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EX-4 - EX-4 - Federal Home Loan Bank of Cincinnatil39003exv4.htm
EX-12 - EX-12 - Federal Home Loan Bank of Cincinnatil39003exv12.htm
EX-24 - EX-24 - Federal Home Loan Bank of Cincinnatil39003exv24.htm
EX-32 - EX-32 - Federal Home Loan Bank of Cincinnatil39003exv32.htm
EX-3.2 - EX-3.2 - Federal Home Loan Bank of Cincinnatil39003exv3w2.htm
EX-10.7 - EX-10.7 - Federal Home Loan Bank of Cincinnatil39003exv10w7.htm
EX-99.1 - EX-99.1 - Federal Home Loan Bank of Cincinnatil39003exv99w1.htm
EX-31.2 - EX-31.2 - Federal Home Loan Bank of Cincinnatil39003exv31w2.htm
EX-99.2 - EX-99.2 - Federal Home Loan Bank of Cincinnatil39003exv99w2.htm
EX-10.8 - EX-10.8 - Federal Home Loan Bank of Cincinnatil39003exv10w8.htm
EX-31.1 - EX-31.1 - Federal Home Loan Bank of Cincinnatil39003exv31w1.htm
Table of Contents

 
 
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Form 10-K
     
þ   ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2009
or
     
o   TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from                      to                     .
Commission File No. 000-51399
FEDERAL HOME LOAN BANK OF CINCINNATI
(Exact name of registrant as specified in its charter)
     
Federally chartered corporation   31-6000228
(State or other jurisdiction of   (I.R.S. Employer
incorporation or organization)   Identification No.)
     
1000 Atrium Two, P.O. Box 598,    
Cincinnati, Ohio   45201-0598
(Address of principal executive offices)   (Zip Code)
Registrant’s telephone number, including area code
(513) 852-7500
Securities registered pursuant to Section 12(b) of the Act:    None
Securities registered pursuant to Section 12(g) of the Act:
Class B Stock, par value $100 per share
(Title of class)
     Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.
o Yes   þ No
     Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d).
o Yes   þ No
     Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.                                                                                                          þ Yes   o No
     Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).                                                                                     o Yes   o No
     Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.      þ
     Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
             
Large accelerated filer o
  Accelerated filer o   Non-accelerated filer þ   Smaller reporting company o
        (Do not check if a smaller reporting company)
     Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).
o Yes   þ No
     As of February 28, 2010, the registrant had 30,601,985 shares of capital stock outstanding. The capital stock of the Federal Home Loan Bank of Cincinnati is not listed on any securities exchange or quoted on any automated quotation system, only may be owned by members and former members and is transferable only at its par value of $100 per share.
Documents Incorporated by Reference: None
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Table of Contents
             
PART I
   
 
       
Item 1.       3  
   
 
       
Item 1A.       19  
   
 
       
Item 1B.       23  
   
 
       
Item 2.       23  
   
 
       
Item 3.       23  
   
 
       
Item 4.  
[Reserved]
       
   
 
       
PART II
   
 
       
Item 5.       24  
   
 
       
Item 6.       25  
   
 
       
Item 7.       26  
   
 
       
Item 7A.       93  
   
 
       
Item 8.          
   
 
       
        94  
   
 
       
        100  
   
 
       
        151  
   
 
       
Item 9.       151  
   
 
       
Item 9A.       152  
   
 
       
Item 9B.       153  
   
 
       
PART III
   
 
       
Item 10.       155  
   
 
       
Item 11.       160  
   
 
       
Item 12.       177  
   
 
       
Item 13.       177  
   
 
       
Item 14.       179  
   
 
       
PART IV
   
 
       
Item 15.       180  
   
 
       
Signatures  
 
    181  
 EX-3.2
 EX-4
 EX-10.7
 EX-10.8
 EX-12
 EX-24
 EX-31.1
 EX-31.2
 EX-32
 ex-99.1
 EX-99.2

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PART I
Special Cautionary Notice Regarding Forward Looking Information
This document contains forward-looking statements that describe the objectives, expectations, estimates, and assessments of the Federal Home Loan Bank of Cincinnati (FHLBank). These statements use words such as “anticipates,” “expects,” “believes,” “could,” “estimates,” “may,” and “should.” By their nature, forward-looking statements relate to matters involving risks or uncertainties, some of which we may not be able to know, control, or completely manage. Actual future results could differ materially from those expressed or implied in forward-looking statements or could affect the extent to which we are able to realize an objective, expectation, estimate, or assessment. Some of the risks and uncertainties that could affect our forward-looking statements include the following:
  §   the effects of economic, financial, credit, market, and member conditions on our financial condition and results of operations, including changes in economic growth, general liquidity conditions, inflation and deflation, interest rates, interest rate spreads, interest rate volatility, mortgage originations, prepayment activity, housing prices, asset delinquencies, and members’ mergers and consolidations, deposit flows, liquidity needs, and loan demand;
  §   political events, including legislative, regulatory, federal government, judicial or other developments that could affect us, our members, our counterparties, other FHLBanks and other government-sponsored enterprises, and/or investors in the Federal Home Loan Bank System’s (FHLBank System) debt securities, which are called Consolidated Obligations or Obligations;
  §   competitive forces, including those related to other sources of funding available to members, to purchases of mortgage loans, and to our issuance of Consolidated Obligations;
  §   the financial results and actions of other FHLBanks that could affect our ability, in relation to the System’s joint and several liability for Consolidated Obligations, to access the capital markets on favorable terms or preserve our profitability, or could alter the regulations and legislation to which we are subject;
  §   changes in investor demand for Consolidated Obligations;
  §   the volatility of market prices, interest rates, credit quality, and other indices that could affect the value of investments and collateral we hold as security for member obligations and/or for counterparty obligations;
  §   the ability to attract and retain skilled individuals;
  §   the ability to develop and support technology and information systems that effectively manage the risks we face;
  §   the ability to successfully manage new products and services; and
  §   the risk of loss arising from litigation filed against us or one or more other FHLBanks.
We do not undertake any obligation to update any forward-looking statements made in this document.
In this filing, the interrelated disruptions in the financial, credit, housing, capital, and mortgage markets during 2008 and 2009 are referred to generally as the “financial crisis.”
Item 1.   Business.
COMPANY INFORMATION
Organizational Structure
The FHLBank is a regional wholesale bank that provides financial products and services to our member financial institutions. We are one of 12 District Banks in the FHLBank System; our region, known as the Fifth District, comprises Kentucky, Ohio and Tennessee. The U.S. Congress created the FHLBank System in the Federal Home Loan Bank Act of 1932 (the FHLBank Act) to improve liquidity in the U.S. housing market. Each District Bank is a government-sponsored

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enterprise (GSE) of the United States of America and operates as a separate entity with its own stockholders, employees, and Board of Directors. A GSE combines private sector ownership with public sector sponsorship. The FHLBanks are not government agencies and are exempt from federal, state, and local taxation (except real property taxes). The U.S. government does not guarantee, directly or indirectly, the debt securities or other obligations of the FHLBank System.
The FHLBank System also includes the Federal Housing Finance Agency (Finance Agency) and the Office of Finance. The Finance Agency is an independent agency in the executive branch of the U.S. government that regulates the FHLBanks, the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac). The Finance Agency also oversees the conservatorships of Fannie Mae and Freddie Mac. The Office of Finance is a joint office of the District Banks established and regulated by the Finance Agency to facilitate the issuing and servicing of the FHLBank System’s Consolidated Obligations.
In addition to being GSEs, the FHLBanks are cooperative institutions. Our stockholders are also our primary customers. Private-sector financial institutions voluntarily become members of our FHLBank and purchase capital stock in order to gain access to products and services. Only members can purchase capital stock. All Fifth District federally insured depository institutions, insurance companies that engage in residential housing finance, and community development financial institutions that meet standard eligibility requirements are permitted to apply for membership. By law, an institution is permitted to be a member of only one Federal Home Loan Bank, although a holding company through its subsidiaries may have memberships in more than one District Bank.
We require each member to purchase capital stock as a condition of membership and may require a member to purchase stock above the membership stock amount when utilizing products or services. We issue, redeem, repurchase, and exchange capital stock only at its stated par value of $100 per share. By law, our stock is not publicly traded. Our Capital Plan enables us to efficiently expand and contract capital needed to capitalize assets in response to changes in the membership base and their credit needs.
The combination of public sponsorship and private ownership that drives our business model is reflected in the composition of our 17-member Board of Directors, all of whom our members elect. Ten directors are executives and/or directors of our member institutions, while the remaining directors are independent directors who represent the public interest.
The number and composition of our members have been relatively stable in the last 10 years, between 720 and 760, with the number of new members generally offset by a similar number of exiting members due to mergers and acquisitions. At the end of 2009, we had 735 members.
As of December 31, 2009, we had 196 full-time employees and 5 part-time employees. Our employees are not represented by a collective bargaining unit.
Mission and Corporate Objectives
The FHLBank’s mission is to provide financial intermediation between our member stockholders and the capital markets in order to facilitate and expand the availability of financing and flow of credit for housing and community lending throughout the Fifth District. We achieve our mission through a cooperative business model. We raise private-sector capital from member stockholders and issue high-quality debt in the capital markets with other FHLBanks to provide members with competitive services—primarily a reliable, readily available, low-cost source of funds called Advances—and a competitive return on their FHLBank capital investment through quarterly dividend payments. An important component of our mission related to public sector sponsorship is providing affordable housing programs and activities to support members in their efforts to assist lower-income housing markets.

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Our corporate objectives are to:
  §   operate safely and soundly, remain able to raise funds in the capital markets, and optimize our counterparty and deposit ratings;
  §   expand business activity with members;
  §   earn and pay a stable long-term competitive return on members’ capital stock;
  §   maximize the effectiveness of contributions to Housing and Community Investment programs; and
  §   maintain effective corporate governance processes.
To accomplish these objectives, we operate under a philosophy of risk aversion. We strive to maintain modest exposure to business, market, credit, and operational risks and to operate with ample liquidity and capitalization. We believe our business is financially sound, conservatively managed, and well capitalized on a risk-adjusted basis.
Our company’s cooperative ownership structure and the constant par value of stockholders’ capital investment mean that member stockholders derive value from two sources:
  §   the competitive prices, terms, and characteristics of our products; and
  §   a competitive dividend return on their capital investment.
In order to maximize these two sources of membership value, we must strike a balance between offering more attractively priced products, which tend to decrease profitability and therefore dividend payments, and paying attractive dividends, which tends to result from higher priced products. We believe members’ investment in our capital stock is comparable to investing in high-grade short-term, or adjustable-rate, money market instruments or in adjustable-rate preferred equity instruments. We structure our risk exposure so that earnings tend to move in the same direction as changes in short-term market rates. Having relatively stable earnings measured against short-term market rates furnishes member stockholders a degree of predictability on their future dividend returns. There is normally a tradeoff between the level and stability of our stock returns, both in the near term and long term. One measure of our successful resolution of this tradeoff is that relatively few member stockholders have historically chosen, absent mergers and consolidations, to withdraw from membership or to request redemption of their stock held in excess of minimum requirements.
Business Activities
Our principal activity is making readily available, competitively priced and fully collateralized Advances to members. Together with the issuance of collateralized Letters of Credit, Advances constitute our “Credit Services” business. As a secondary business line, we purchase qualifying residential mortgages through the Mortgage Purchase Program and hold them as portfolio investments. This program offers members a competitive alternative to the traditional secondary mortgage market. Together, these product offerings constitute our “Mission Asset Activity.”
In addition, through various Housing and Community Investment programs, we assist members in serving very- low-, low-, and moderate-income housing markets and community economic development. These programs provide Advances at below-market rates of interest, as well as direct grants and subsidies, and can help members satisfy their regulatory requirements under the Community Reinvestment Act. In contrast to Mission Asset Activity, these programs normally generate no profits.
To a more limited extent, we also offer members various correspondent services that assist them in their administration of operations.
To help us achieve our mission, we invest in highly-rated debt instruments of financial institutions and the U.S. government and in mortgage-related securities. In practice, these investments normally include short-term money market instruments and longer-term mortgage-backed securities. Investments furnish additional liquidity, help us manage market risk exposure, enhance earnings, and (through the purchase of mortgage-related securities) support the housing market.
Our primary source of funding and liquidity is through participating in the issuance of the FHLBank System’s unsecured debt securities—Consolidated Obligations—in the capital markets. Obligations are the joint and several obligations of all

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12 District Banks, backed only by the financial resources of the 12 FHLBanks. A secondary source of funding is our capital. A critical component to the success of our operations is the ability to regularly issue Obligations under a wide range of maturities, structures, and amounts, and at relatively favorable spreads to benchmark market interest rates (represented by U.S. Treasury securities and the London InterBank Offered Rate (LIBOR)) compared with many other financial institutions. We also execute cost-effective derivative transactions to help hedge market risk exposure. These capabilities enable us to offer members a wide range of Mission Asset Activity and enable members to access the capital markets, through their activities with the FHLBank, in ways that they may be unable to do without our services.
The System’s comparative advantage in funding is due largely to its GSE status, which is acknowledged in its excellent credit ratings from nationally recognized statistical rating organizations (NRSROs). Moody’s Investors Service (Moody’s) and Standard & Poor’s currently assign, and historically have assigned, the System’s Obligations the highest ratings available: long-term debt is rated Aaa by Moody’s and AAA by Standard & Poor’s, and short-term debt is rated P-1 by Moody’s and A-1+ by Standard & Poor’s. These two rating agencies also assign the highest counterparty and deposit ratings available (triple-A) to our FHLBank. These ratings indicate a belief that the FHLBanks have an extremely strong capacity to meet their commitments to pay timely principal and interest on their debt and that the debt is considered to be of the highest quality with minimal credit risk. Maintaining these ratings is vital to fulfilling our mission. No FHLBank has ever defaulted on repayment of, or delayed return of principal or interest on, any Obligation.
The agencies’ rationales for the System’s and our ratings include:
  §   the FHLBank System’s status as a GSE;
  §   the joint and several liability for Obligations;
  §   excellent overall asset quality;
  §   strong liquidity;
  §   conservative use of derivatives;
  §   adequate capitalization relative to our risk profile; and
  §   a permanent capital structure.
A credit rating is not a recommendation to buy, sell or hold securities. A rating organization may revise or withdraw its ratings at any time, and each rating should be evaluated independently of any other rating. We cannot predict what future actions, if any, a rating organization may take regarding the System’s and our ratings.
Sources of Earnings
Our major source of revenue is interest income earned on Advances, Mortgage Purchase Program notes, and investments. Major items of expense are:
  §   interest paid on Consolidated Obligations and deposits to fund assets;
  §   the requirement to pay 20 percent of annual net earnings to the Resolution Funding Corporation (REFCORP) fund;
  §   costs of providing below-market-cost Advances and direct grants and subsidies under the Affordable Housing Program; and
  §   non-interest expenses (i.e., other expenses on the Statements of Income).

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The largest component of earnings is net interest income, which equals interest income minus interest expense. We derive net interest income from three elements, each of which can vary over time with changes in market conditions, including most importantly interest rates, business conditions and our risk management activities:
  §   the interest rate spread, being the difference between the interest we earn on assets and the interest we pay on liabilities;
  §   funding a portion of interest-earning assets with capital on which we do not pay interest; and
  §   leverage of capital with interest-earning assets.
Regulatory Oversight
The Finance Agency is headed by a director (the Director) who has sole authority to promulgate Agency regulations and to make other Agency decisions. The Finance Agency is charged with ensuring that each FHLBank:
  §   carries out its housing and community development finance mission;
  §   remains adequately capitalized;
  §   operates in a safe and sound manner; and
  §   complies with Finance Agency Regulations.
To carry out these responsibilities, the Finance Agency conducts on-site examinations at least annually of each FHLBank, as well as periodic on- and off-site reviews. Regulations prohibit the public disclosure of examination results. Each FHLBank must submit monthly information to the Agency on its financial condition and operating results. Penalties for non-compliance with Finance Agency Regulations are at the discretion of the Agency. While each FHLBank has substantial discretion in governance and operational structure, the Finance Agency maintains broad supervisory and regulatory authority. In addition, the Comptroller General has authority to audit or examine the Finance Agency and the FHLBanks, to decide the extent to which the FHLBanks fairly and effectively fulfill the purposes of the FHLBank Act, and to review any audit, or conduct its own audit, of the financial statements of an FHLBank.
BUSINESS SEGMENTS
We manage the development, resource allocation, product delivery, pricing, credit risk management, and operational administration of our Mission Asset Activity in two business segments: Traditional Member Finance and the Mortgage Purchase Program. Traditional Member Finance includes Credit Services, Housing and Community Investment, Investments, some correspondent and deposit services, and other financial products of the FHLBank. See the “Segment Information” section of “Results of Operations” in Item 7 and Note 18 of the Notes to Financial Statements for more information on our business segments including their results of operations.
Traditional Member Finance
Credit Services
Features. Advances provide members competitively priced sources of funding to manage their asset/liability and liquidity needs. Advances can both complement and be alternatives to retail deposits, other wholesale funding sources, and corporate debt issuance. We strive to facilitate efficient, fast, and continual access to funds for our members, which we believe provides substantial benefit to members. Because of our normally ample liquidity and because a member must have in place approved applications and processes—including adequate collateral—before it can borrow from us, in most cases members can access funds on a same-day basis.
Each member must supply us with a security interest in eligible collateral with total estimated market value of more than 100 percent of its borrowings outstanding. Collateral is composed primarily of high quality performing loans—primarily one- to four-family residential mortgages. We believe that the combination of conservative collateral policies and risk-based credit underwriting activities effectively mitigate credit risk associated with Advances. We have never experienced a credit loss on Advances, nor have we ever determined it necessary to establish a loss reserve. Item 7’s “Qualitative and

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Quantitative Disclosures About Risk Management” has more detail on our credit risk management of member borrowings.
Letters of Credit are collateralized contractual commitments we issue on our members’ behalves to guarantee their performance to third parties. A Letter of Credit may obligate us to make direct payments to a third party, in which case it is treated as an Advance to the member. The most popular use of Letters of Credit is as collateral supporting public unit deposits. Public unit deposits are deposits held by governmental units at financial institutions. Our Letters of Credit have a triple-A rating because of our triple-A long-term credit ratings. We earn fees on Letters of Credit based on the actual notional amount of the Letters utilized.
We price 13 standard Advance programs every business day and several other standard programs on demand. We also offer customized, non-standard Advances that fall under one of the standard programs. Having diverse programs gives members the flexibility to choose and customize their borrowings according to the features listed below (among others).
  §   size: from $1 to a maximum amount limited by a member’s collateral requirements and borrowing capacity, by our capital leverage requirements, and by our available liquidity;
  §   final maturity: from overnight to 30 years;
  §   interest rate: fixed-rate or adjustable-rate coupons;
  §   coupon payment frequency;
  §   interest rate index on adjustable-rate coupons;
  §   rate reset for adjustable-rate Advances: monthly, quarterly, or other;
  §   prepayment ability: no, partial, or full prepayment options, some of which involve a fee;
  §   principal paydown: with no, partial, or full amortization of principal; and
  §   interest rate options, or other options, embedded in Advances.
Advance Programs. Repurchase based (REPO) Advances are structured similarly to repurchase agreements from investment banks, with one principal difference. Members collateralize their REPO Advances through our normal collateralization process, instead of being required to pledge specific securities as they do in a repurchase agreement. REPO Advances have fixed rates of interest and short-term maturities from one day up to one year, with principal and interest paid at maturity. A majority of REPO Advances outstanding tend to have overnight maturities.
LIBOR Advances have adjustable interest rates typically priced off 1- or 3-month LIBOR indices. Generally, any prepayment is permitted without a fee if it is made on a repricing date.
Regular Fixed Rate Advances have terms of three months to 30 years, with interest normally paid monthly and principal repayment normally at maturity. They have no call or put options.
Putable and Convertible Advances are fixed or adjustable-rate Advances that provide us an option to terminate the Advance (for the Putable) or an option to convert it to a LIBOR Advance (for the Convertible), usually after an initial “lockout” period. Selling us these options enables members to secure lower rates on Putable/Convertible Advances compared to Regular Fixed Rate Advances with the same final maturity. Although we stopped offering Convertible Advances at the beginning of 2006, we still have a substantial amount outstanding.
Mortgage-Related Advances are fixed rate, amortizing Advances with final maturities of 5 to 30 years. Members structure amortization and prepayment schedules that may be similar to those of residential mortgage loans. We offer two basic prepayment structures for which we do not charge prepayment fees. The first structure is an annual constant prepayment rate, which establishes a fixed and required principal paydown schedule. The second structure permits the member, at its option, to repay principal, once annually, in excess of the scheduled amortization based on actual annualized prepayment speeds experienced on 15-year or 30-year current-coupon mortgage-backed securities from Fannie Mae and Freddie Mac specified on the Advance’s trade date. For each structure, members can prepay additional principal subject to our standard applicable prepayment fees.
We also offer several other Advance programs that have smaller outstanding balances.

