by
    Jim Miller, senior vice president of finance, and
    Jim Putnam, senior vice president of financial services

In this article we look at interest rates. In a companion article we look at how the Farm Credit System taps into funds from investors worldwide and delivers those funds to borrowers throughout Rural America.

We read about interest rates in the newspapers almost every day. We listen to reports about interest rates on television. We want to know what Fed Chairman Alan Greenspan is doing about them. And we think about the cost of interest for our businesses.

In spite of all this, interest rates are still a mystery to many. What determines interest rates? Where do First Pioneer's loan funds come from? What does the stock market have to do with interest rates? How do world money markets fit in?

Since renting money to you is our business, we thought that we would provide a plain English guide on the complicated topic of "interest rates."

Down, down, down in 2001

By early November, First Pioneer variable rate borrowers received eight notices in the mail just this year alone. The notices announced reductions in their billed interest rate for a total 4 percent drop. Each notice told our borrowers that we reduced our rate by the same amount that the Federal Reserve decreased its rate. In other words, First Pioneer matched the Federal Reserve every step downward.

Clearly, 2001 has been a notable year for interest rates with the Federal Reserve adjusting rates nine times and achieving a historically low level for short-term rates. First Pioneer may not always match each Federal Reserve move, however. We have been fortunate that our cost of funds have tracked the prime rate closely this year, but given the volatility in interest markets right now, we may not always be in that position.

Today, First Pioneer offers our lowest interest rates in more than a generation.

Some interesting historical benchmarks:

• Farm Credit's short-term variable rates may be lower than they have ever been.
• 1950 was the last time we offered long-term variable rates this low!

Bear in mind that this comparison and the accompanying chart understates the difference in rates. In the 1950s and 1960s, borrower stock was 5 percent for long-term loans and 10 percent for short-term loans compared to today's 5 percent/ $3,000 maximum. In addition, we had no patronage dividend program back then.

Interest Rate Economics 101

Basic business cycle = A long period of economic expansion (growth in the economy) followed by brief periods of recession (contraction of the economy) leading to recovery (regaining the ground lost during recession) and finally back to expansion.

Since the Great Depression, the Federal government managed the business cycle and minimized recessions with the help of two broad sets of tools: monetary policy and fiscal policy.

Monetary policy is synonymous with the Federal Reserve Board (the Fed), which also means Alan Greenspan, its current chairman. The Fed uses short-term interest rates to "drive" the economy and manage the business cycle. Reducing interest rates is like a "gas pedal" to accelerate economic growth and avoid recession. Raising rates is like applying the "brakes" to slow the economy and moderate price inflation.

Since January 1, 2001, the Fed reduced interest rates in response to growing concerns that the U.S. economy was heading into recession. In theory, reducing the cost of money to businesses and consumers encourages them to spend more money for goods and services, which is good medicine for a slowing recessionary economy. This is especially true in interest rate sensitive areas, such as business investment in plants and equipment and also housing.

How much more can the Fed reduce rates? Already the Fed reduced interest rates way beyond what anyone anticipated this year. The economic fallout of the September 11 terrorist attacks on our country further complicated an already complex economic situation. While further interest rate reductions may occur, most analysts feel that the Fed is running out of monetary tools to stimulate the economy.

To complete the picture, the American economy will begin to heal and economic growth will resume some time in the coming months. As economic growth gains momentum, you can count on the Fed to raise interest rates as a means to guard against inflation.

Fiscal policy is the other set of tools that the federal government uses to manage the business cycle. Fiscal policy, which is primarily in Congress's control, means how much money the federal government taxes us, how much it spends and how the two relate to each other (creating either a surplus or deficit).

The theory behind fiscal policy is that a combination of decreasing taxes and/or increasing federal spending will accelerate economic growth and avoid recession. Or increasing taxes and/or decreasing federal spending will restrain economic growth and curb inflation.

Earlier this year, we all heard a lot about fiscal policy when proponents of the tax cut argued that the cut would help the economy. In the wake of the September 11 tragedy, you will hear renewed proposals for a combination of increased government spending and/or tax cuts to help revive the economy. This may be especially so now that monetary policy is running out of room to stimulate the economy through lower interest rates

Various market forces help determine your First Pioneer rate

The interest rates that we charge our customers are determined by many different factors, including the following:

• On any given day, different loan products, loan maturities and risk profiles have many different interest rates. Examples are rates on prime-based business loans, fixed rate residential loans and overnight funds that banks lend to each other. These different interest rates also drive the rates we charge for our loans.
• Federal Reserve actions directly affect short-term rates, such as First Pioneer's variable rate.
• Long-term rates. Customers often asked us this year why our fixed rates are not as low as our variable rates. The answer is that long-term rates are different than short-term rates. Our variable rates are tied mostly to the Federal Reserve and our fixed rates are influenced by many market factors, such as investor confidence, perceptions about inflation, demand for credit and foreign exchange rates, with the Fed short-term rate policy playing a small role as well.

Interest rate trends will likely change when the economy moves into a recovery, which may also be an opportune time for you to lock in a fixed rate on some of your borrowed money.

Low cost of funds and efficient operations mean lower rates for First Pioneer borrowers

Low cost of funds. First Pioneer obtains money from CoBank, our wholesale lender, and rents it to our 9,500 customers.

Behind the scenes, CoBank is an efficient, low-cost source of funding, lending First Pioneer about $1.1 billion. CoBank obtains our loan funds in the New York City money markets, adding a small interest rate charge (their "spread") to cover their costs. CoBank also pays First Pioneer a patronage dividend each year based on their earnings. In addition, they have helped us be a "smarter" borrower, giving us tools to better manage our net earnings.

First Pioneer's operating costs are the final link between national money markets and your rate on your billed interest rate. Our operating costs are added to your cost of money as another markup (First Pioneer's "spread") to the interest rate charged:

National Money Market Rates
+ CoBank Spread
+ First Pioneer Spread
Your Billed Interest Rate

More efficient operations. Since its formation, First Pioneer has significantly reduced our cost of operation, through mergers, new technology, growth of financial services and fewer branch offices. Ten years ago, our operating cost per $100 of loans was more than $2.00. In 2000, this same dropped to $0.99. Operating efficiencies have helped us to:

• Reduce billed interest rates relative to the market
• Reduce borrowers' purchased stock requirement
• Pay patronage dividends to customers every year since 1996

Agriculture has been a leader in improved efficiency in the American economy. First Pioneer is also proud to have a demonstrated record of improved efficiency since we were founded.

Capital management strategies pay off

First Pioneer prices its loans and services very competitively in the marketplace. Our goal is to be profitable enough to generate needed capital to run our business and to pay anything beyond that as patronage dividends to our stockholder- customers.

Key to our profitability is earnings on the equity capital in the ACA. In the past, lower interest rates would definitely have meant lower earnings for First Pioneer and reduced patronage dividends to our customers. However, in 2001, that will not necessarily occur. Over the past three years, we took steps to stabilize the interest earnings on First Pioneer's capital. Working with CoBank, we entered into a "hedging" program to help even out the highs and lows of the interest rate cycle on your association capital.

This means that our net interest income earned from our capital has not declined by as much as the market in the first nine months of 2001. In addition, we will pay less income tax this year because of our newly implemented holding company structure. These strategies will likely enable your board to pay more 2001 patronage in cash and also move toward its long-term goal of paying 100 percent cash.

First Pioneer's customers manage tight bottom lines. Increased costs for some inputs and weaker farm product prices in some industries added to their challenge this year. In 2001, most First Pioneer customers will see the lowest interest cost than they have seen in many years. And that is good news for difficult times.

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