes one-time retirement awards of $70,800 to Mr. Dyer and $169,621 to other senior officers and unused vacation payouts of $30,032 to Mr. Dyer and $46,891 to other senior officers. Base Salaries Base salaries for all Association employees, including the CEO and other senior officers, are determined based upon position, experience, responsibilities, performance and competitive market compensation data. CEO and other senior officers base salaries are approved by the Board of Directors. Annual Incentive Plans In addition to base salaries, substantially all employees and executives could earn additional compensation under the Association s Annual Incentive Plan for each year which is tied to the Association s overall business performance and the employee s individual performance in such year. Each Annual Incentive Plan was designed to motivate employees and executives to exceed annual performance targets established by the Board of Directors for such fiscal year. In 2014, performance targets were established for Association capitalization, asset quality, earnings and loan growth. The purpose of each Annual Incentive Plan is to: Ensure the Association s reward structure is consistent with the Association s consolidated mission statement, long-term vision and strategic business plan; Focus decisions on key operating objectives that will provide long-term financial growth and stability to the Association; Provide attractive compensation levels that will allow the Association to attract, motivate and retain superior employees; Reward successful results with compensation levels approaching competitive norms; and Emphasize teamwork as a basis for incentive compensation. Payments are made annually based on actual Association, branch/department and, depending on position, individual performance goals. Payments are a percentage of the employee s base salary. All full-time or regular part-time employees are eligible to participate in the Annual Incentive Plan. The Annual Incentive Plan is in addition to market adjustments of individual salaries and is subject to modification or termination at the Board's discretion. No payment will be made if the Association s credit 89

92 FARM CREDIT SERVICES SOUTHWEST FCA REQUIRED DISCLOSURES administration is rated unsatisfactory, the Association is in default on its General Financing Agreement with CoBank, or if the Association is unable to pay cash patronage refunds to borrowers. Payments under this plan are shown in the Summary Compensation Table under Annual Incentive Compensation. Due to the events described in Note 2 to the financial statements, Restatement under Summary of Significant Accounting Policies included in this annual report to shareholders, no incentive was awarded to employees under the 2014 Annual Incentive Plan. Long-Term Incentive Plan The Association has implemented a key employee incentive plan which provides an incentive for certain employees who are deemed critical to operations to remain with the Association for a three-year period. The purpose of this plan is to: Provide for the retention of key employees in an increasingly tight labor market; Avoid the cost of replacing capable and experienced lending and leadership staff; Ensure continuity of key employees for the benefit of the Association s borrowers; and Provide a benefit that is similar in value to long-term incentive and stock option plans of Association competitors. Benefits under the plan that commenced on January 1, 2011 and terminated on December 31, 2013, were paid to eligible employees in 2014 and are shown in the Summary Compensation Table under Long-Term Incentive Compensation for A new three-year plan was adopted by the Board of Directors commencing January 1, 2014 and ending December 31, Payments under the plan depend upon satisfactory performance of the key employee. Key employees who voluntarily terminate employment are dismissed for cause or do not maintain satisfactory performance forfeit these long-term awards. Mr. Dyer was also a party to an Additional Long-term Incentive Plan implemented to ensure leadership continuity for a three-year period ending on December 31, 2013, facilitate a smooth succession plan, and rebuild the Association s financial position. The plan established vesting conditions that required Mr. Dyer to remain with the Association until December 31, 2013 and for the Association to achieve certain performance criteria relating to capitalization, asset quality and earnings. Mr. Dyer earned a long-term incentive payment of $119,540 in 2013 which was paid in 2014 and included in the Summary Compensation Table under Long-term Incentive Compensation for Retirement Plans Overview -- Mr. Dyer and certain senior officers participated in the 11 th Farm Credit District Employee s Retirement Plan, which is a qualified defined benefit plan that was closed to new employees hired after December 31, 1997, and the former 11 th District Pension Restoration Plan which is a nonqualified defined benefit retirement plan. Mr. Dyer also participated in a supplemental executive retirement plan which is a non-qualified retirement plan. Substantially all employees participate in the 401(k) Plan which has an employer matching contribution. There is an additional fixed employer contribution to an Employer Contribution Plan under the 401(k) Plan for those employees that were not eligible to participate in the qualified defined benefit plan. Certain eligible employees participate in the NQDC Plan which allows individuals to defer compensation and restores the benefits limited in the 401(k) Plan by restrictions in the Internal Revenue Code. 401(k) Plan and NQDC Plan payments are described above in the Summary Compensation Table. The following pension benefits table shows certain pension benefit information by plan for Mr. Dyer and senior officers as a group. As of December 31, 2014, Mr. Becker was not a participant in any pension plan. 90