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Advance Prepayment Fees. For many Advance programs, Finance Agency Regulations require us to charge members prepayment fees for early termination of principal when the early termination results in an economic loss to us. We do not charge prepayment fees for certain short-term Advance programs or under the prepayment structures described above for Mortgage-Related Advances. Certain Advance programs are structured as non-prepayable, such as REPO Advances.
We determine prepayment fees using standard present-value calculations that make us economically indifferent to the prepayment. The prepayment fee equals the present value of the estimated profit that we would have earned over the remaining life of the prepaid Advance. If a member prepays principal on an Advance that we have hedged with an interest rate swap, we may also assess the member a fee to compensate us for the cost we incur for terminating the swap before its stated final maturity.
Housing and Community Investment
Our Housing and Community Investment Programs include the Affordable Housing Program and various housing and community economic development-related Advance programs. We fund the Affordable Housing Program with an accrual equal to 10 percent of our previous year’s regulatory income. See Note 14 of the Notes to Financial Statements for a complete description of the Affordable Housing calculation. This assessment is mandated by the Financial Institutions Reform, Recovery and Enforcement Act of 1989 (FIRREA).
The Affordable Housing Program consists of the Competitive Program and two homeownership set-aside programs: the Welcome Home Program and the Mortgage Refinancing Assistance Program. Under the Competitive Program, we distribute funds in the form of either grants or below-market rate Advances to members that apply and successfully compete in semiannual offerings. Under the Welcome Home Program, funds are normally available beginning in March until they have been fully committed. Members use Welcome Home to assist very low-, low-, and moderate-income families with the down payment and closing costs associated with home purchases. Under the Mortgage Refinancing Assistance Program, funds were first available beginning October 1, 2009, and remain available until the funds are fully committed or until July 30, 2010. Members may use the Mortgage Refinancing Assistance Program to assist homeowners in refinancing mortgages under qualified mortgage refinancing programs. Under both the competitive and set-aside programs, the income of qualifying individuals or households must be 80 percent or less of the area median income. For 2010, up to 35 percent of the Affordable Housing accrual will be set aside for the Welcome Home Program and the Mortgage Refinancing Assistance Program and the remainder allocated to the Competitive Program.
Two other housing programs that fall outside the auspices of the Affordable Housing Program are the Community Investment Program and the smaller Economic Development Advance Program. Advances under the former program have rates equal to our cost of funds, while Advances under the latter program have rates equal to our cost of funds plus three basis points. Members use the Community Investment Program primarily to fund housing and, under certain conditions, community economic development projects, while they use Economic Development Advances exclusively for economic development projects.
Finally, the Board may allocate funds to two voluntary programs: the American Dream Homeownership Challenge program and the Preserving the American Dream program. Both programs are funded with voluntary contributions over and above any regulatory mandated programs. The American Dream Homeownership Challenge grant program provides funds through our members to increase homeownership by minorities and those with special needs. The Preserving the American Dream program provides grant funds through members to non-profit agencies to assist households facing delinquency and default. The Board reviews these programs annually to determine the amount to fund, if any.
Investments
We invest in short-term unsecured money market instruments and longer-term mortgage-related securities. There are five ways the investment portfolio helps us achieve our corporate objectives:
  §   Liquidity management. Investments, especially money market investments, help us manage liquidity. We can structure our short-term debt issuances so that money market investments mature sooner than this debt, providing a source of contingent liquidity when Advance demand spikes or in periods of market stresses when it may not be advantageous or possible to participate in new debt issuance. We also may be able to transform certain investments to cash without a significant loss of value. Money market investments also support our ability to issue most Advances on the same day members request them.

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  §   Earnings enhancement. The investments portfolio assists with earning a competitive return on capital, which enhances the value of membership, members’ preferences to hold excess capital stock to support Mission Asset Activity, and our commitment to Housing and Community Investment programs.
  §   Market risk management. Short-term money market investments help stabilize earnings because they typically earn a “locked in” match-funded spread with little market risk.
  §   Debt issuance management. Maintaining a money market investment portfolio can help us participate in attractively priced debt issuance, on an opportunistic basis. We can temporarily invest proceeds from debt issuances in short-term liquid assets and quickly access them to fund demand for Mission Asset Activity, rather than having debt issuances dictated solely by the timing of member demand.
  §   Support of housing market. Investment in mortgage-backed securities and state housing finance agency bonds directly supports the residential mortgage market by providing capital and financing for mortgages.
We strive to ensure our investment purchases have a moderate degree of market risk and credit risk, which tends to limit the returns we expect to earn on these securities. We believe that a philosophy of purchasing investments with a high degree of market or credit risk would be inconsistent with our public sponsorship and GSE status. Finance Agency Regulations and our internal policies specify general guidelines for, and relatively tight constraints on, the types, amounts, and risk profile of investments we are permitted to hold and the maximum amount of credit risk exposure we are permitted to have with eligible counterparties. We are permitted to invest only in the instruments of counterparties with high credit ratings, and because of our prudent investment policies and practices, we believe all of our investments have high credit quality. We have never had a credit loss or credit-related write down of any investment security. Item 7’s “Qualitative and Quantitative Disclosures About Risk Management” has more detail on our credit risk management of investments.
For short-term money market instruments, we are permitted to purchase overnight and term Federal funds, certificates of deposit, bank notes, bankers’ acceptances, and commercial paper. We may also place deposits at the Federal Reserve Bank. For longer-term investments, we are permitted to purchase:
  §   debt securities issued by the U.S. government or its agencies;
  §   mortgage-backed securities and collateralized mortgage obligations supported by mortgage securities (together, mortgage-backed securities) and issued by GSEs or private issuers;
  §   asset-backed securities collateralized by manufactured housing loans or home equity loans and issued by government-sponsored enterprises or private issuers; and
  §   marketable direct obligations of certain government units or agencies (such as state housing finance agencies) that supply needed funding for housing or community lending and that do not exceed 20 percent of our regulatory capital.
Each security in the last three categories, except those issued by GSEs, must be rated triple-A by Moody’s or Standard & Poor’s on its purchase date. We are not permitted to purchase most common stocks, instruments issued by non-U.S. entities, debt instruments that are non-investment grade on their trade dates, and interest-only and principal-only stripped securities, among other securities. We have never purchased any asset-backed security, have not purchased any adjustable-rate mortgage-backed security in the last fifteen years, and historically have limited our purchases of private-issued mortgage-backed securities to a small percentage of our total investments. We believe these types of securities historically have tended to provide a less favorable risk/return tradeoff, including credit risk, than fixed-rate and GSE mortgage-backed securities.
Per regulation, our total investment in mortgage-backed securities and asset-backed securities normally may not exceed, on a book value basis, 300 percent of previous month-end regulatory capital on the day we purchase the securities. (See the “Capital Resources” section below for the definition of regulatory capital.)
Deposits
We provide a variety of deposit programs, including demand, overnight, term and Federal funds, which enable depositors to invest idle funds in short-term liquid assets. We accept deposits from members, other FHLBanks, any institution to which we offer correspondent services, and other government instrumentalities. The rates of interest we pay on deposits

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are subject to change daily based on comparable money market interest rates. The balances in deposit programs tend to vary positively with the amount of idle funds members have available to invest as well as the level of short-term interest rates. Deposits have represented a small component of our funding in recent years, typically between one and two percent of our funding sources.
Mortgage Purchase Program (Mortgage Loans Held for Portfolio)
Features and Benefits of the Mortgage Purchase Program
Finance Agency Regulations permit the FHLBanks to purchase and hold specified mortgage loans from their members. We offer the Mortgage Purchase Program, which purchases two types of loans: qualifying conforming fixed-rate conventional 1-4 family residential loans and residential mortgages fully guaranteed by the Federal Housing Administration (FHA). Members approved to sell us loans are referred to as Participating Financial Institutions (PFIs).We hold purchased mortgage loans on our balance sheet and account for them as Mortgage Loans Held for Portfolio. We do not securitize mortgage loans. Although we are permitted to purchase qualifying mortgage loans originated within any state or territory of the United States, we currently do not purchase loans originated in New York, Massachusetts, Maine, Rhode Island or New Jersey due to features of those states’ Anti-Predatory Lending laws that are less restrictive than we prefer. We do not use any trust or intermediary to purchase mortgage loans from members.
A “conventional” mortgage refers to a non-government-guaranteed mortgage. A “conforming” mortgage refers to the maximum amount permissible to be lent as a regular prime (i.e., non-jumbo, non-subprime) mortgage. For 2010, the Finance Agency established that limit at $417,000, the same as 2006-2009, with loans originated in a limited number of high-cost cities and counties receiving higher conforming limits. However, our policies prohibit us from purchasing conforming mortgages subject to these higher amounts.
The Mortgage Purchase Program directly supports our public policy mission of supporting housing finance. By selling mortgage loans to us, members can increase their balance sheet liquidity and reduce their interest rate risk and mortgage prepayment risk. Our Program, along with similar programs at other FHLBanks, promotes a greater degree of competition among mortgage investors. It also enables small- and medium-sized community-based financial institutions to use their existing relationship with us to participate more effectively in the secondary mortgage market. Finally, the Program enhances our long-term profitability on a risk-adjusted basis, which augments the return on member stockholders’ capital investment.
Loan Purchase Process
We negotiate a Master Commitment Contract with each PFI, in which the PFI agrees to make a best efforts attempt to sell us a specific dollar amount of loans over a nine-month period. We purchase loans pursuant to a Mandatory Delivery Contract, which is a legal commitment we make to purchase, and a PFI makes to deliver, a specified dollar amount of mortgage loans, with a forward settlement date, at a specified range of mortgage note rates and prices. Shortly before delivering the loans that will fill the Mandatory Delivery Contract, the PFI must submit loan level detail including underwriting information. We apply procedures through the automated Loan Acquisition System designed to screen out loans that do not comply with our policies. Our underwriting guidelines generally mirror those of Fannie Mae and Freddie Mac for conforming conventional loans, although our guidelines and pool composition requirements are more conservative in a number of ways in order to further limit credit risk exposure. If the loan information satisfies the Master Commitment Contract, the Mandatory Delivery Contract and our underwriting guidelines, we purchase the loans for cash on the settlement date by placing funds into the PFI’s demand deposit account at our FHLBank.
PFIs are required to make certain representations and warranties against our underwriting guidelines on the loans they sell to us. If loans are sold in breach of those representations and warranties, we have the contractual right to require the PFI to repurchase those loans.
Allocation of Activities and Risks Between Members and the FHLBank
Because of the FHA guarantee, we bear no credit risk on purchased FHA loans.
A unique feature of the Mortgage Purchase Program is that it separates the various activities and risks associated with residential mortgage lending for conventional loans. We manage the funding of the loans, interest rate risk (including prepayment risk), and liquidity risk. PFIs manage marketing, originating and, in most cases, servicing. PFIs may either retain servicing or sell it to a qualified and approved third-party servicer (also referred to as a PFI). Because PFIs manage

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and bear most of the credit risk, they do not pay us a guarantee fee to transfer credit risk. The conventional Program has a feature, the Lender Risk Account, that helps us manage residual credit risk. The Lender Risk Account is a purchase-price holdback that PFIs may receive back from the FHLBank for managing credit risk to pre-defined acceptable levels of exposure. Actual loan losses are deducted against the amount we ultimately pay the PFI. The Lender Risk Account provides PFIs a strong incentive to sell us high quality performing mortgage loans.
Credit risk exposure is mitigated for conventional loans through conservative underwriting and pool composition requirements and by applying several layers of credit enhancements. These enhancements include the collateral supporting the mortgage loan assets (i.e., homeowners’ equity) and several layers of credit enhancements including (in order of priority) primary mortgage insurance (when applicable), the Lender Risk Account, and Supplemental Mortgage Insurance that the PFI purchases from one of our approved third-party providers naming us as the beneficiary. Item 7’s “Qualitative and Quantitative Disclosures About Risk Management” has more detail on our credit risk management of the Mortgage Purchase Program.
The totality of these credit enhancements protects us against credit risk exposure on each conventional loan down to approximately a 50 percent “loan-to-value” level at the time of origination, subject, in certain cases, to an aggregate stop-loss feature in the Supplemental Mortgage Insurance policy. Because of these credit enhancements, our actual and expected exposure to credit risk on conventional loans purchased in the Mortgage Purchase Program is de minimis.
Earnings from the Mortgage Purchase Program
We generate earnings in the Program from monthly interest payments minus the cost of funding and the cost of hedging the Program’s interest rate risk. Interest income on each loan is computed as the mortgage note rate multiplied by the loan’s principal balance:
  §   minus servicing costs (0.25 percent for conventional loans and 0.44 percent for FHA loans);
  §   minus the cost of Supplemental Mortgage Insurance (required for conventional loans only);
  §   adjusted for the amortization of purchase premiums or the accretion of purchase discounts; and
  §   adjusted for the amortization or the accretion of fair value adjustments on commitments.
We consider the cost of the Lender Risk Account and Supplemental Mortgage Insurance when we set conventional loan prices and evaluate the Program’s expected return. The pricing of each structure depends on a number of factors and is PFI specific. We do not receive fees or income for retaining the risk of losses in excess of the credit enhancements.
CONSOLIDATED OBLIGATIONS
Features
Our primary source of funding is through participation in the sale of FHLBank System debt securities, called Consolidated Obligations. There are two types of Obligations: Consolidated Bonds (Bonds) and Consolidated Discount Notes (Discount Notes). We participate in the issuance of Bonds for three purposes:
  §   to finance and hedge intermediate- and long-term fixed-rate Advances and mortgage assets;
  §   to finance and hedge short-term, LIBOR-indexed adjustable-rate Advances, and swapped Advances, typically by synthetically transforming fixed-rate Bonds to adjustable-rate LIBOR funding through the execution of interest rate swaps; and
  §   to acquire liquidity.
Bonds may have fixed or adjustable (i.e., variable) rates of interest. Fixed-rate Bonds are either noncallable or callable. Generally, our adjustable-rate Bonds use LIBOR for interest rate resets. In the last three years, we have not issued step-up Bonds, range Bonds, zero coupon Bonds or other similarly complex instruments.
The maturity of Bonds typically ranges from one year to 20 years, although there is no statutory or regulatory limit. Bonds can be issued and distributed through negotiated or competitively bid transactions with approved underwriters or

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selling group members. The FHLBanks also have a TAP Issue Program for fixed-rate, noncallable (bullet) Bonds using specific maturities that may be reopened daily during a 3-month period through competitive auctions. The goal of the TAP Issue Program is to aggregate frequent smaller issues into a larger bond issue that may have greater market liquidity.
We participate in the issuance of Discount Notes to fund short-term Advances, adjustable-rate Advances, swapped Advances, short-term money market investments, and a portion of longer-term fixed-rate assets, as well as to acquire liquidity. Discount Notes have maturities from one day to one year, with most of ours normally maturing within three months. Discount Notes are offered daily through a selling group or regularly scheduled competitive auctions. After issuance, Discount Notes are often traded in a liquid secondary market through securities dealers and banks.
Many Obligations are issued with the participating FHLBank(s) concurrently entering into interest rate exchange agreements with approved counterparties. No underwriter has a large concentration of issuance volume.
Pricing of Consolidated Obligations
There are frequent changes in the interest rates and prices of Obligations and in their interest cost relationship to other products such as U.S. Treasury securities and LIBOR. Interest costs are affected by a multitude of factors including (but not limited to) the following:
  §   overall economic and credit conditions;
  §   credit ratings of the FHLBank System;
  §   investor demand and preferences for our debt securities;
  §   the level of interest rates and the shape of the U.S. Treasury curve and the LIBOR swap curve;
  §   the supply, volume, timing, and characteristics of debt issuances by the FHLBanks, other GSEs, and other highly rated issuers;
  §   actions by the federal government, including the Federal Reserve Board, U.S. Treasury Department, Federal Deposit Insurance Corporation (FDIC), and legislative and executive branches to affect the economy, financial system, and/or debt or mortgage markets;
  §   political events, including legislation and regulatory actions;
  §   the volatility of market prices and interest rates;
  §   interpretations of market events and issuer news;
  §   the presence of inflation or deflation; and
  §   currency exchange rates.
Regulatory Aspects
Finance Agency Regulations govern the issuance of Consolidated Obligations. The Office of Finance services Obligations, prepares the FHLBank System’s quarterly and annual combined financial statements, serves as a source of information for the FHLBanks on capital market developments, and administers REFCORP and the Financing Corporation. REFCORP and the Financing Corporation are separate corporations established by Congress to provide funding for the resolution and disposition of insolvent savings institutions.
We have the primary liability for our portion of Obligations, i.e., those issued on our behalf for which we receive the proceeds. However, we also are jointly and severally liable with the other 11 FHLBanks for the payment of principal and interest on all Obligations. If we do not pay the principal or interest in full when due on any Obligation issued on our FHLBank’s behalf, we are prohibited from paying dividends or redeeming or repurchasing shares of capital stock. If an FHLBank were unable to repay its participation in an Obligation for which it is the primary obligor, the Finance Agency could call on each of the other FHLBanks to repay all or part of the Obligation.
The Finance Agency has never invoked this authority. If it did, the paying FHLBank(s) would be entitled to reimbursement from the non-complying FHLBank. If the Finance Agency were to determine that the non-complying

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FHLBank was unable to satisfy its reimbursement obligations, the Finance Agency could allocate the outstanding liability among the remaining FHLBanks on any basis it might determine.
An FHLBank may not issue individual debt securities without Finance Agency approval.
LIQUIDITY
The FHLBank’s operations require a continual and substantial amount of liquidity to provide members access to timely Advance funding and mortgage loan sales in all financial environments and to meet financial obligations (primarily maturing Consolidated Obligations) as they come due in a timely and cost-efficient manner. Our liquidity requirements are significant because Advance balances can be highly volatile, many have short-term maturities, and we strive to offer access to Advances on the same day members request them. We regularly monitor liquidity risks and the investment and cash resources available to meet liquidity needs, as well as statutory and regulatory liquidity requirements.
Our primary long-term source of liquidity under most operating environments is participation in the issuance of Consolidated Obligations. Because Obligations are triple-A rated and because the FHLBank System is one of the largest sellers of debt in the worldwide capital markets, the System historically has been able to satisfy its liquidity needs through flexible debt issuance across a wide range of structures at relatively favorable spreads to benchmark market interest rates. During the recent financial crisis, the System had a reduced ability to issue long-term Obligations, especially noncallable Bonds. However, the System continued to be able to issue shorter-term Discount Notes and callable Bonds in adequate amounts and at cost effective rates to maintain sufficient liquidity and funding for our operations. This is discussed further in Item 1A’s “Risk Factors.”
Besides proceeds from debt issuances, our sources of liquidity include cash, maturing Advances, maturing investments, principal paydowns of mortgage assets, the ability to sell certain investments, and interest payments received. Additionally, under certain circumstances, the U.S. Treasury historically has had the ability to acquire up to $4 billion of the FHLBank System’s Obligations. Although this has never happened, if it did, the terms, conditions, and interest rates would be determined by the Secretary of the Treasury. As noted above in the “Investments” section, money market investments and, to a lesser extent, mortgage-backed securities are sources of liquidity to fund ongoing operations.
Uses of liquidity include repayments of Obligations, issuances of new Advances, purchases of loans under the Mortgage Purchase Program, purchases of investments, and payments of interest.
CAPITAL RESOURCES
Capital Plan
Basic Characteristics
We are authorized by law (the Gramm-Leach-Bliley Act of 1999 (GLB Act)) to have either one or two classes of stock. Class A stock is conditionally redeemable with a member’s six-month written notice, and Class B stock is conditionally redeemable with a member’s five-year written notice. We have always offered only Class B stock. In accordance with the GLB Act, our Capital Plan permits us to issue shares of capital stock only under the following circumstances:
  §   as required for an institution to become a member or maintain membership;
  §   as required for a member to capitalize Mission Asset Activity; and
  §   to pay stock dividends.
Under Finance Agency Regulations, regulatory capital is composed of all capital stock (including stock classified as mandatorily redeemable), retained earnings, general loss allowances, and other amounts from sources the Finance Agency determines are available to absorb losses. Currently, our regulatory capital consists of capital stock and retained earnings. Under the GLB Act, permanent capital equals Class B stock plus retained earnings and is available to absorb financial losses.

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GAAP capital excludes mandatorily redeemable capital stock, while regulatory capital includes it. We account for mandatorily redeemable capital stock as a liability on our Statements of Condition and account for related dividend payments as interest expense. The classification of some capital stock as a liability has no effect on our safety and soundness, liquidity position, market risk exposure, or ability to meet interest payments on our participation in Obligations. Mandatorily redeemable capital stock is fully available to absorb losses until the stock is redeemed or repurchased. See Note 16 of the Notes to Financial Statements for more discussion of mandatorily redeemable capital stock.
The GLB Act also requires us to satisfy three capital requirements. The most important of these is a minimum 4.00 percent regulatory capital-to-assets ratio. Our capital requirements are further discussed in the “Capital Adequacy” section of Item 7’s “Quantitative and Qualitative Disclosures About Risk Management.”
Membership Stock, Activity Stock, Excess Stock, and Cooperative Capital
Our Capital Plan ties the amount of each member’s required capital stock to both the amount of the member’s assets (membership stock) and the amount and type of its Mission Asset Activity with us (activity stock). Membership stock is required to become a member and maintain membership. The amount required currently ranges from 0.15 percent to 0.03 percent of each member’s total assets, with a current minimum of $1 thousand and a current maximum of $100 million for each member. Each member’s asset information is updated at least annually.
In addition to its membership stock, a member may be required to purchase and hold activity stock to capitalize its Mission Asset Activity. For purposes of the Capital Plan, Mission Asset Activity includes the principal balance of Advances, guaranteed funds and rate Advance commitments (GFR), and the principal balance of loans and commitments in the Mortgage Purchase Program that occurred after implementation of the Capital Plan.
The FHLBank must capitalize all Mission Asset Activity with capital stock at a rate of at least four percent. By contrast, each member must maintain an amount of Class B activity stock within the range of minimum and maximum percentages for each type of Mission Asset Activity. We can modify these percentages for new Mission Asset Activity based on our business needs. The current percentages, which have been in effect since the implementation of the Capital Plan, are as follows:
                 
Mission Asset Activity   Minimum Activity Percentage   Maximum Activity Percentage
 
Advances
    2 %     4 %
 
Advance Commitments
    2       4  
 
Mortgage Purchase Program
    0       4  
If a member’s capitalization of Mission Asset Activity falls to the minimum percentage, it must purchase additional stock to capitalize further Mission Asset Activity. If a member owns more stock than is needed to satisfy its membership stock requirement and the maximum activity stock percentage for its Mission Asset Activity, we designate the remaining stock as the member’s excess capital stock. The Capital Plan permits each member, within constraints, to use its own excess capital stock to capitalize additional Mission Asset Activity. In this case, the excess stock is re-allocated to activity stock for that member, at the maximum percentage rate in effect at the time. We are permitted to repurchase excess capital stock at any time, subject to the terms and conditions of the Capital Plan.
After a member’s excess stock falls to zero, the Capital Plan normally permits the member to capitalize additional Mission Asset Activity with excess stock owned by other members (at the maximum percentage rate), instead of having to purchase new stock. This essential feature, called “cooperative capital,” enables us to more efficiently utilize our capital stock. A member’s use of cooperative capital reduces the ratio of its activity stock to its Mission Asset Activity for each type of Mission Asset Activity. The Capital Plan currently has two limits on each member’s maximum use of cooperative capital.
  §   The member must maintain a ratio of activity stock to Mission Asset Activity at least equal to the minimum allocation percentage identified in the table above.
  §   It cannot use more than $100 million of cooperative capital.

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When a member reaches one of these limits through either growth in its Mission Asset Activity or reduction in its capital stock balance, it must capitalize additional Mission Asset Activity with a purchase of new capital stock.
Benefits of the Capital Plan
The Capital Plan enables us to efficiently obtain new stock to capitalize asset growth, thus maintaining a prudent amount of financial leverage. It also enables us to deploy excess capital into Mission Assets. When Mission Asset Activity contracts, it permits us, at our option, to repurchase capital stock in a timely and prudent manner, thus maintaining an adequate level of profitability. Additionally, the concept of “cooperative capital” better aligns the interests of heavy users of our products with light users by enhancing the dividend return.
Prior to 2007, the “cooperative capital” feature of our Capital Plan enabled us to continue our long historical practice of paying dividends with additional shares of stock rather than in cash. We believe that paying stock dividends enables members to have more flexibility in managing the amount of their capital investment in our FHLBank in the context of their business needs and that it also is the most efficient and cost effective tool available to raise capital. However, under a Finance Agency capital rule effective in January 2007, if the sum of each member’s excess capital stock exceeds one percent of our total assets, we are not permitted to pay dividends in the form of additional shares of stock. In accordance with this rule, we paid cash dividends in the fourth quarter of 2008 and each quarter of 2009.
Retained Earnings
Retained earnings are important to protect members’ capital stock investment against the risk of impairment and to enhance our ability to pay stable and competitive dividends when current earnings are volatile. Impairment risk is the risk that members would have to write down the par value of their capital stock investment in our FHLBank as a result of their analysis of ultimate recoverability. An extreme situation of earnings instability, in which losses exceeded the amount of our retained earnings for a period of time determined to be other-than-temporary, could result in a determination that the value of our capital stock was impaired.
Our Retained Earnings Policy establishes a range for the amount of retained earnings needed to mitigate impairment risk and augment dividend stability in light of all the material risks we face. The current Retained Earnings Policy establishes a range of adequate retained earnings of $140 million to $285 million, with a target level of $170 million. At the end of 2009, our retained earnings were $412 million. We believe the current amount of retained earnings is sufficient to protect our capital stock against impairment risk and to provide the opportunity for dividend stability.
RISK MANAGEMENT
Our FHLBank faces various risks that could affect the ability to achieve our mission and corporate objectives. We categorize risks into 1) business/strategic risk (including regulatory/legislative), 2) market risk (also referred to as interest rate risk), 3) capital adequacy, 4) credit risk 5) funding/liquidity risk, 6) accounting risk, and 7) operational risk (including fraud risk). Our Board of Directors is required to monitor, oversee, and control all risks and to establish corporate objectives regarding risk philosophy, risk tolerances, and financial performance expectations. We have numerous Board-adopted policies and processes that address risk management. These policies establish risk tolerances, limits, and guidelines, must comply with all Finance Agency Regulations, and are designed to achieve continual safe and sound operations. The Board delegates day-to-day responsibility for managing and controlling most of these risks to senior management. Our cooperative business model, corporate objectives, and strong regulatory oversight provide us clear incentives to minimize risk exposures, and risk management practices are infused throughout all of our business activities.
Our policies and operating practices are designed to limit risk exposures from ongoing operations in the following broad ways:
  §   by anticipating potential business risks and appropriate responses;
  §   by defining permissible lines of business;
  §   by limiting the kinds of assets we are permitted to hold and the kinds of hedging and financing arrangements we are permitted to use;

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  §   by limiting the amount of market risk to which we are permitted to be exposed; and
  §   by requiring strict adherence to internal controls, adequate insurance coverage, and comprehensive Human Resources policies, procedures, and strategies.
The FHLBank actively manages risk exposures on an enterprise-wide basis through regular formal meetings of several groups and committees. These include, among others, the Asset/Liability Management Committee, the Credit Risk Committee, the Information Technology Steering Committee, the Disclosure Committee, the Business Resumption and Contingency Planning Committee, the End User Computing Committee, the Financial and Correspondent Services Committee, and senior staff meetings. We also manage risk via regular reporting to and discussion with the Board of Directors and its committees, particularly the Financial and Risk Management Committee and the Audit Committee, as well as by continuous discussion and decision-making among key personnel across the FHLBank.
USE OF DERIVATIVES
Finance Agency Regulations and policies establish guidelines for the execution and use of derivative transactions. Permissible derivatives include interest rate swaps, swaptions, interest rate cap and floor agreements, calls, puts, and futures and forward contracts executed as part of our market risk management and financing. We are prohibited from trading in or the speculative use of these instruments and have limits on the amount of credit risk to which we may be exposed from derivatives. Most of our derivatives activity involves interest rate swaps. We account for all derivatives at their fair values.
Similar to our participation in debt issuances, derivatives help us hedge market risk created by Advances and mortgage commitments. Derivatives related to Advances most commonly hedge either:
  §   below-market rates and/or the market risk exposure on Putable and Convertible Advances for which members have sold us options embedded within the Advances;
  §   the market risk exposure of options we have sold that are embedded with Advances; or
  §   Regular Fixed Rate Advances when it may not be as advantageous to issue Obligations or when it may improve our market risk management.
We also use derivatives to hedge the market risk created by commitment periods of Mandatory Delivery Contracts in the Mortgage Purchase Program.
Derivatives help us intermediate between the normal preferences of capital market investors for intermediate-and- long-term fixed-rate debt securities and the normal preferences of our members for shorter-term or adjustable-rate Advances. We can satisfy the preferences of both groups by issuing long-term fixed-rate Bonds and entering into an interest rate swap that synthetically converts the Bonds to an adjustable-rate LIBOR funding basis that matches up with the short-term and adjustable-rate Advances, thereby preserving a favorable interest rate spread.
Because we have a cooperative business model, our Board of Directors has emphasized the importance of minimizing earnings volatility, including volatility from the use of derivatives. Accordingly, our strategy is to execute derivatives that we expect both to be highly effective hedges of market risk exposure and to receive fair value hedge accounting treatment. Therefore, the volatility in the market value of equity and earnings from our use of derivatives has historically tended to be moderate.
In this context, we have not executed derivatives, nor do we currently plan to do so, to hedge market risk exposure outside of specifically identified assets or liabilities or to hedge the market risk of mortgage assets, except for the commitment period of loans in the Mortgage Purchase Program. We believe that the economic benefits of using derivatives to hedge at the level of the entire balance sheet instead of individual instruments, or to hedge mortgage assets (except commitment periods), would generally be less than the increased hedging costs and risks, which include potentially higher earnings volatility.

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COMPETITION
Numerous economic and financial factors influence the competition for Advance lending to members. The most important factor that affects Advance demand is the general availability of competitively-priced local retail deposits, which most members view as their primary funding source, in amounts and maturity structures that satisfy members’ funding needs. In addition, both small and large members typically have access to brokered deposits, repurchase agreements and public unit deposits, each of which presents competitive alternatives to Advances. Larger members typically have greater access to other competitive sources of funding and asset/liability management facilitated via the national and global credit markets. These sources include subordinated debt, interbank loans, covered bonds, interest rate swaps, options, bank notes, and commercial paper. An important new source of competition for Advances beginning in the fourth quarter of 2008 and continuing in 2009 was the combined effects of the various fiscal and monetary stimuli and financial guarantees initiated by the federal government to combat the financial crisis and recession. These recent government actions are discussed further in Item 1A’s “Risk Factors” and in Item 7’s “Executive Overview.”
The holding companies of some of our large asset members have membership(s) in other FHLBanks through affiliates chartered in other FHLBank Districts. Others could initiate memberships in other FHLBank Districts. The competition among FHLBanks for the business of multiple-membership institutions is similar to the FHLBanks’ competition with other wholesale lenders and other mortgage investors. We compete with other FHLBanks on the offerings and pricing of Mission Asset Activity, earnings and dividend performance, collateral policies, capital plans, and members’ perceptions of our relative safety and soundness. Some members may also evaluate the actual or perceived benefits of diversifying business relationships among FHLBank memberships. We regularly monitor, to the extent possible, these competitive forces among the FHLBanks.
The primary competitors for loans we purchase in the Mortgage Purchase Program are other housing GSEs, government agencies (Ginnie Mae), other FHLBanks, private issuers, and, beginning in 2009, the federal government. We compete primarily based on price, products, and services. Fannie Mae and Freddie Mac in particular have long-established and efficient programs and are the dominant purchasers of residential conforming fixed-rate conventional mortgages. In addition, a number of private financial institutions have well-established securitization programs, although they may not currently be active. The Program also may compete indirectly with the U.S. government to the extent it purchases mortgage-backed securities.
For debt issuance, the FHLBank System competes with issuers in the national and global debt markets, including most importantly the U.S. government and other GSEs. Competitive factors include, but are not limited to, the following:
  §   interest rates offered;
  §   the amount of debt offered;
  §   the market’s perception of the credit quality of the issuing institutions and the liquidity of the debt;
  §   the types of debt structures offered; and
  §   the effectiveness of marketing.
TAX STATUS
We are exempt from all federal, state, and local taxation other than real property taxes. However, we are obligated to make payments to REFCORP equal to 20 percent of net earnings after operating expenses and the Affordable Housing Program expense, but before charges for REFCORP. Currently, the combined assessments for REFCORP and the Affordable Housing Program are the equivalent of a 26.7 percent annualized net tax rate. Despite our tax exempt status, any cash dividends we issue are taxable to members and do not benefit from the corporate dividends received exclusion. Notes 1, 14, and 15 of the Notes to Financial Statements have additional details regarding the assessments for the Affordable Housing Program and REFCORP.