93 FARM CREDIT SERVICES SOUTHWEST FCA REQUIRED DISCLOSURES ($ in Thousands) Pension Benefits Table Name of CEO Plan Name Number of Credited Years of Service Actuarial Present Value (if applicable) of Accumulated Benefits Payments made during 2014 Dyer 11 th Farm Credit District Employees 35.7 $3,256 $140 1 Retirement Plan Former 11 th District Pension 35.7 $3,395 None Restoration Plan Supplemental Executive Retirement Program N/A $505 None Total 35.7 $7,156 $140 Aggregate number of senior officers and highly compensated employees (excluding CEO) 1 11th Farm Credit District Employees Retirement Plan 25.8 $1,626 None Total 25.8 $1, Represents post-retirement benefit payments made during 2014 after Mr. Dyer s retirement. Qualified Defined Benefit Plan The 11 th Farm Credit District Employee s Retirement Plan generally provides participants with a single life annuity benefit at normal retirement that is equal to 1.95% of average monthly compensation during the 60 consecutive months in which an individual receives his highest compensation multiplied by his years of benefit service. The benefit is actuarially adjusted if the individual chooses a different form of distribution than a single life annuity. The pension valuation was determined using a blended approach assuming 30% of the benefits would be paid as a lump sum and 70% as an annuity at the participants earliest unreduced retirement age. This plan pays benefits up to the applicable limits under the Internal Revenue Code. This plan was closed in 1997 and only Mr. Dyer, one senior officer and two other employees were participants in As of January 1, 2015, only one employee remains a participant. Non-qualified Pension Restoration Plan The 11 th District Pension Restoration Plan was partially funded as of December 31, 2014 with a Rabbi Trust. It is not qualified for tax purposes. Benefits payable under this plan are equal to the excess of the amount that would be payable under the terms of the qualified defined benefit plan disregarding the limitations imposed under Internal Revenue Code Sections 401(a)(17) and 415, over the pension actually payable under the qualified defined benefit plan. This plan also restores any benefits attributable to non-qualified deferred compensation excluded from the benefit determined under the qualified defined benefit plan. The non-qualified pension restoration valuation was 91

94 FARM CREDIT SERVICES SOUTHWEST FCA REQUIRED DISCLOSURES determined using an assumption that benefits would be paid as a lump sum at the participants earliest unreduced retirement age. Mr. Dyer was the only participant in this plan. Supplemental Executive Retirement Program - Mr. Dyer also had an employment agreement containing a supplemental executive deferred compensation agreement ( SERP ). The liability for the SERP, including accrued interest, for the year ending 2014 is included in the Pension Benefits Table above. The purpose of the SERP was to provide additional retention benefits to Mr. Dyer in exchange for Mr. Dyer agreeing to remain with the Association through the vesting date of June 30, The benefits under the SERP were previously reported when vested and earned in 2011 by Mr. Dyer. Interest earned on the SERP corpus is recognized annually as compensation to Mr. Dyer as reported in the Summary Compensation Table under Other. Payments under the SERP are made on an annual basis over a three-year period beginning in January TRAVEL, SUBSISTENCE AND OTHER RELATED EXPENSES The Association has a policy that provides that all employees, including senior officers, shall be reimbursed for actual reasonable travel and related expenses that are necessary and support the Association s business interests, a copy of which is available to shareholders upon written request. TRANSACTIONS WITH SENIOR OFFICERS AND DIRECTORS The Association's policies on loans to, and transactions with, its senior officers and directors, are incorporated herein by reference from Note 12 to the financial statements, "Related Party Transactions," included in this annual report to shareholders. At December 31, 2014, no loans to directors, their immediate families, or affiliated organizations involved more than a normal risk of collectability. No loans were outstanding to senior officers as of December 31, INVOLVEMENT IN CERTAIN LEGAL PROCEEDINGS With the exception of the previously disclosed litigation, there were no matters that came to the attention of management or the Board of Directors regarding involvement of current directors or senior officers in specified legal proceedings required to be disclosed in this section. RELATIONSHIP WITH INDEPENDENT AUDITOR There were no changes in auditor or material disagreements with our independent auditor on any matter of accounting principles or financial statement disclosures during the year. FINANCIAL STATEMENTS The financial statements, together with the report thereon of PricewaterhouseCoopers LLP dated July 29, 2015, which are included in this annual report to shareholders, are incorporated herein by reference. 92

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