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Item 1A. Risk Factors.
The following are the most important risks we currently face. The realization of one or more of the risks could negatively affect our results of operations, financial condition, and, at the extreme, the viability of our business franchise. The effects could include reductions in Mission Asset Activity, lower dividends, and, in extreme situations, an inability to participate in issuances of Consolidated Obligations. Many of the risks are directly related to the residual effects from the financial crisis and the economic recession. The risks identified below are not the only risks we face. Additional risks not presently known or which we currently deem immaterial may also impact our business, and even the risks identified may adversely affect our business in ways not anticipated.
Another economic recession could further reduce Mission Asset Activity and could lower profitability.
    Member demand for Mission Asset Activity depends in part on the general health of the economy and business conditions. A recessionary economy, or an economy characterized by stagflation in which growth is weak but inflation high, normally lowers the amount of Mission Asset Activity, could decrease profitability and could cause stockholders to request redemption of a portion of their capital or request withdrawal from membership (both referred to here as “request withdrawal of capital”). These unfavorable effects are more likely to occur and be more severe if a weak economy is accompanied by significant changes in interest rates, stresses in the housing market, elevated competitive forces, or changes in the legislative and regulatory environment relative to the FHLBank System. All of these changes occurred in 2009. The recession in 2008 and 2009 substantially decreased our Advances and Letters of Credit activity. Although our profitability relative to short-term interest rates increased and there was no unfavorable impact on our capitalization, we are concerned that another recession or a weak recovery from the recent recession could further decrease Advance balances and ultimately erode profitability. As discussed in another risk factor, an extremely severe economic downturn, especially if combined with significant disruptions in housing conditions or other external events, could result in credit losses on our assets.
Continuation of the recently elevated competitive environment could further decrease Mission Asset Activity and lower earnings and capitalization.
    We operate in a highly competitive environment for our Mission Asset Activity and debt issuance. Increased competition can decrease the amount of Mission Asset Activity and narrow net spreads on that activity, both of which can reduce profitability and cause stockholders to request withdrawal of capital. Historically, our chief competition has been from other wholesale lenders and debt issuers, including other GSEs. A new and intense source of competition arose in the fourth quarter of 2008 and in 2009 from the federal government’s actions to stimulate the economy. These actions significantly expanded funding and liquidity available to members and provided various forms of additional government guarantees of financial institution liabilities, which lowered our Advance demand. We cannot predict how long these negative effects will continue or how much more severe the effects could be. However, we expect overall Advance demand will remain weak until the government reduces these initiatives, in particular the liquidity stimulus, by tightening monetary policy and winding down its purchases of mortgage-backed securities.
Congressional legislation to resolve the financial issues and reform the business models of Fannie Mae and Freddie Mac, combined with the heightened regulatory environment, could unfavorably affect our business model, financial condition, and results of operations.
    The federal government put Fannie Mae and Freddie Mac into conservatorship in September 2008, after their financial condition, capital position, and actual and expected earnings losses worsened dramatically due to the financial crisis. These two GSEs and the FHLBank System have the same regulator, the Finance Agency, which is charged with helping resolve the current housing finance crisis and with addressing reform of Fannie Mae and Freddie Mac. While there is agreement that a permanent financial and political solution for Fannie Mae and Freddie Mac must be implemented, no consensus has evolved around any of the various options proposed to date and no legislation has been proposed. Fannie Mae and Freddie Mac, which are publicly traded, stockholder-owned companies, have a different business model than the FHLBanks, which are cooperatives owned by their member financial institutions and which have no publicly traded stock. However, because all these GSEs share a common regulator and housing mission, the FHLBanks could be subject to legislation related to the ultimate disposition of Fannie Mae and Freddie Mac. Such legislation could inadequately account for the significant differences between

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    those GSEs and the FHLBanks and, therefore, could imperil the ability of the FHLBanks to continue operating effectively within their current business model or could change the business model. Also, because of the financial crisis and financial challenges at Fannie Mae, Freddie Mac, and some FHLBanks discussed below, the FHLBanks have faced heightened regulatory scrutiny in the last several years, thereby imparting additional uncertainty regarding the political and regulatory environment in which the FHLBanks will ultimately operate in the future.
    We believe the legislative and regulatory uncertainty has negatively impacted Mission Asset Activity and made some members less willing to hold a capital investment in our company. At this time, we are unable to predict what effects GSE reform and the related heightened regulatory environment will have on the FHLBanks’ business model, financial condition, or results of operations, or whether the effects will be positive or negative.
    In addition, related to the housing crisis, in early February 2010, Fannie Mae and Freddie Mac announced plans to purchase loans that are 120 days or more delinquent out of mortgage pools. The initial purchases were slated to occur from February 2010 through May 2010, with additional delinquency purchases as needed thereafter. As Fannie Mae and Freddie Mac may need to raise additional funds for these loan purchases, funding costs in the short-end of the agency debt market may be affected. At this time, we cannot predict what effect this event will have on our financial condition or results of operation.
Impaired access to the capital markets for debt issuance could deteriorate our liquidity, decrease the amount of Mission Asset Activity, lower earnings by raising debt costs and, at the extreme, prevent the System from meeting its financial obligations.
    Our principal long-term source of funding, liquidity, and market risk management is through access to the capital markets for participation in the issuance of debt securities and for execution of derivative transactions at attractive prices and yields. This is the fundamental source of the FHLBank System’s business franchise. The System’s triple-A debt ratings, the implicit U.S. government backing of our debt, and our effective funding management are instrumental in ensuring satisfactory access to the capital markets. However, our ability to access the capital markets could be affected by external events (such as general economic and financial instabilities, political instability, wars, and natural disasters) and by our joint and several liability along with other FHLBanks for Consolidated Obligations (which exposes us to events at other FHLBanks).If our access were to be impaired for any extended period, the effect on our financial condition and results of operations could be material. At the extreme, the System’s ability to achieve its mission and satisfy its financial obligations could be threatened.
    During 2008 and the early part of 2009, the financial crisis and economic recession, and the federal government’s significant measures enacted to mitigate their effects, changed the traditional bases on which market participants valued GSE debt securities and consequently affected our funding costs and practices. Particularly in 2008, funding costs associated with issuing long-term Consolidated Obligations rose sharply and were more volatile compared to LIBOR and U.S. Treasury securities. We believe this reflected dealers’ reluctance to sponsor, and investors’ reluctance to buy, as much long-term GSE debt as they previously did, coupled with strong investor demand for short-term, high-quality assets. At various times in 2008 and early 2009 the System had a reduced ability to issue long-term noncallable debt Obligations at acceptable rates. As 2009 progressed, funding costs began to return to more normal levels relative to other market rates.
    Although we believe that events to date have not materially or permanently raised debt costs or impeded access to the capital markets, and that the chance of a liquidity or funding crisis in the FHLBank System or external event that would impair access to the capital markets currently is remote, we can provide no assurance that this will remain true.
Financial difficulties at other FHLBanks could require us to provide financial assistance to another FHLBank and/or increase the System’s debt costs. Either of these events could materially and adversely affect our results of operations or our financial condition.
    Each FHLBank has a joint and several liability for principal and interest payments on Consolidated Obligations, which are backed only the financial resources of the FHLBanks. Although, no FHLBank has ever defaulted on its principal or interest share of an Obligation and the Finance Agency has never required an FHLBank to make principal or interest payments based on another FHLBank’s Consolidated Obligation liability, there can be no

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    assurance that this will continue to be the case. In 2009, as in 2008, several FHLBanks reported, and are expected to continue reporting, issues with capital adequacy and profitability. These issues could require our FHLBank to provide financial assistance to one or more other FHLBanks, for example, by making a payment on an Obligation on behalf of another FHLBank. Such assistance could, at the extreme, adversely affect our financial condition, earnings, ability to pay dividends, or redeem or repurchase capital stock.
    Capital and earnings at other FHLBanks have been pressured due primarily to impairment charges taken on private-label mortgage-backed securities. These issues could raise investors’ and rating agencies’ concern regarding the credit risk of FHLBank System debt securities, which could result in higher and more volatile debt costs, lower debt ratings, and impaired ability to issue debt. As a result, our financial condition and results of operations could be adversely affected.
We are exposed to credit risk that, if realized, could materially and adversely affect our financial condition and results of operations.
    We believe that residual credit risk exposure to Advance collateral, loans in the Mortgage Purchase Program, investments, and derivatives, including exposure to loans that may have “subprime” and “alternative/nontraditional” characteristics, continues to be minimal. In general, however, and especially given the residual effects of the recent financial crisis and recession, we cannot make any assurances that credit losses will continue to be minimal. Most members are on a blanket lien status for Advances which, because it does not require specific loan collateral to be delivered, imparts a degree of uncertainty as to what types of loans members have pledged to collateralize their Advances. Also, in 2009, as in 2008, there was a significant downward trend in the internal credit ratings assigned to members. During the year, for certain members, it became necessary for us to reduce their borrowing capacity, increase their collateral requirements and/or require them to deliver collateral or provide greater detail on pledged assets. Regarding the Mortgage Purchase Program, although loans have strong credit enhancements, continuing substantial reductions in home prices could increase delinquencies and foreclosures sufficiently to result in credit losses. Money market investments and the uncollateralized portion of interest rate swaps are unsecured; we collateralize most credit risk exposure of swaps by exchanging cash or high-grade securities (daily, if necessary) with the counterparties based on the net market value positions of the swaps. Although we make investments in the securities of, and execute derivatives with, highly rated institutions, failure of a counterparty with which we have a large unsecured position could have a material adverse affect on our financial conditions and results of operations.
    An extremely severe and prolonged economic downturn, especially if combined with significant disruptions in housing conditions, could result in credit losses on our assets that could materially impair our financial condition or results of operations.
Changes in interest rates and mortgage prepayment speeds could significantly reduce our ability to pay members a competitive dividend from current earnings.
    Sharp increases in interest rates, especially short-term rates, or sharp decreases in long-term interest rates could threaten the competitiveness of dividend rates relative to member stockholders’ alternative investment choices. A major way that interest rate movements could lower profitability is by changes in mortgage prepayment speeds that we have not hedged appropriately with Consolidated Obligations. Exposure to unhedged changes in mortgage prepayment speeds is one of our largest ongoing risks. In some extremely stressful scenarios, changes in interest rates and prepayment speeds could result in dividends being below stockholders’ expectations for an extended period of time. In such a situation, members could engage in less Mission Asset Activity and could request withdrawal of capital.
Spreads on assets to funding costs may narrow because of changes in market conditions and competitive factors, resulting in lower profitability.
    Spreads on many of our assets tend to be narrow compared to those of many other financial institutions due to our cooperative business model, resulting in relatively lower profitability. Market conditions could cause asset spreads, and therefore our profitability, to decrease substantially. This could result in lower dividends, reductions in Mission Asset Activity, and members’ requests to withdraw their capital.

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Members face increased regulatory scrutiny, especially from the FDIC, which could further decrease Mission Asset Activity and lower profitability.
    In response to the financial crisis and ongoing elevations in financial institution failures, members’ regulators have appeared to heighten regulatory requirements and scrutiny, especially in the areas of capitalization, assessments of asset classifications, reliance on Advances for funding and interest rate risk management. We believe these activities have resulted in members’ decreased use of Advances. The Federal Deposit Insurance Corporation (FDIC) has made changes, or has proposed to make changes, in several of its practices that has reduced or could reduce members’ ability or preferences to engage in Mission Asset Activity. These practices include raising deposit insurance coverage levels; providing guarantees to unsecured debt issuance of insured depository institutions; and requiring certain depository institutions to include Advances when calculating their deposit insurance premiums.
The concentration of Mission Asset Activity and capital among a small number of members could reduce dividend rates available if several large members were to withdraw or sharply reduce their activity.
    A relatively small number of members provide the bulk of our Mission Asset Activity and capital. These members could decrease their Mission Asset Activity and the amount of their FHLBank capital stock as a result of merger and acquisition activity or their reduced demand for our products. Our business model is structured to be able to absorb sharp changes in our Mission Asset Activity because we can undertake commensurate reductions in our liability balances and capital and because of our low operating expenses. Therefore, although possible, we believe the chance is small that a significant membership withdrawal of large members or a significant reduction in their Mission Asset Activity could negatively affect profitability sufficiently to threaten our ability to satisfy principal and interest payments on Consolidated Obligations or ability to pay competitive dividends to remaining members.
The amount of our retained earnings could become insufficient to preserve a competitive dividend return or protect stockholders’ capital investment against impairment.
    If dividend rates paid to stockholders become uncompetitive because of an insufficient amount of current earnings, and/or because of an inability to distribute retained earnings, stockholders may request withdrawal of their capital. At the extreme, if the amount of retained earnings were insufficient to protect stockholders’ capital investment against losses, the value of our capital stock on their books could be written down below its par value and be designated as an impaired asset. Although we believe that we have a sufficient amount of retained earnings to protect against dividend volatility and impairment risk, we can provide no assurance that this will continue to be the case.
Changes in relevant accounting standards could materially increase earnings volatility and consequently reduce the quality of members’ capital investment, the amount of Mission Asset Activity and the amount of capital.
    To date, we believe there have been no material effects on our Mission Asset Activity, capitalization, or earnings because of our application of accounting standards, especially those related to accounting for derivatives and hedging activities and accounting for premiums and discounts. Although unlikely to occur, changes in certain accounting standards could increase earnings volatility, causing less demand for Mission Asset Activity and stockholders to request withdrawal of capital. Earnings volatility could also increase if we began to execute more derivatives involving economic or macro hedges or if we significantly increased the amount of mortgage assets with premiums or discounts.
Our financial condition and results of operations could suffer if we are unable to hire and retain skilled key personnel.
    The success of our business mission depends, in large part, on the ability to attract and retain key personnel. Competition for qualified people can be intense. Should we be unable to hire or retain effective key personnel, our financial condition and results of operations could be harmed.

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Failures or interruptions in our internal controls, information systems and other operating technologies could harm our financial condition, results of operations, reputation, and relations with members.
    Control failures, including those over financial reporting, or business interruptions with members and counterparties could occur from human error, fraud, breakdowns in computer systems and operating processes, or natural or man-made disasters. We rely heavily on internal and third-party computer systems. Although we believe there are substantial control processes in place, if a significant credit or operational risk event were to occur, it could materially damage our financial condition and results of operations. We may not be able to foresee, prevent, mitigate, reverse or repair the negative effects of any such failure or interruption.
Item 1B. Unresolved Staff Comments.
None.
Item 2. Properties.
Our offices are located in 70,879 square feet of leased space in downtown Cincinnati, Ohio. We also maintain a leased, fully functioning, back-up facility in suburban Cincinnati. Additionally, we lease a small office in Nashville, Tennessee for the area marketing representative. We believe that our facilities are in good condition, well maintained, and adequate for our current needs.
Item 3. Legal Proceedings.
We are subject to various pending legal proceedings arising in the normal course of business. Management does not anticipate that the ultimate liability, if any, arising out of these matters will have a material adverse effect on our financial condition or results of operations.

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PART II
Item 5.   Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.
By law, only our members (and former members that have outstanding Mission Asset Activity) may own our stock. As a result, there is no public market for our stock. The par value of our capital stock is $100 per share. As of December 31, 2009, we had 735 stockholders and 31 million shares of capital stock outstanding, all of which were Class B Stock.
We paid quarterly dividends in 2009 and 2008 as outlined in the table below.
(Dollars in millions)
                                                         
    2009   2008
            Percent Per                   Percent Per      
Quarter
  Amount   Annum   Form   Amount   Annum   Form (1)
First
  $ 45       4.50     Cash   $ 47       5.25     Capital Stock
Second
    44       4.50     Cash     49       5.50     Capital Stock
Third
    50       5.00     Cash     51       5.50     Capital Stock
Fourth
    44       4.50     Cash     49       5.00     Cash
 
                                           
 
Total
  $ 183       4.63             $ 196       5.31          
 
                                           
          (1) Fractional share amounts were paid in cash.
Generally, our Board of Directors has discretion to declare or not declare dividends and to determine the rate of any dividend declared. Our dividend declaration policy states that dividends for a quarter are declared and paid from retained earnings after the close of a calendar quarter and are based on average stock balances for the then closed quarter. Thus, any dividend declared during a quarter does not include any actual or projected earnings for the current quarter.
On January 29, 2007, a final Finance Agency Capital Rule became effective that prohibits an FHLBank from issuing new excess capital stock to members, either by paying stock dividends or otherwise, if before or after the issuance the amount of member excess capital stock exceeds or would exceed one percent of the FHLBank’s assets. Excess capital stock for this regulatory purpose is calculated as the aggregate of capital stock owned by all members that is in excess of each member’s membership and Mission Asset Activity requirements (as defined in our Capital Plan). In accordance with this Rule, we paid cash dividends in each quarter of 2009 and in the fourth quarter of 2008 and stock dividends in each of the first three quarters of 2008. Our Board, and we believe our members, continue to have a stated preference for paying dividends in the form of stock.
We may not declare a dividend if, at the time, we are not in compliance with all of our capital requirements. We also may not declare or pay a dividend if, after distributing the dividend, we would fail to meet any of our capital requirements or if we determine that the dividend would create a safety and soundness issue for the FHLBank. We expect to continue to pay dividends at a spread above comparable short-term interest rates. See Note 16 of the Notes to the Financial Statements for additional information regarding our capital stock.
RECENT SALES OF UNREGISTERED SECURITIES
From time-to-time we provide Letters of Credit in the ordinary course of business to support members’ obligations issued in support of unaffiliated, third-party offerings of notes, bonds or other securities. We provided $203 million, $200 million and $10 million of such credit support during 2009, 2008 and 2007, respectively. To the extent that these Letters of Credit are securities for purposes of the Securities Act of 1933, their issuance is exempt from registration pursuant to section 3(a)(2) thereof.

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Item 6.  Selected Financial Data.
The following table presents selected Statement of Condition information (based on book balances), statement of income data and financial ratios for the five years ended December 31, 2009.
                                         
    Year Ended December 31,  
(Dollars in millions)   2009     2008     2007     2006     2005  
STATEMENT OF CONDITION DATA:
                                       
 
                                       
Total assets
  $ 71,387     $ 98,206     $ 87,335     $ 81,381     $ 77,074  
Advances
    35,818       53,916       53,310       41,956       40,262  
Mortgage loans held for portfolio, net
    9,366       8,632       8,928       8,461       8,418  
Investments (1)
    24,193       35,325       24,678       30,614       28,114  
Consolidated Obligations, net:
                                       
Discount Notes
    23,187       49,336       35,437       21,947       17,578  
Bonds
    41,222       42,393       46,179       53,239       53,520  
 
                             
Total Consolidated Obligations, net
    64,409       91,729       81,616       75,186       71,098  
Mandatorily redeemable capital stock
    676       111       118       137       418  
Capital:
                                       
Capital stock – putable
    3,063       3,962       3,473       3,658       3,504  
Retained earnings
    412       326       286       255       208  
Accumulated other comprehensive income
    (8 )     (6 )     (4 )     (6 )     (3 )
 
                             
Total capital
    3,467       4,282       3,755       3,907       3,709  
 
                                       
STATEMENT OF INCOME DATA:
                                       
 
                                       
Net interest income
  $ 387     $ 364     $ 421     $ 386     $ 340  
Provision for credit losses
    -       -       -       -       -  
Other income (loss)
    38       9       (6 )     6       3  
Other expenses
    59       51       48       46       42  
Assessments
    98       86       98       93       81  
 
                             
Net income
  $ 268     $ 236     $ 269     $ 253     $ 220  
 
                             
 
                                       
Dividend payout ratio (2)
    68 %     83 %     88 %     81 %     82 %
 
                                       
Weighted average dividend rate (3)
    4.63 %     5.31 %     6.59 %     5.81 %     5.00 %
Return on average equity
    6.38       5.73       6.87       6.70       5.79  
Return on average assets
    0.32       0.25       0.32       0.32       0.28  
Net interest margin (4)
    0.46       0.39       0.50       0.49       0.43  
Average equity to average assets
    4.96       4.37       4.63       4.76       4.78  
Regulatory capital ratio (5)
    5.81       4.48       4.44       4.98       5.36  
Operating expense to average assets
    0.057       0.041       0.046       0.046       0.042  
  (1)   Investments include interest bearing deposits in banks, securities purchased under agreements to resell, Federal funds sold, trading securities, available-for-sale securities, and held-to-maturity securities.
 
  (2)   Dividend payout ratio is dividends declared in the period as a percentage of net income.
 
  (3)   Weighted average dividend rates are dividends paid in stock and cash divided by the average number of shares of capital stock eligible for dividends.
 
  (4)   Net interest margin is net interest income as a percentage of average earning assets.
 
  (5)   Regulatory capital ratio is period end regulatory capital (capital stock, mandatorily redeemable capital stock and retained earnings) as a percentage of period end total assets.

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Item 7.   Management’s Discussion and Analysis of Financial Condition and Results of Operations.
EXECUTIVE OVERVIEW
Financial Condition
Mission Asset Activity
The following table summarizes our financial condition.
                                 
    Year Ended December 31,  
    Ending Balances     Average Balances  
(Dollars in millions)   2009     2008     2009     2008  
 
                               
Advances (principal)
  $ 35,123     $ 52,799     $ 43,624     $ 59,973  
 
                               
Mortgage Purchase Program:
                               
 
                               
Mortgage loans held for
portfolio (principal)
    9,280       8,590       9,498       8,621  
 
                               
Mandatory Delivery
Contracts (notional)
    79       917       566       182  
         
 
                               
Total Mortgage Purchase
Program
    9,359       9,507       10,064       8,803  
 
                               
Letters of Credit (notional)
    4,415       7,917       5,917       7,894  
         
 
                               
Total Mission Asset Activity
  $ 48,897     $ 70,223     $ 59,605     $ 76,670  
         
 
                               
Retained earnings
  $ 412     $ 326     $ 405     $ 335  
 
                               
Capital-to-assets ratio
    4.86%       4.36%       4.96%       4.37%  
 
                               
Regulatory capital-to-assets ratio (1)
    5.81         4.48         5.22         4.51     
                 (1) See the “Capital Resources” section for further description of regulatory capital.
The trends in our financial condition that began in the fourth quarter of 2008 continued in 2009. Like many financial institutions, our asset balances—especially Advances—have been negatively affected by the economic recession and the residual effects of the financial crisis. The Advance business is cyclical and we normally experience slower growth, if not a decrease in balances, in an economic contraction. The effect of the recession on our financial condition has been exacerbated by the extraordinary liquidity programs and financial guarantees that the federal government continues to provide. We also lost Advances due to mergers, in 2009 and prior years, of former members with financial institutions chartered outside our Fifth District.
Ending and average balances of Mission Asset Activity—comprised of Advances, Letters of Credit, and the Mortgage Purchase Program—decreased in each quarter of 2009. Mission Asset Activity ended the year at $48,897 million, which was a decrease of $21,326 million (30 percent) from year-end 2008. The end-of-year principal balance of Advances fell $17,676 million (33 percent) and the notional principal of Letters of Credit fell $3,502 million (44 percent). Similar decreases were experienced for average balances.
The decrease in Advance balances began during the fourth quarter of 2008, after they had reached a record high in October 2008 as members’ demand for wholesale liquidity increased during the beginnings of the financial crisis before the federal government implemented its liquidity and guarantee programs. The FHLBank System was an early responder in providing additional needed liquidity to its members during this early stage of the financial crisis. The decrease occurred broadly throughout our membership but was disproportionately accounted for by the ten largest members, both

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on an absolute and percentage basis. Members having assets below $1 billion reduced their Advances less than ten percent in 2009.
There were three reasons for the decrease in Advance balances from the high point in October 2008.
  §   The economic recession lowered demand for members’ consumer, mortgage, and commercial loans. Their loans decreased ten percent from the third quarter of 2008 to the end of 2009 (excluding our two largest members, which had acquisitions that would skew results).
  §   There was a substantial increase in many members’ deposit base. Members’ deposit base expanded four percent from the third quarter of 2008 to the end of 2009 (again, excluding the two largest members).
  §   The government significantly expanded funding and liquidity stimulus programs made available to members. These activities were implemented to combat the financial crisis and recession and were led by the Federal Reserve System. The most important aspects related to Advance demand were 1) new sources of government-provided liquidity through the Troubled Asset Relief Program (TARP), 2) various forms of additional government guarantees of liabilities of financial institutions, and 3) a dramatic increase in bank reserves created by the Federal Reserve’s expansion of its balance sheet, in particular its quantitative easing programs including massive direct purchases of mortgage-backed securities.
The decrease in the available lines in the Letters of Credit program occurred from the actions of a few large members consistent with their lower need for liquidity and financial guarantees from the FHLBank. This program is more concentrated than Advances.
The Mortgage Purchase Program’s principal balance totaled $9,280 million at the end of 2009, an increase of $690 million (eight percent) from the end of 2008. The Program expanded substantially in the fourth quarter of 2008 and the first quarter of 2009, due to increased overall financing activity in the mortgage markets in response to the generally lower mortgage rates. The $917 million of mandatory delivery contracts at the end of 2008 became principal balances in 2009 and contributed to the $3,627 million of principal purchases in 2009. Mortgage rates were on average modestly higher in the last three quarters of 2009, which led to lower volumes after the first quarter. The Program currently has strong member participation and interest. This was evidenced in 2009 by 26 approvals of new sellers to the Program, by a similar number of additional applications currently being processed for approval, and by an over 50 percent increase in regular sellers.
Despite the lower overall Mission Asset Activity, we continued to fulfill our business role as an important provider of reliable and attractively priced wholesale funding to our members. At the end of 2009, members funded on average approximately five percent of their assets with Advances, the penetration rate was relatively stable with almost 80 percent of members holding Mission Asset Activity, and, as noted above, the number of active sellers and participants in the Mortgage Purchase Program increased substantially.
During 2009, we accrued $31 million for future use in the Affordable Housing Program. Since the Program was established 20 years ago, we have set-aside from earnings $332 million of funds for affordable housing initiatives. Since 2003, we also have voluntarily disbursed over $16 million to support affordable housing. The voluntary contributions are over and above the regulatory Affordable Housing Program requirements.
Capital
Capital adequacy continued to be strong and exceeded all minimum regulatory and internal capital requirements. GAAP capital stood at $3.5 billion at the end of 2009, including $412 million of retained earnings. The GAAP capital-to-assets ratio ended the year at 4.86 percent. The year-end regulatory capital-to-assets ratio was 5.81 percent, well above the required minimum of 4.00 percent. Regulatory capital includes mandatorily redeemable capital stock accounted for as a liability, which provides the same protections as GAAP capital against losses to holders of our Consolidated Obligations. Financial leverage, as represented by these capital ratios, decreased in 2009, due primarily to the reduction in Advance balances.

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Total capital decreased $815 million, or 19 percent, during 2009 due to the reclassification of a substantial amount of capital stock to mandatorily redeemable stock in response to excess stock redemption requests and the membership terminations of a few large members purchased by out-of-district financial institutions.
The difference between earnings generated and dividends paid to stockholders resulted in the change to retained earnings, which grew $86 million, or 26 percent, during all of 2009. The business and market environments allowed us to generate earnings sufficient to pay stockholders a very favorable dividend return in each quarter of 2009 and to increase retained earnings, thereby enhancing protection of future dividends against earnings volatility and members’ capital stock against impairment risk.
Other Assets
The balance of investments at the end of 2009 was $24,193 million, a decrease of $11,132 million (32 percent) from year-end 2008. Total investments included $11,437 million of mortgage-backed securities and $12,746 million of short-term money market instruments. The latter are generally held for liquidity purposes to support members’ funding needs and to protect against the potential inability to access capital markets for debt issuance. We generally decreased short-term money market investment balances after the first quarter of 2009 in response to the decreased Advance demand and the improvement in market and credit conditions.
Results of Operations
The table below summarizes our results for operations.
                         
    Year Ended December 31,
(Dollars in millions)   2009   2008   2007
 
Net income
  $ 268     $ 236     $ 269  
 
Affordable Housing Program accrual
    31       27       31  
 
Return on average equity (ROE)
    6.38 %     5.73 %     6.87 %
 
Return on average assets
    0.32       0.25       0.32  
 
Weighted average dividend rate
    4.63       5.31       6.59  
 
Average 3-month LIBOR
    0.69       2.92       5.29  
 
Average overnight Federal Funds effective rate
    0.16       1.92       5.02  
 
ROE spread to 3-month LIBOR
    5.69       2.81       1.58  
 
Dividend rate spread to 3-month LIBOR
    3.94       2.39       1.30  
 
ROE spread to Federal Funds effective rate
    6.22       3.81       1.85  
 
Dividend rate spread to Federal Funds effective rate
    4.47       3.39       1.57  
Net income was $268 million in 2009, up 13 percent from $236 million in 2008, and return on average equity (ROE) was 6.38 percent compared to 5.73 percent in 2008. Earnings continued to represent a competitive level of profitability on stockholders’ capital investment in our company. The ROE spreads to 3-month LIBOR and the Federal funds effective rate are two market benchmarks we believe stockholders use to assess the competitiveness of the return on their capital investment, which, along with access to our products and services, is a key source of membership value. These spreads were significantly above those benchmarks in both 2009 and 2008.
The increase in net income for the full year resulted primarily from the following factors:
  §   Beginning in late 2008 and continuing in 2009, in response to the decline in intermediate- and long-term interest rates, we retired before their final maturities approximately $17 billion of relatively high-cost long-term Consolidated Obligation Bonds and replaced them with new Obligations, much of which was at substantially lower interest costs.

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  §   Until midyear, we earned wider portfolio spreads on many short-term and adjustable-rate assets indexed to LIBOR relative to short-term funding costs.
  §   Prepayment speeds of relatively high yielding mortgages did not accelerate sharply despite the lower overall mortgage rates, due to the ongoing difficulties in the housing and mortgage markets.
  §   Market yield curves were significantly steeper because short-term interest rates fell to historical lows of close to zero while longer-term rates fell less. This benefited earnings due to use of a modest amount of short-term debt to fund long-term assets.
The wider portfolio spreads earned during the first half of 2009 resulted from the financial market disruptions that began in 2008, which increased the cost of inter-bank lending (represented by LIBOR) relative to other short-term interest costs such as our Discount Notes. We use Discount Notes to fund a large amount of our LIBOR-indexed Advances. In the second half of 2009, as market participants viewed that the financial crisis had subsided, short-term LIBOR decreased and the spread between LIBOR and Discount Notes reverted back to approximately its long-term historical level.
Earnings in 2009 also benefited from the following: increases in net market value gains (primarily unrealized) of almost $16 million in accounting for derivatives; the sale of mortgage-backed securities in the first and fourth quarters, resulting in gains of $12 million; and increases in Advance prepayment fees of $6 million.
Partially offsetting these favorable earnings factors was a significant decrease in earnings generated from funding assets with interest-free capital due to reductions in average interest rates. The benchmark 3-month LIBOR rate, for example, averaged 0.69 percent during 2009, compared to 2.92 percent in 2008. Another offset was the reduction in assets, especially Advances.
Our Board of Directors authorized payment of quarterly cash dividends to stockholders at an annual average rate of 4.63 percent. This was 3.94 percentage points above 2009’s average 3-month LIBOR. The dividend rate was an annualized 4.50 percent in the first, second, and fourth quarters, and 5.00 percent in the third quarter.
Business Outlook
This section outlines what we believe are our major current risk exposures. Item 1A’s “Risk Factors” has a more detailed discussion of risk factors that could affect our corporate objectives, financial condition, and results of operations. “Quantitative and Qualitative Disclosures About Risk Management” provides details on current risk exposures. Many of the issues related to our financial condition, results of operations, and liquidity discussed throughout this document relate directly to the recent financial crisis and economic recession, and to the federal government’s actions to attempt to mitigate their unfavorable effects.
Strategic/Business Risk
We expect overall Advance demand will remain weak until the Federal Reserve tightens monetary policy, an economic recovery brings an expansion of members’ loan demand, and the government’s funding and liquidity programs and purchases of mortgage-backed securities are wound down.
We expect the Mortgage Purchase Program to grow slowly, if at all, for the foreseeable future because most current sellers and recent new approvals are smaller community-based members. Growth could re-accelerate if mortgage rates fall substantially again for a sustained period, or if one or more larger members decides to sell us a significant volume of loans. We do not currently anticipate the latter event to occur. We continue to emphasize both recruiting community financial institution members to the Program and increasing the number of regular sellers.
Issues with our two Supplemental Mortgage Insurance providers could harm the sustainability of the Mortgage Purchase Program. Due to the deterioration in the mortgage markets over the last two years, the providers currently have ratings below the double-A rating required by a Finance Agency Regulation, which results in a technical violation of this Regulation. In August 2009, the Finance Agency, with certain stipulations, granted a one-year waiver of the double-A rating requirement for existing loans and commitments and a six-month initial waiver for new commitments, which was extended in early 2010. In addition, the insurer we use for new business has continually increased the cost of purchasing the insurance, which threatens to make the Program uncompetitive. We have submitted a proposal to the Finance Agency that, if approved, would replace the current reliance on the credit enhancement provided by these mortgage insurers with

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increased use of the primary already-existing credit enhancement feature (the Lender Risk Account). We believe this change in credit enhancement structure would maintain compliance with the Program’s legal, accounting, and other regulatory requirements, preserve the Program’s minimal credit risk profile, and enable the Program to continue as a beneficial business activity for our members. We cannot provide at this time any assurance as to whether or when the Finance Agency will approve the proposal.
We continue to closely monitor several scenarios that could result in further reductions in Mission Asset Activity and lower profitability. The effects from the recession and the financial crisis could result in a longer and more severe reduction in Mission Asset Activity, which could reduce profitability. The scenarios that could unfavorably affect Mission Asset Activity include:
  §   a new economic recession, which could further reduce Advance demand;
  §   a renewal of the financial crisis;
  §   unfavorable effects on the competitiveness of our business model from the continuation of current or from new federal government actions to mitigate the recession and financial crisis; and
  §   issues with earnings pressures and capital adequacy at other FHLBanks, primarily resulting from market value losses and expected credit losses on their private-label mortgage-backed securities.
However, we believe that, even if Mission Asset Activity experiences further significant reductions, profitability would remain competitive.
We cannot determine the ultimate impact on our business operations from the issues with earnings and capital at some other FHLBanks. Potential effects could include 1) requiring us to provide financial assistance to one or more other FHLBanks, 2) higher and more volatile debt costs, 3) more difficulty in issuing debt, especially less reliance on FHLBank System issued longer-term debt, and 4) decreases in Mission Asset Activity and profitability.
Regulatory and Legislative Risk
The FHLBank System currently faces heightened legislative and regulatory risks and uncertainties, which we believe has affected, and could continue to affect, Mission Asset Activity and capitalization. These risks are discussed in Item 1A’s “Risk Factors.”
Funding and Liquidity Risk
We believe that in 2009 our liquidity position remained strong and our overall ability to fund operations through debt issuance at acceptable interest costs remained sufficient. Although we can make no assurances, we expect this to continue to be the case, and we believe the possibility of a liquidity or funding crisis in the FHLBank System that would impair our FHLBank’s ability to participate in issuances of new debt, service outstanding debt or pay competitive dividends is remote. The financial crisis significantly elevated our long-term funding costs, compared to U.S. Treasury securities and LIBOR, in the early part of 2009 as in most of 2008. As 2009 progressed, long-term funding costs began to return to more normal spreads relative to other market rates. In 2009, average money market balances were maintained at higher than historical levels because the financial crisis and economic uncertainty prompted us to hold more asset liquidity. Because the financial crisis appeared to subside as 2009 progressed, we determined in the second half of 2009 that it was acceptable from a risk perspective to partially reduce the amount of asset liquidity held from funding short-term (mostly overnight) investments with longer-term Consolidated Obligation Discount Notes. Holding excess liquidity can be at a cost to earnings.
Market Risk and Profitability
Residual exposure to market risk continued to be moderate and at levels consistent with historical averages. The current level of market risk exposure should ensure that profitability will be competitive across a wide range of stressed interest rate and business environments. However, even under the current market conditions, we expect profitability will decrease in 2010 and beyond compared to the levels of 2009. The level of profitability in 2009 was inconsistent with the sustained fundamental earnings generated by our business model.

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The FHLBank has historically emphasized strategies aimed at providing a competitive earnings stream over a multitude of market and business environments and a relative lack of earnings volatility. These strategies include, among others: 1) conservative management of market risk exposure, 2) controlled growth in mortgage assets, 3) holding a nominal amount of riskier types of mortgage-backed securities, 4) accounting and hedging practices that attempt to minimize earnings volatility from use of derivatives, and 5) limiting growth in operating expenses.
The following are major factors that we are experiencing, or could experience in the near-to intermediate-term future, which could decrease profitability:
  §   continuation of extremely low short-term interest rates, especially if coupled with reductions in mortgage rates and accelerated mortgage prepayment speeds;
  §   the potential for significantly higher interest rates, especially if coupled with a flatter yield curve;
  §   replacing expected paydowns of mortgages earning wide net spreads with new mortgages at lower net spreads; and/or
  §   continued reductions in Advance balances.
Credit Risk
The FHLBank expects to continue to have limited credit risk exposure from offering Advances, purchasing mortgage loans, making investments, and executing derivative transactions. We have robust policies, strategies and processes designed to identify, manage and mitigate credit risk. Advances are overcollateralized and we have a perfected first lien position on all pledged loan collateral, as well as very conservative policies and procedures related to managing Advances’ credit risk. As a result, we do not expect any losses from Advances or Letters of Credit. The Mortgage Purchase Program is comprised only of conforming fixed-rate conventional loans and loans fully insured by the Federal Housing Administration. Multiple layers of credit enhancements on the Program’s loans protect the FHLBank against credit losses down to approximately a 50 percent loan-to-value level (based on value at origination). Actual program delinquencies on conventional loans are well below national averages on similar loans and any losses have been well below the amount of credit enhancements, except for a de minimis loss expected in 2010.
On December 31, 2009, 98 percent, or $11.3 billion, of our mortgage-backed securities’ principal balances were issued and guaranteed by Fannie Mae or Freddie Mac, which we believe have the backing of the United States government. Only $187 million of the holdings were private-label mortgage-backed securities; these securities are comprised of high-quality residential mortgage loans issued and purchased in 2003 and continue to be rated triple-A. The underlying collateral has a de minimis level of delinquencies and foreclosures as reflected in the average serious delinquency rate (loans at least 60 days past due including foreclosures) of 0.54 percent of total principal, while their average credit enhancement stood at 7.6 percent.
Although most of our money market investments are unsecured, we invest in the debt securities of highly rated, investment-grade institutions, have conservative limits on dollar and maturity exposure to each institution, and have strong credit underwriting practices. Finally, we collateralize most of the credit risk exposure resulting from interest rate swap transactions; only the uncollateralized portion of our derivative asset position (which was $9 million at the end of 2009) represents unsecured exposure. We continue to expect no credit losses on this source of unsecured credit exposure.
Overall, we have never experienced a credit-related loss on, nor have we ever established a loss reserve for, any asset other than as noted above. In addition, we have not taken an impairment charge on any investment. Based on our analysis of exposures and application of GAAP we continue to believe no loss reserves are required for Advances or mortgage assets, nor do we consider any investments to be other-than-temporarily impaired. We expect that this will continue to be the case.

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CONDITIONS IN THE ECONOMY AND FINANCIAL MARKETS
Economy
The primary external factors that affect our Mission Asset Activity and earnings are the general state and trends of the economy and financial institutions, especially in the states of our District; conditions in the financial, credit, and mortgage markets; and interest rates. The economy entered a sharp recession in the fourth quarter of 2007, which continued through 2008 and into 2009. As measured by real Gross Domestic Product (GDP), the national economy grew slightly by 0.4 percent overall in 2008 but contracted 5.4 percent in the fourth quarter of 2008, contracted 6.4 percent in the first quarter of 2009, and contracted 0.7 percent in the second quarter, before expanding 2.2 percent in the third quarter and by an estimated 5.9 percent in the fourth quarter (all rates are annualized).
Although there are indications—including the recent GDP growth, reduction in credit spreads, unfreezing of some credit markets and some positive signs in housing markets—that the recession has ended and the financial crisis subsided, it is premature to know if the positive indications will be sustained. Contraindications against a robust pickup in economic activity are that lending by financial institutions appears not to have accelerated, bank reserves continue to be at very high levels, unemployment appears to still be increasing or at least not falling (although unemployment is generally a lagging indicator of economic growth), financial institutions continue to have credit difficulties, interest rates remain low, and most stock market indices remain well below their historical highs.
The residual effects of the financial crisis and recession may continue for some time. These effects may include diminished lending activity, credit risk difficulties, strong deposit growth, and the existence of substantial liquidity and funding alternatives from the federal government. To the extent these effects continue to be realized, we expect a continuation of subdued demand for our Advances.

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Interest Rates
Trends in market interest rates affect members’ demand for Mission Asset Activity, earnings, spreads on assets, funding costs and decisions in managing the tradeoffs in our market risk/return profile. The following table presents key market interest rates (obtained from Bloomberg L.P.).
                                         
    Year 2009   Year 2008   Year 2007
    Average   Ending   Average   Ending   Ending
 
                                       
Federal Funds Target
    0.25 %     0.25 %     2.09 %     0.25 %     4.25 %
Federal Funds Effective
    0.16       0.05       1.92       0.14       3.06  
 
                                       
3-month LIBOR
    0.69       0.25       2.92       1.43       4.70  
2-year LIBOR
    1.41       1.42       2.95       1.48       3.81  
5-year LIBOR
    2.66       2.99       3.70       2.13       4.18  
10-year LIBOR
    3.44       3.97       4.25       2.56       4.67  
 
                                       
2-year U.S. Treasury
    0.94       1.14       2.00       0.77       3.05  
5-year U.S. Treasury
    2.19       2.68       2.79       1.55       3.44  
10-year U.S. Treasury
    3.24       3.84       3.64       2.21       4.03  
 
                                       
15-year mortgage current coupon (1)
    3.73       3.78       4.97       3.64       4.95  
30-year mortgage current coupon (1)
    4.31       4.57       5.47       3.93       5.54  
 
                                       
15-year mortgage note rate (2)
    4.58       4.54       5.63       4.91       5.79  
30-year mortgage note rate (2)
    5.04       5.14       6.05       5.14       6.17  
                                 
    Year 2009 by Quarter - Average
    Quarter 1   Quarter 2   Quarter 3   Quarter 4
     
 
                               
Federal Funds Target
    0.25 %     0.25 %     0.25 %     0.25 %
Federal Funds Effective
    0.18       0.18       0.15       0.12  
 
                               
3-month LIBOR
    1.24       0.85       0.41       0.27  
2-year LIBOR
    1.54       1.50       1.40       1.21  
5-year LIBOR
    2.38       2.74       2.86       2.64  
10-year LIBOR
    2.94       3.50       3.72       3.59  
 
                               
2-year U.S. Treasury
    0.89       1.01       1.01       0.86  
5-year U.S. Treasury
    1.75       2.23       2.45       2.29  
10-year U.S. Treasury
    2.71       3.31       3.50       3.45  
 
                               
15-year mortgage current coupon (1)
    3.75       3.84       3.82       3.52  
30-year mortgage current coupon (1)
    4.13       4.31       4.50       4.28  
 
                               
15-year mortgage note rate (2)
    4.72       4.63       4.61       4.38  
30-year mortgage note rate (2)
    5.06       5.01       5.16       4.92  
(1)   Simple average of current coupon rates of Fannie Mae and Freddie Mac mortgage-backed securities.
 
(2)   Simple weekly average of 125 national lenders’ mortgage rates surveyed and published by Freddie Mac.
After decreasing sharply in 2008, the overnight Federal funds target and effective rates were relatively stable in 2009. The Federal Reserve maintained the overnight Federal funds target rate at a range of zero to 0.25 percent, which it had established by the end of 2008. Short-term LIBOR decreased at a slower pace. By the third quarter of 2009, short-term LIBOR had decreased to a level consistent with its historical relationship to Federal funds.
In the first three quarters of 2009, average longer-term LIBOR and U.S. Treasury rates tended to rise, with stability in the fourth quarter. However, spreads of our Consolidated Obligation Bonds to these indices narrowed, with the result being relatively stable and even lower Bond rates. The combination of falling short-term rates and more stable longer-term Bond rates resulted in a steeper funding yield curve, which improved earnings. In addition, earnings benefited from the reduction in Bond spreads relative to market indices. Likewise, mortgage note rates were more stable in 2009 than longer-term LIBOR and U.S. Treasuries. This, along with falling home prices, the recession, and difficult mortgage refinancing conditions, resulted in relatively moderate increases in mortgage prepayments.

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ANALYSIS OF FINANCIAL CONDITION
Asset Composition Data
Mission Asset Activity includes the following components:
  §   the principal balance of Advances;
  §   the notional principal amount of available lines in the Letters of Credit program;
  §   the principal balance in the Mortgage Purchase Program (Mortgage Loans Held for Portfolio); and
  §   the notional principal amount of Mandatory Delivery Contracts.
The following two tables show the composition of total assets, which support the discussions in the “Analysis of Financial Condition” and the “Executive Overview.”
Asset Composition - Ending Balances (Dollars in millions)
                                                                                                 
    2009   2008   2007
            % of   Change From           % of   Change From           % of   Change From
            Total   Prior Year           Total   Prior Year           Total   Prior Year
    Balance     Assets   Amount   Pct   Balance     Assets   Amount   Pct   Balance     Assets   Amount     Pct
             
Advances
                                                                                               
Principal
  $ 35,123       49 %   $ (17,676 )     (33 )%   $ 52,799       54 %   $ (154 )     -%   $ 52,953       61 %   $ 11,011       26 %
Other items (1)
    695       1       (422 )     (38 )     1,117       1       760       213       357       -       343       2,450  
                                           
 
                                                                                               
Total book value
    35,818       50       (18,098 )     (34 )     53,916       55       606       1       53,310       61       11,354       27  
Mortgage Loans Held for Portfolio
Principal
    9,280       13       690       8       8,590       9       (272 )     (3 )     8,862       10       483       6  
Other items
    86       -       44       105       42       -       (24 )     (36 )     66       -       (16 )     (20 )
                                           
 
                                                                                               
Total book value
    9,366       13       734       9       8,632       9       (296 )     (3 )     8,928       10       467       6  
 
                                                                                               
Investments
                                                                                               
 
                                                                                               
Mortgage-backed securities
                                                                                               
Principal
    11,448       16       (1,449 )     (11 )     12,897       13       740       6       12,157       14       93       1  
Other items
    (11 )     -       17       61       (28 )     -       (5 )     (22 )     (23 )     -       (14 )     (156 )
                                           
 
                                                                                               
Total book value
    11,437       16       (1,432 )     (11 )     12,869       13       735       6       12,134       14       79       1  
 
                                                                                               
Short-term money market
    12,746       18       (9,698 )     (43 )     22,444       23       9,917       79       12,527       15       (6,009 )     (32 )
 
 
Other long-term investments
    10       -       (2 )     (17 )     12       -       (5 )     (29 )     17       -       (7 )     (29 )
                                           
 
                                                                                               
Total investments
    24,193       34       (11,132 )     (32 )     35,325       36       10,647       43       24,678       29       (5,937 )     (19 )
 
                                                                                               
Loans to other FHLBanks
    -       -       -       -       -       -       -       -       -       -       -       -  
                                     
 
                                                                                               
Total earning assets
    69,377       97       (28,496 )     (29 )     97,873       100       10,957       13       86,916       100       5,884       7  
 
                                                                                               
Other assets
    2,010       3       1,677       504       333       -       (86 )     (21 )     419       -       70       20  
                                           
 
Total assets
  $ 71,387       100 %   $ (26,819 )     (27 )   $ 98,206       100 %   $ 10,871       12     $ 87,335       100 %   $ 5,954       7  
                                           
 
                                                                                               
Other Business Activity (Notional)
 
                                                                                               
Letters of Credit
  $ 4,415             $ (3,502 )     (44 )   $ 7,917             $ 994       14     $ 6,923             $ 425       7  
 
                                                                                   
Mandatory Delivery
Contracts
  $ 79             $ (838 )     (91 )   $ 917             $ 869       1,810     $ 48             $ (59 )     (55 )
 
                                                                                   
 
                                                                                               
Total Mission Asset Activity
(Principal and Notional)
  $ 48,897       68 %   $ (21,326 )     (30 )   $ 70,223       72 %   $ 1,437       2     $ 68,786       79 %   $ 11,860       21  
                                           
          (1)     The majority of these balances are hedging related basis adjustments.

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Asset Composition - Average Balances (Dollars in millions)
                                                                                                 
    2009   2008   2007
            % of     Change From           % of     Change From           % of     Change From
            Total     Prior Year           Total     Prior Year           Total     Prior Year
    Balance     Assets     Amount     Pct   Balance     Assets     Amount     Pct   Balance     Assets     Amount     Pct
             
 
                                                                                               
Advances
                                                                                               
Principal
  $ 43,624       52 %   $ (16,349 )     (27 )%   $ 59,973       64 %   $ 10,671       22 %   $ 49,302       59 %   $ 3,528       8 %
Other items (1)
    880       1       354       67       526       -       466       777       60       -       33       122  
                                           
 
                                                                                               
Total book value
    44,504       53       (15,995 )     (26 )     60,499       64       11,137       23       49,362       59       3,561       8  
Mortgage Loans Held for Portfolio
Principal
    9,498       11       877       10       8,621       9       (121 )     (1 )     8,742       10       417       5  
Other items
    72       -       10       16       62       -       (13 )     (17 )     75       -       (13 )     (15 )
                                           
 
                                                                                               
Total book value
    9,570       11       887       10       8,683       9       (134 )     (2 )     8,817       10       404       5  
 
                                                                                               
Investments
                                                                                               
 
                                                                                               
Mortgage-backed securities
                                                                                               
Principal
    12,135       14       (488 )     (4 )     12,623       14       507       4       12,116       15       289       2  
Other items
    (17 )     -       13       43       (30 )     -       (14 )     (88 )     (16 )     -       (18 )     (900 )
                                           
 
                                                                                               
Total book value
    12,118       14       (475 )     (4 )     12,593       14       493       4       12,100       15       271       2  
 
                                                                                               
Short-term money market
    18,166       22       5,960       49       12,206       13       (1,381 )     (10 )     13,587       16       545       4  
 
                                                                                               
Other long-term investments
    11       -       (5 )     (31 )     16       -       (3 )     (16 )     19       -       (7 )     (27 )
                                           
 
                                                                                               
Total investments
    30,295       36       5,480       22       24,815       27       (891 )     (3 )     25,706       31       809       3  
 
                                                                                               
Loans to other FHLBanks
    19       -       1       6       18       -       11       157       7       -       (3 )     (30 )
                                           
 
                                                                                               
Total earning assets
    84,388       100       (9,627 )     (10 )     94,015       100       10,123       12       83,892       100       4,771       6  
 
                                                                                               
Other assets
    282       -       (60 )     (18 )     342       -       (59 )     (15 )     401       -       121       43  
                                           
 
                                                                                               
Total assets
  $ 84,670       100 %   $ (9,687 )     (10 )   $ 94,357       100 %   $ 10,064       12     $ 84,293       100 %   $ 4,892       6  
                                           
 
                                                                                               
Other Business Activity (Notional)
 
                                                                                               
Letters of Credit
  $ 5,917             $ (1,977 )     (25 )   $ 7,894             $ 2,343       42     $ 5,551             $ 3,666       194  
 
                                                                                   
Mandatory Delivery
Contracts
  $ 566             $ 384       211     $ 182             $ 94       107     $ 88             $ 12       16  
 
                                                                                   
 
                                                                                               
Total Mission Asset Activity
(Principal and Notional)
  $ 59,605       70 %   $ (17,065 )     (22 )   $ 76,670       81 %   $ 12,987       20     $ 63,683       76 %   $ 7,623       14  
                                         
     (1)     The majority of these balances are hedging related basis adjustments.
To measure the extent of our success in achieving growth in Mission Asset Activity, we consider changes in both period-end balances and period-average balances. There can be large differences in the results of these two computations. Average data can provide more meaningful information about the ongoing condition of and trends in Mission Asset Activity and earnings than period-end data because day-to-day volatility can impact the period-end data.
On December 31, 2009, total assets were $71,387 million, a decrease of $26,819 million (27 percent) from year-end 2008, led by reductions in balances of Advances and short-term money market instruments. The principal balance of Advances represented just under half (49 percent) of total assets, a decrease of five percentage points from year-end 2008. The Mortgage Portfolio Program increased from nine percent of total assets to 13 percent, due to growth in the Program’s principal balance and the decrease in total assets.
On an average-balance basis, total assets decreased $9,687 million (10 percent). Average total assets fell less than year-end assets because Advances declined throughout all of 2009 and the average balance of money market instruments increased $5,960, which offset some of the decline in Advances.

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Credit Services
Credit Activity and Advance Composition
The principal balance of Advances began to decline in the fourth quarter of 2008, after they had reached record highs in October 2008. Balances were lower in each quarter of 2009 over the previous quarter. The “Financial Condition” section of the “Executive Overview” discusses the reasons for the decrease in Advance balances.
Members’ available lines and usage of the Letters of Credit program also fell substantially and for the same reasons. Most of our Letters of Credit support members’ public unit deposits. We earn fees on the actual amount of the available lines members use, which can be substantially less than the lines outstanding.
The following tables present Advance balances by major program for the years ended December 31, 2009 and 2008 and for each quarter of 2009.
(Dollars in millions)
                                 
    2009   2008
    Balance     Percent(1)   Balance     Percent(1)
     
Short-Term and Adjustable-Rate
                               
REPO/Cash Management
  $ 1,605       5 %   $ 5,886       11 %
LIBOR
    14,077       40       24,225       46  
     
Total
    15,682       45       30,111       57  
 
                               
Long-Term
                               
Regular Fixed Rate
    7,466       21       9,722       18  
Convertible(2)
    2,816       8       3,479       7  
Putable(2)
    7,037       20       6,981       13  
Mortgage Related
    1,748       5       1,815       4  
     
Total
    19,067       54       21,997       42  
 
                               
Other Advances
    374       1       691       1  
     
 
                               
Total Advances Principal
    35,123       100 %     52,799       100 %
 
                           
 
                               
Other Items
    695               1,117          
 
                           
 
                               
Total Advances Book Value
  $ 35,818             $ 53,916          
 
                           
                                                                 
    December 31, 2009   September 30, 2009   June 30, 2009   March 31, 2009
(Dollars in millions)   Balance     Pct(1)   Balance     Pct(1)   Balance     Pct(1)   Balance     Pct(1)
     
 
                                                               
Short-Term and Adjustable-Rate
REPO/Cash Management
  $ 1,605       5 %   $ 1,770       5 %   $ 3,616       8 %   $ 3,257       7 %
LIBOR
    14,077       40       15,354       41       18,142       41       20,612       45  
     
Total
    15,682       45       17,124       46       21,758       49       23,869       52  
 
                                                               
Long-Term
                                                               
Regular Fixed Rate
    7,466       21       7,830       21       9,983       23       9,818       21  
Convertible(2)
    2,816       8       3,231       9       3,253       7       3,335       7  
Putable(2)
    7,037       20       7,046       19       7,049       16       7,054       15  
Mortgage Related
    1,748       5       1,740       4       1,736       4       1,728       4  
     
Total
    19,067       54       19,847       53       22,021       50       21,935       47  
 
                                                               
Other Advances
    374       1       283       1       313       1       307       1  
     
 
                                                               
Total Advances Principal
    35,123       100 %     37,254       100 %     44,092       100 %     46,111       100 %
 
                                                       
 
                                                               
Other Items
    695               828               773               1,001          
 
                                                       
 
                                                               
Total Advances Book Value
  $ 35,818             $ 38,082             $ 44,865             $ 47,112          
 
                                                       
(1)   As a percentage of total Advances principal.
 
(2)   Related interest rate swaps executed to hedge these Advances convert them to an adjustable-rate tied to LIBOR.
Most of the year-over-year and quarterly reduction in balances occurred in the REPO, LIBOR, and Regular Fixed Rate Advance programs. REPO and LIBOR programs normally have the most fluctuation in balances because larger members tend to use them disproportionately more than smaller members do, they tend to have shorter-term maturities than other

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programs, and in the case of LIBOR Advances, borrowers can prepay them without a fee on repricing dates subject to pre-established prepayment “lock out” periods. Other Advance programs experienced smaller changes, with the only increase being in Putable Advances.
Short-term and adjustable-rate Advances decreased to 45 percent of total Advances, while long-term Advances increased to 54 percent. The shift in composition reflected the larger decreases in short-term and adjustable-rate Advances, not a noticeable change in the preference of members for long-term Advances.
Advance Usage
The following tables present the principal balances and related weighted average interest rates for our top five Advance borrowers. The decrease in total weighted average interest rates from the end of 2008 to the end of 2009 was due to the reductions in short-term interest rates during 2009.
     (Dollars in millions)

                 
December 31, 2009
    Ending     Weighted Average
Name   Balance     Interest Rate
 
U.S. Bank, N.A.
  $     9,315       1.64 %
PNC Bank, N.A. (1)
    4,282       0.70  
Fifth Third Bank
    2,538       1.96  
New York Community Bank (2)
    1,635       3.76  
RBS Citizens, N.A.
    1,269       0.24  
 
             
 
               
Total of Top 5
  $        19,039       1.56  
 
             
 
               
Total Advances (Principal)
  $ 35,123       2.27  
 
             
 
               
Top 5 Percent of Total
    54 %        
 
             
                 
December 31, 2008
    Ending     Weighted Average
Name   Balance     Interest Rate
 
U.S. Bank, N.A.
  $       14,856       3.02 %
PNC Bank, N.A. (1)
    6,435       2.83  
Fifth Third Bank
    5,639       3.18  
The Huntington National Bank
    2,590       1.22  
AmTrust Bank
    2,338       3.75  
 
             
 
               
Total of Top 5
  $ 31,858       2.92  
 
             
 
               
Total Advances (Principal)
  $ 52,799       3.00  
 
             
 
               
Top 5 Percent of Total
    60 %        
 
             


(1)   Formerly National City Bank.
 
(2)   Assumed Advances of AmTrust Bank during 2009.
Three of our top five Advance borrowers are now nonmembers. PNC Bank, N.A., New York Community Bank, and RBS Citizens, N.A. are chartered outside the Fifth District. PNC Bank, N.A. and RBS Citizens, N.A. hold Advances because they purchased financial institutions that previously had been chartered in our District. New York Community Bank assumed the Advances of AmTrust Bank after its assets were seized by the FDIC. All Advance balances held by nonmembers will eventually mature or be prepaid. Nonmembers are not eligible to increase their Advance holdings with us.
As indicated in the table above, Advances are concentrated among a small number of members. Concentration ratios to the top five borrowers have fluctuated in the range of 50 to 65 percent in the last several years. We believe that having large members who actively use our Mission Asset Activity augments the value of membership to all members because it enables us to improve operating efficiency, increase financial leverage, possibly enhance dividend returns, obtain more favorable funding costs, and provide competitively priced Mission Asset Activity.
Although Advance usage fell broadly across the membership, usage decreased disproportionately among our largest borrowers. The top five borrowers accounted for 73 percent of the total decrease in balances, but they represented a smaller proportion (54 percent) of total Advances. In addition, as shown in the following table, the unweighted average ratio of each member’s Advance balance to its most-recently available total assets decreased more for larger members

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than smaller members. Despite the decreases in these ratios, we believe that their levels and the fact that the number of borrowing members in recent years has been maintained at a high percentage of total membership (in the range of 70 to 85 percent) continue to demonstrate that members view Advances as important sources of funding and liquidity.
                 
    December 31, 2009   December 31, 2008
Average Advances-to-Assets for Members
               
 
               
Assets less than $1.0 billion (678 members)
    5.05 %     6.11 %
 
               
Assets over $1.0 billion (57 members)
    4.06 %     5.47 %
 
               
All members
    4.97 %     6.06 %
The number of Advances outstanding at the end of 2009 was 15,950. The average-sized Advance was $2.2 million. We have always placed emphasis on serving all of our members by not having a minimum size constraint for most Advance programs.
Mortgage Purchase Program (Mortgage Loans Held for Portfolio)
The growth in the principal balance of the Mortgage Purchase Program in 2009 came after several years in which the Program’s balance was relatively stable. Significantly lower mortgage interest rates in the fourth quarter of 2008 and the first quarter of 2009 increased refinancing activity, which resulted in Program balances increasing. In addition, because of falling home prices, the recession, and difficult mortgage refinancing conditions, mortgage prepayments did not accelerate as much as would normally have been the case given the lower mortgage rates. The Program’s growth helped offset a portion of the earnings lost from the lower balances in the Advance portfolio. Growth slowed after the first quarter principally because mortgage rates stabilized within a narrow range and the difficulties in the housing and mortgage markets continued, both of which reduced refinancing activity.
Our focus continues to be on recruiting community-based members to participate in the Program and on increasing the number of regular sellers. In 2009, we approved 26 new participants in the Program and the number of regular sellers doubled. A substantial number of members either are actively interested in joining the Program or are in the process of joining. Members transacted 4,639 separate commitments to sell us loans in 2009, over 50 percent more than the amount in any prior year.
The following table shows the percentage of principal balances from PFIs supplying five percent or more of total principal.
                                 
    December 31, 2009   December 31, 2008
(Dollars in millions)   Unpaid Principal   % of Total   Unpaid Principal   % of Total
 
PNC Bank, N.A. (1)
    $        3,608       39 %     $        4,709       55 %
Union Savings Bank
    2,726       29       1,995       23  
Guardian Savings Bank FSB
    751       8       544       6  
 
                               
Liberty Savings Bank
    488       5                  
 
                               
 
                               
Total
    $        7,573       81 %     $        7,248       84 %
 
                               
              (1) Formerly National City Bank.
The decrease in the percentage of loans outstanding from PNC Bank, N.A. reflected its lack of new activity with us since mid-2007, while the increases from Union Savings Bank and Guardian Saving Bank FSB reflected refinancing activity in their portfolios that resulted in new loans sold to us.

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The following table reconciles changes in the Program’s principal balances (excluding Mandatory Delivery Contracts) for 2009 and 2008.
                 
(In millions)   2009     2008  
 
               
Balance, beginning of year
  $ 8,590     $ 8,862  
Principal purchases
    3,627       1,027  
Principal paydowns
    (2,937 )     (1,299 )
 
           
 
               
Balance, end of year
  $ 9,280     $ 8,590  
 
           
We closely track the refinancing incentives of all of our mortgage assets because the option for homeowners to change their principal payments represents almost all of our market risk exposure. The principal paydowns equated to a 23 percent annual constant prepayment rate in 2009, compared to 12 percent in 2008. The acceleration in prepayment rates reflected the significant decline in mortgage rates in the last quarter of 2008 and early 2009 and the overall low mortgage rate environment throughout 2009. However, as noted above, the refinancing response was more muted than normally would be expected given the amount of the reductions in mortgage rates.
The following table presents the composition of the Program’s principal balances by loan type, mortgage note rate, and loan age.
                                                 
December 31, 2009 (Dollars in millions)  
    Conventional     FHA (Gov’t        
    30 Year   20 Year   15 Year   Total     Guaranteed)     Total  
       
 
                                               
Total Unpaid Principal
  $ 6,180     $ 245     $ 1,320     $ 7,745     $ 1,535     $ 9,280  
 
                                               
Percent of Total
    66%       3%       14%       83%       17%       100%  
 
                                               
Weighted Average Mortgage Note Rate
    5.62%       5.38%       4.97%       5.50%       5.76%       5.54%  
 
                                               
Weighted Average Loan Age (in months)
    37       46       44       38       52       41  
 
                                               
December 31, 2008 (Dollars in millions)  
    Conventional     FHA (Gov’t        
    30 Year   20 Year   15 Year   Total     Guaranteed)     Total  
       
 
                                               
Total Unpaid Principal
  $ 5,743     $ 282     $ 1,169     $ 7,194     $ 1,396     $ 8,590  
 
                                               
Percent of Total
    67%       3%       14%       84%       16%       100%  
 
                                               
Weighted Average Mortgage Note Rate
    5.89%       5.61%       5.22%       5.77%       5.97%       5.80%  
 
                                               
Weighted Average Loan Age (in months)
    38       56       54       42       55       44  
The Program’s composition of balances by loan type and original final maturity did not change materially in 2009 compared to 2008. However, the weighted average mortgage note rate fell from 5.80 percent at year-end 2008 to 5.54 percent at year-end 2009, reflecting the prepayments of higher rate mortgages and our purchase of a substantial amount of lower rate mortgages in 2009’s low mortgage rate environment. Almost 40 percent of total principal balances at the end of 2009 came from new loans purchased in 2009.
As in prior years, yields earned in 2009 on new mortgage loans in the Program, relative to funding costs, offered acceptable risk-adjusted returns. The federal government’s actions to purchase mortgage-backed securities put upward pressure on mortgage prices, which normally lowers market yields, but the impact was not large enough to cause initial or expected profitability on new mortgages to decrease substantially. We cannot predict whether the effects on net spreads from the government’s purchase activities will continue to be modest.

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Housing and Community Investment
Since its inception in 1990, our Affordable Housing Program has provided funding for more than 51,000 housing units. In 2009, we accrued $30.8 million of earnings for the Affordable Housing Program, which we can award to members in 2010. This amount represents a $3.6 million (13 percent) increase from 2008 and resulted from 2009’s greater income before assessments.
Including funds recaptured or de-obligated from previous years’ offerings, we had available $35.9 million of funds for the Affordable Housing Program in 2009. De-obligated funds represent Affordable Housing projects for which we committed funds in prior years but which used fewer subsidies than originally anticipated or were for projects that did not go forward. Funds are also recaptured from projects in accordance with Finance Agency Regulations. We redeploy Affordable Housing Program funds if they are not used for the purposes intended.
Of the total funds available in 2009 for the Affordable Housing Program, $24.5 million was awarded through two competitive offerings, for which we approved 83 applications. Funds totaling $9.4 million were awarded to 164 members through the Welcome Home Set-Aside Program to assist home owners with down payments and closing costs. Funds totaling $1 million were allocated to fund the Mortgage Refinance Assistance Set-Aside Program. In total, almost one-third of our members received approval for funding under the Affordable Housing Program.
In addition, in 2009, our Board authorized two voluntary commitments (American Dream Homeownership Challenge and Preserving the American Dream), for which a total of $2.8 million was awarded to assist minority families and persons with special needs to become homeowners and to assist households facing delinquency and defaults.
Our activities to support affordable housing also include offering Advances with below-market interest rates at or near zero profit for us. Average 2009 Advance balances related to Housing and Community Investment Programs totaled $174 million for Affordable Housing Program Advances and $412 million for the Community Investment and Economic Development Programs. This represented a sizeable reduction from the balances in 2008, due, we believe, to the economic contraction that created greater risk for affordable housing projects.
Investments
In 2009, our investments portfolio continued to provide liquidity, enhance earnings, help us manage market risk, and, in the case of mortgage-backed securities, help us support the housing market.
Money Market Investments
Short-term unsecured money market instruments consist of the following accounts on the Statements of Condition: interest-bearing deposits; securities purchased under agreements to resell; Federal funds sold; GSE discount notes, most of which are in our trading portfolio; and certificates of deposit and bank notes in our available-for-sale portfolio. The composition of our money market investment portfolio varies over time based on relative value considerations. Daily balances can fluctuate significantly, usually within a range of $10,000 million to $20,000 million, due to numerous factors, including changes in the actual and anticipated amount of Mission Asset Activity, liquidity requirements, net spreads, opportunities to warehouse debt at attractive rates for future use, and management of financial leverage. Money market investments normally have one of the lowest net spreads of any of our assets, typically ranging from 3 to 15 basis points.
In 2009, we maintained average money market balances at higher than historical levels. The portfolio’s balance averaged $18,166 million in 2009, compared to an annual average of between $12,000 million and $14,000 million from 2006-2008. The increase in balances, many of which had overnight maturities, began in the fourth quarter of 2008 and occurred for three reasons. First, we wanted more asset liquidity during the financial crisis and continuing economic uncertainty. Second, some of the higher money market balances offset a portion of earnings lost from the sharp reductions in Advance balances, without a significant increase in risk. Third, Finance Agency guidance to target as many as 15 days of liquidity required more money market balances. We generally funded the money market investments required for increased asset liquidity with longer-term Discount Notes. Because of the upward sloping yield curve, these actions tended to negatively affect our earnings.

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Because the financial crisis appeared to subside as 2009 progressed, we determined in the second half of 2009 that it was acceptable from a risk perspective to partially reduce the amount of asset liquidity held from funding short-term (mostly overnight) investments with longer-term Consolidated Obligation Discount Notes.
In the third and fourth quarters of 2009, we invested in the short-term discount note obligations of Freddie Mac and Fannie Mae. These investments provide us a vehicle to diversify our short-term investments at attractive yields and augment liquidity. We also believe they present less credit risk of delayed or nonrepayment of principal and interest compared to other unsecured short-term investments. On December 31, 2009, our investments in Freddie Mac and Fannie Mae Discount Notes totaled $2,300 million and $1,500 million, respectively.
Mortgage-Backed Securities
Mortgage-backed securities currently comprise almost 100 percent of the held-to-maturity securities and $3 million of the trading securities on the Statements of Condition. Our current philosophy is to invest in the mortgage-backed securities of GSEs and government agencies. We have not purchased any mortgage-backed securities issued by other entities since 2003, and we have no plans to do so.
We historically have been permitted by Finance Agency Regulation to hold mortgage-backed securities up to a multiple of three times regulatory capital, measured at the time of additional mortgage purchases. Our strategy is to attempt to utilize as much of this authority as possible, subject to the availability of investments that fit our investment parameters, including an acceptable risk/return profile. In 2009, because of the financial crisis, recession and the Federal Reserve’s actions to directly purchase mortgage-backed securities, the availability of securities for us to purchase that fit our investment parameters was limited. As shown in the table below, in 2009 we purchased $992 million fewer securities than paydowns; we also sold $457 million of securities. We did not purchase any securities from September 2009 through year end. However, because the amount of regulatory capital fell in 2009, the mortgage-backed security multiple did not decrease significantly. On December 31, 2009, the principal balance of mortgage-backed securities totaled $11,448 million and regulatory capital was $4,151 million, for a multiple of 2.76.
In May 2008, the Finance Agency approved our request, pursuant to a Finance Agency authorization permitting a higher multiple, to temporarily expand our mortgage-backed security percentage by up to an additional 1.5 times regulatory capital until March 31, 2010. For the reasons discussed above, we have been unable to benefit substantially from the expanded authority. After purchasing $850 million of securities in January and February 2010 and repurchasing $269 million of additional excess capital stock in January (see the “Capital Resources” section below for discussion), the multiple increased to 3.00 on February 28, 2010.
The following table reconciles changes in the principal balance of mortgage-backed securities for 2009 and 2008.
                 
(In millions)   2009     2008  
 
               
Balance, beginning of year
  $ 12,897     $ 12,157  
Principal purchases
    2,690       2,862  
Principal paydowns
    (3,682 )     (2,122 )
Principal sales
    (457 )     -  
 
           
 
               
Balance, end of year
  $ 11,448     $ 12,897  
 
           
The principal paydowns equated to a 26 percent annual constant prepayment rate in 2009, compared to 16 percent in 2008. Similar to the Mortgage Purchase Program, the acceleration in prepayment rates reflected the overall low mortgage rate environment throughout 2009.

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The following table presents the composition of the principal balances of the mortgage-backed securities portfolio by security type, collateral type, and issuer.
                   
(In millions) December 31, 2009   December 31, 2008
 
                 
Security Type
                 
Collateralized mortgage obligations
  $ 3,268       $ 5,433  
Pass-throughs (1)
    8,180         7,464  
 
             
 
                 
Total
  $ 11,448       $ 12,897  
 
             
 
                 
Collateral Type
                 
15-year collateral
  $ 5,455       $ 5,169  
20-year collateral
    3,225         3,365  
30-year collateral
    2,768         4,363  
 
             
 
                 
Total
  $ 11,448       $ 12,897  
 
             
 
                 
Issuer
                 
GSE residential mortgage-backed securities
  $ 11,258       $ 12,581  
Agency residential mortgage-backed securities
    3         12  
Private-label residential mortgage-backed securities
    187         304  
 
             
 
                 
Total
  $ 11,448       $ 12,897  
 
             
(1)   At both year-end 2009 and 2008, $3 million of the pass-throughs were 30-year adjustable-rate mortgages. All others were 15-year or 20-year fixed-rate pass-throughs.
Most purchases in 2009 were 15-year pass-through collateral securities. This change was driven by our assessment that 15-year collateral had a more favorable risk/return tradeoff. We continued to own no pass-throughs backed by 30-year fixed-rate collateral. Because over 80 percent of Mortgage Purchase Program loans have 30-year original terms, purchasing pass-throughs with shorter than 30-year original terms is one way we diversify mortgage assets to help manage market risk exposure. We also tend to purchase the front-end prepayment tranches of collateralized mortgage obligations, which can have less market value sensitivity than other tranches. As discussed elsewhere, we have historically held a very small amount of private-label securities.
In 2009, yields earned on new mortgage-backed securities relative to funding costs offered acceptable risk-adjusted returns. However, as discussed above, the availability of securities to purchase was limited. In addition, we were prudent in purchasing securities at the low levels of mortgage coupons in 2009 because of the potential for significantly higher interest rates in the future. If significantly higher rates occur, future earnings levels may be materially lower because the low-coupon mortgages would pay down more slowly than the maturities of Consolidated Obligations issued to fund and hedge them, thus obligating us to issue new debt in a higher interest rate environment. More discussion about our current and 2009 market risk management strategies is in the “Market Risk” section of “Quantitative and Qualitative Disclosures About Risk Management.”

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Consolidated Obligations
Changes in Balances and Composition
Our primary source of funding and liquidity is through participating in the issuance of the System’s debt securities—Consolidated Obligations—in the capital markets. The table below presents the ending and average balances of our participations in Consolidated Obligations.
                                 
(In millions)   2009     2008  
    Ending     Average     Ending     Average  
    Balance     Balance     Balance     Balance  
             
 
                               
Consolidated Discount Notes:
                               
Par
  $ 23,189     $ 35,286     $ 49,389     $ 40,450  
Discount
    (2 )     (14 )     (53 )     (94 )
             
Total Consolidated Discount Notes
    23,187       35,272       49,336       40,356  
             
 
                               
Consolidated Bonds:
                               
Unswapped fixed-rate
    25,090       25,528       25,650       25,468  
Unswapped adjustable-rate
    1,000       3,623       6,424       9,638  
Swapped fixed-rate
    14,997       12,543       10,140       11,969  
             
 
                               
Total Par Consolidated Bonds
    41,087       41,694       42,214       47,075  
             
 
                               
Other items (1)
    135       145       179       62  
             
Total Consolidated Bonds
    41,222       41,839       42,393       47,137  
             
 
                               
Total Consolidated Obligations (2)
  $ 64,409     $ 77,111     $ 91,729     $ 87,493  
             
  (1)   Includes unamortized premiums/discounts, hedging and other basis adjustments.
 
  (2)   The 12 FHLBanks have joint and several liability for the par amount of all of the Consolidated Obligations issued on their behalves. See Note 13 of the Notes to Financial Statements for additional detail and discussion related to Consolidated Obligations. The par amount of the outstanding Consolidated Obligations of all 12 FHLBanks was (in millions) $930,617 and $1,251,542 at December 31, 2009 and 2008, respectively.
All of our Obligations issued and outstanding in 2009, as in the last several years, had “plain-vanilla” interest terms. None had step-up, inverse floating rate, convertible, range, or zero-coupon structures.
Balances and compositions of the various Obligation types can fluctuate significantly based on Advance demand, money market investment balances, comparative changes in their cost levels, supply and demand conditions, and our balance sheet management strategies. We fund short-term and adjustable-rate Advances, Advances hedged with interest rate swaps, and money market investments with Discount Notes, unswapped adjustable-rate Bonds, and swapped fixed-rate Bonds (which effectively create short-term funding). The ability to have three different sources of short-term and adjustable-rate funding is an important component in managing financial performance. We fund long-term assets principally with unswapped fixed-rate Bonds to help manage the market risk exposure of the long-term assets.
In 2009, the average and ending balances of Discount Notes were lower than 2008’s balances. The reduced reliance on Discount Notes in 2009 resulted from the substantial decrease in Advance balances. The relatively stable balance of unswapped fixed-rate Bonds in 2009 compared to 2008 reflected the modest growth in our mortgage assets and the reduction in long-term fixed-rate Advances.

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The following table shows the allocation on December 31, 2009 of unswapped fixed-rate Bonds according to their final remaining maturity and next call date (for callable Bonds).
                                         
(In millions)
  Year of Maturity     Year of Next Call
    Callable     Noncallable     Amortizing     Total     Callable
               
 
               
Due in 1 year or less
  $ -     $ 3,686     $ 4     $ 3,690    
$
7,516  
Due after 1 year through 2 years
    400       3,207       4       3,611       1,695  
Due after 2 years through 3 years
    1,245       3,089       51       4,385       125  
Due after 3 years through 4 years
    1,500       2,162       14       3,676       -  
Due after 4 years through 5 years
    1,161       1,196       4       2,361       25  
Thereafter
    5,055       2,182       130       7,367       -  
               
 
 
 
                                       
Total
  $ 9,361     $ 15,522     $ 207     $ 25,090    
$
9,361  
               
 
 
The allocations were consistent with those in the last several years. The Bonds were distributed relatively smoothly throughout the maturity spectrum. Twenty-nine percent had final remaining maturities greater than five years. Thirty-seven percent provide us with call options, which help manage the prepayment volatility of mortgage assets. Over 80 percent of the callable Bonds have next call dates within the next 12 months and most of them are callable daily after an initial lockout period. Daily call options provide considerable flexibility in managing market risk exposure to lower mortgage rates.
Relative Cost of Funding
Consolidated Obligation Bonds normally have an interest cost at a spread above U.S. Treasury securities and below LIBOR. These spreads can be volatile, and in 2008 and the first quarter of 2009, they were significantly wider and more volatile than in prior years. The financial crisis caused investors to demand significantly more relative compensation for debt securities, especially longer-term securities, issued by non-government entities. We responded to the higher spreads on noncallable Bonds by issuing a greater percentage of callable Bonds and Discount Notes because callable Bond spreads did not widen as much as noncallable Bond spreads. In the last three quarters of 2009, both noncallable and callable Bonds spreads and volatility improved back towards historical norms. The reversion of spreads benefited our earnings to the extent we issued more Bonds and replaced called and matured Bonds.
For discussion of the relative cost of Discount Note funding, which was a major driver of 2009’s earnings, see the “Net Interest Income” section of “Results of Operations.”
Eligible Assets Requirement
Finance Agency Regulations require us to maintain certain eligible assets free from any lien or pledge in an amount at least equal to the outstanding amount of our participation in Obligations. Eligible assets principally include Advances, loans under the Mortgage Purchase Program, mortgage-backed securities, money market investments, and deposits. The following table shows that we complied with this requirement on the dates presented, which are indicative of ongoing compliance.
                 
(In millions)   December 31, 2009   December 31, 2008
 
               
Total Book Value Eligible Assets
 
$
71,786    
$
98,922  
Total Book Value Consolidated Obligations
    (64,409 )     (91,729 )
 
 
 
   
 
 
 
               
Excess Eligible Assets
 
$
7,377    
$
7,193  
 
 
 
   
 
 
Deposits
Members’ deposits with us are a relatively minor source of low-cost funding. As shown on the “Average Balance Sheet and Yield/Rates” table in the “Results of Operations,” the average balance of term deposits and other interest-bearing deposits increased $287 million (20 percent) in 2009 compared to the same period of 2008. On December 31, 2009, the balance of deposits was $2,085 million, an increase of $891 million (75 percent) over year-end 2008. Deposit growth reflected members’ greater excess liquidity.

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Derivatives Hedging Activity and Liquidity
We discuss our use of and accounting for derivatives in the “Use of Derivatives in Market Risk Management” section of “Quantitative and Qualitative Disclosures About Risk Management.” We discuss liquidity in “Executive Overview” and in the “Liquidity Risk and Contractual Obligations” section of “Quantitative and Qualitative Disclosures About Risk Management.”
Capital Resources
Capital Leverage
The Gramm-Leach-Bliley Act of 1999 (GLB Act) and Finance Agency Regulations specify limits on how much we can leverage capital by requiring at all times at least a 4.00 percent regulatory capital-to-assets ratio. A lower ratio indicates more leverage. We have adopted a more restrictive additional limit in our Financial Management Policy, which targets a floor on the regulatory quarterly average capital-to-assets ratio of 4.20 percent. If financial leverage increases too much, or becomes too close to the regulatory limit, we have discretionary ability within our Capital Plan to enact changes to ensure capitalization remains strong and in compliance with regulatory limits. The following tables present capital amounts and capital-to-assets ratios, on both a GAAP and regulatory basis.
          GAAP and Regulatory Capital
                                 
    Year Ended December 31,  
(In millions)   2009     2008  
    Year End     Average     Year End     Average  
GAAP Capital Stock
  $ 3,063     $ 3,801     $ 3,962     $ 3,798  
Mandatorily Redeemable
Capital Stock
    676       211       111       127  
 
                       
Regulatory Capital Stock
    3,739       4,012       4,073       3,925  
Retained Earnings
    412       405       326       335  
 
                       
 
                               
Regulatory Capital
  $ 4,151     $ 4,417     $ 4,399     $ 4,260  
 
                       
     GAAP and Regulatory Capital-to-Assets Ratios
                                 
    2009   2008
    Year End   Average   Year End   Average
GAAP
    4.86 %     4.96 %     4.36 %     4.37 %
Regulatory
    5.81       5.22       4.48       4.51  
The decrease in financial leverage in 2009, as measured by higher capital-to-asset ratios, was due principally to the decrease in Advance balances. Retained earnings increased in 2009 over year-end 2008 by $86 million because we paid stockholders an average annualized dividend rate of 4.63 percent dividend while the ROE averaged 6.38 percent.
The substantial decrease in GAAP capital stock and substantial increase in mandatorily redeemable capital stock were due primarily to requests from a number of members for redemption of their excess stock balances and to the termination of several memberships as a result of mergers with financial institutions outside our Fifth District. When a membership terminates, the outstanding GAAP capital stock of the former member is automatically converted to mandatorily redeemable capital stock. Based on our communications with members, the increase in excess stock redemption requests in 2009 reflected attempts by several members to limit their investment concentrations and concerns with the financial condition of the FHLBank System, knowing that System Consolidated Obligations are the joint and several responsibilities of all FHLBanks. Members expressed no concern about our FHLBank’s financial condition or performance. Per the GLB Act and our Capital Plan, we have up to five years to repurchase mandatorily redeemable capital stock after a request for redemption of excess stock or a termination of membership (assuming, in the latter case, that Advances collateralized by the stock have been repaid).

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Changes in Capital Stock Balances
The following table presents changes in our regulatory capital stock balances.
                 
(In millions)   2009     2008  
 
 
Regulatory stock balance at beginning of year
  $ 4,073     $ 3,591  
 
               
Stock purchases:
               
Membership stock
    47       72  
Activity stock
    45       303  
Stock dividends
    -       152  
Stock repurchases:
               
Member redemptions
    (376 )     (23 )
Withdrawals
    (50 )     (22 )
 
           
 
               
Regulatory stock balance at the end of the year
  $ 3,739     $ 4,073  
 
           
Regulatory capital stock balances decreased $334 million, resulting primarily from our repurchase of $376 million of excess stock that several members had requested be redeemed. Although total Advance balances decreased, some members increased their Mission Asset Activity, resulting in the $45 million increase in activity stock. The increase in membership stock resulted from the annual recalculation of members’ minimum capital investment requirement. In January 2010, we repurchased $269 million of mandatorily redeemable excess capital stock.
Excess Stock
Because Advances declined during 2009, the amount of excess capital stock outstanding increased and the amount of capital stock members cooperatively utilized within our Capital Plan decreased. This occurred despite our repurchase of $376 million of members’ excess stock. A key component of our Capital Plan is cooperative utilization of capital stock, which, within constraints, permits members who have no excess stock of their own to capitalize additional Mission Asset Activity using excess stock owned by other members. Excess capital stock outstanding under our Capital Plan is reduced by the amount of cooperative utilization. If our Capital Plan did not have a cooperative capital feature, members would have been required to purchase up to $216 million of additional stock to capitalize the same total amount of Mission Asset Activity.
                       
(In millions)   December 31, 2009   December 31, 2008
 
               
Excess capital stock (Capital Plan definition)
 
$
905    
$
649  
 
 
 
   
 
 
 
               
Cooperative utilization of capital stock
 
$
216    
$
406  
 
 
 
   
 
 
 
               
Mission Asset Activity capitalized with cooperative capital stock
 
$
5,394    
$
10,150  
 
 
 
   
 
 
A Finance Agency Regulation prohibits us from paying stock dividends if the amount of our regulatory excess stock (defined by the Finance Agency to include stock cooperatively used) exceeds one percent of our total assets. At year-end 2008 and in each quarter of 2009, we were above the regulatory threshold and, therefore, were required to pay cash dividends for these quarters. Until Advances grow substantially again, we expect to continue to pay cash dividends.
Retained Earnings
On December 31, 2009, stockholders’ investment in our FHLBank was supported by $412 million of retained earnings. This represented 11 percent of total regulatory capital stock and 0.58 percent of total assets. When allocating earnings between dividends and retained earnings our Board of Directors considers the goals of paying stockholders a competitive dividend and having an adequate amount of retained earnings to mitigate impairment risk and potentially augment future dividend stability.

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Membership and Stockholders
On December 31, 2009, we had 735 member stockholders. In 2009, 19 institutions became new member stockholders while 12 were lost, producing a net gain of seven member stockholders. Most of the new members were community financial institutions with relatively small borrowing capacity. We lost members for the following reasons: four merged with other members; five merged with a nonmember (four outside our District); one relocated its charter outside our District; one was subject to an FDIC seizure with its assets subsequently purchased by another member; and one (AmTrust Bank) was subject to an FDIC seizure with its assets subsequently purchased by a financial institution chartered outside our District.
Of the members lost in 2009, two were National City Bank and AmTrust Bank, which have been among our largest stockholders and borrowers. The decrease in Mission Asset Activity from these lost members was modest in 2009, but will become greater over time as their Advances mature or are prepaid. We believe that these membership losses will not materially affect our business model, the adequacy of our liquidity, the ability to make timely principal and interest payments on participations in Consolidated Obligations and other liabilities, the ability to continue providing sufficient membership value to remaining members, or our profitability. We believe the impact on profitability will not be material because, as these former members’ Advances decrease, we can repurchase their capital stock, which will reduce the unfavorable impact on profitability from losing the Advances.
The following tables list institutions holding five percent or more of our outstanding Class B capital stock. The amounts include stock held by any known affiliates that are members of our FHLBank.
   (Dollars in millions)
                                     
December 31, 2009   December 31, 2008
            Percent               Percent
Name   Balance     of Total   Name   Balance     of Total
 
                                   
U.S. Bank, N.A.
  $ 591       16 %   U.S. Bank, N.A.   $ 841       21 %
PNC Bank, N.A.(1)
    404       11     PNC Bank, N.A.(1)     404       10  
Fifth Third Bank
    401       11     Fifth Third Bank     394       10  
The Huntington National Bank
    241       6     The Huntington National Bank     241       6  
 
       
 
                     
 
                  AmTrust Bank     223       5  
 
                           
 
 
 
 
Total
  $ 1,637       44 %                    
 
       
 
                     
 
                            Total   $ 2,103       52 %
 
                           
 
 
          (1) Formerly National City Bank.
The decrease in stock held by U.S. Bank, N.A. was due to its request for redemption of a portion of its excess stock in order to reduce its total holdings of FHLBank System stock. We repurchased this excess stock in September 2009. In November 2009, National City Bank notified us of its membership withdrawal due to a charter consolidation with a non-Fifth District financial institution, PNC Financial Services Group, Inc., which acquired National City in January 2009.
The following table provides the number of member stockholders by charter type.
                 
    December 31,
    2009   2008
 
               
Commercial Banks
    473       474  
Thrifts and Savings Banks
    128       130  
Credit Unions
    110       104  
Insurance Companies
    24       20  
 
               
 
               
Total Member Stockholders
    735       728  
 
               

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In 2009, net membership growth came from credit unions and insurance companies. The membership market share by charter for institutions that are eligible for membership and also satisfy performance trend criteria are as follows, as of December 31, 2009: 96 percent of commercial banks, 99 percent of thrifts and savings banks, and 62 percent of credit unions with assets above $25 million. There are approximately 85 Fifth District depository institutions eligible for membership that are not already members. The number of eligible insurance companies is difficult to compute accurately, but we believe several dozen are not members. At the end of 2009, the composition of membership by state was Ohio with 311, Kentucky with 218, and Tennessee with 206.
The following table provides the ownership of capital stock by charter type.
               
(In millions)   December 31,
    2009     2008
 
 
Commercial Banks
  $ 2,422     $ 3,053
Thrifts and Savings Banks
    455       667
Credit Unions
    98       94
Insurance Companies
    168       149
Other (1)
    596       110
 
         
 
             
Total
  $ 3,739     $ 4,073
 
         
  (1)   “Other” includes capital stock of former members that have been, or will be, merged with non-members. This stock is mandatorily redeemable capital stock.
Credit union members hold relatively less stock because they tend to be smaller than the average member and borrow less. Insurance company members hold relatively more stock because they tend to be larger than average and borrow more. Stock outstanding to commercial banks decreased substantially in 2009, due to requests for redemption of excess stock, some of which we subsequently repurchased, and mergers with non-members.
The following table provides a summary of member stockholders by asset size.
                 
      December 31,  
Member Asset Size (1)     2009       2008  
 
 
Up to $100 million
    226       235  
> $100 up to $500 million
    395       381  
> $500 million up to $1 billion
    57       58  
> $1 billion
    57       54  
 
               
 
               
Total Member Stockholders
    735       728  
 
               
  (1)   The December 31, 2009 membership composition reflects members’ assets as of September 30, 2009.
Most members are small financial institutions, with approximately 85 percent having assets up to $500 million. As noted elsewhere, having larger members, such as those with assets over $1 billion, is critical to helping achieve our mission objectives, including providing valuable products and services to all members.

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RESULTS OF OPERATIONS
Components of Earnings and Return on Equity
The following table is a summary income statement for each of the last three years. Each ROE percentage is computed by dividing income or expense for the category by the average amount of stockholders’ equity for the period.
                                                 
(Dollars in millions)   2009     2008     2007  
    Amount     ROE (a)   Amount     ROE (a)   Amount     ROE (a)  
 
                                               
Net interest income
  $ 387       6.75 %   $ 364       6.46 %   $ 421       7.90 %
 
                                               
Net gain (loss) on derivatives
and hedging activities
    18       0.31       2       0.03       (12 )     (0.22 )
Other non-interest income
    20       0.35       7       0.13       6       0.11  
 
                                   
 
                                               
Total non-interest income (loss)
    38       0.66       9       0.16       (6 )     (0.11 )
 
                                   
 
                                               
Total revenue
    425       7.41       373       6.62       415       7.79  
 
                                               
Total other expense
    (59 )     (1.03 )     (51 )     (0.89 )     (48 )     (0.92 )
Assessments
    (98 )     (b )     (86 )     (b )     (98 )     (b )
 
                                   
 
                                               
Net income
  $ 268       6.38 %   $ 236       5.73 %   $ 269       6.87 %
 
                                   
  (a)   The ROE amounts have been computed using dollars in thousands. Accordingly, recalculations based upon the disclosed amounts (millions) in this table may produce nominally different results.
 
  (b)   The effect on ROE of the REFCORP and Affordable Housing Program assessments is pro-rated within the other categories.
Net Interest Income
For our FHLBank, the largest component of net income is almost always net interest income. We manage net interest income within the context of managing the tradeoff between market risk and return. Effective risk/return management requires us to focus principally on the relationships among assets and liabilities that affect net interest income, rather than individual balance sheet and income statement accounts in isolation. Our ROE normally is lower than that of many other financial institutions because of our cooperative wholesale business model, our members’ desire to have dividends correlate with short-term interest rates, and our modest overall risk profile.
Components of Net Interest Income
We generate net interest income from two components: 1) the net interest rate spread and 2) funding interest-earning assets with interest-free capital. The sum of these, when expressed as a percentage of the average book balance of interest-earning assets, equals the net interest margin. Because of our relatively low net interest rate spread compared to other financial institutions, we normally derive a substantial proportion of net interest income from deploying our capital to fund assets.
  §   Net interest rate spread. This component equals the balance of total earning assets multiplied by the difference between the book yield on interest-earning assets and the book cost of interest-bearing liabilities. It is composed of net (amortization)/accretion, prepayment fees on Advances, and all other earnings from interest-earning assets net of funding costs. The latter is the largest component and represents the coupon yields of interest-earning assets net of the coupon costs of Consolidated Obligations and deposits.
 
  §   Earnings from funding assets with interest-free capital (“earnings from capital”). Because yields on assets funded with capital change when market interest rates move, earnings from capital funding move in the same direction as rates change. We deploy much of our capital in short-term and adjustable-rate assets in order to help ensure that ROE moves in the same direction as short-term interest rates and to help control market risk exposure. Earnings from capital can be computed as the average capital balance multiplied by the average cost of interest-bearing liabilities.

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The following table shows the two major components of net interest income, as well as the three major subcomponents of the net interest spread, for each of the last three years.
                                                 
    2009   2008   2007
(Dollars in millions)           Pct of             Pct of             Pct of  
            Earning             Earning             Earning  
    Amount     Assets     Amount     Assets     Amount     Assets  
                   
Components of net interest rate spread:
                                               
Other components of net interest rate spread
  $ 326       0.39 %   $ 253       0.27 %   $ 229       0.27 %
Net (amortization)/accretion (1) (2)
    (34 )     (0.04 )     (48 )     (0.05 )     (30 )     (0.03 )
Prepayment fees on Advances, net (2)
    8       0.01       2       -       3       -  
                         
 
                                               
Total net interest rate spread
    300       0.36       207       0.22       202       0.24  
                         
 
                                               
Earnings from funding assets with interest-free capital
    87       0.10       157       0.17       219       0.26  
                         
 
                                               
Total net interest income/net interest margin
  $ 387       0.46 %   $ 364       0.39 %   $ 421       0.50 %
                         
  (1)   Includes (amortization)/accretion of premiums/discounts on mortgage assets and Consolidated Obligations and deferred transaction costs (concession fees) for Consolidated Obligations.
 
  (2)   These components of net interest rate spread have been segregated here to display their relative impact.
The increase in 2009’s net interest income, compared to 2008’s, was due primarily to the factors identified in the “Other Components of Net Interest Rate Spread” section below. The decrease in 2008’s net interest income, compared to 2007’s, was due to the earnings from capital and net amortization/accretion categories.
Earnings From Capital. Earnings from capital decreased in 2009 versus 2008 and in 2008 versus 2007 because of the significant reductions each year in annual average market interest rates, especially short-term rates. Short-term interest rates had mostly reached their low points by the end of 2008. However, on an annual average basis, short-term rates were much lower in 2009 than in 2008, resulting in a 1.53 percentage points decrease in the average cost of interest-bearing liabilities, which in turn caused a steep decrease ($70 million, or 0.07 percentage points of interest earning assets) in 2009’s earnings from capital. A similar decrease ($62 million) in the earnings from capital occurred in 2008 compared to 2007.
Net Amortization/Accretion. Net amortization/accretion includes purchase premiums and discounts on mortgage assets and concessions on Consolidated Obligations. Amortization/accretion depends primarily on the levels of, and changes in, intermediate- and long-term interest rates and the shape of the Consolidated Obligation yield curve. Interest rates affect amortization/accretion of purchase premiums and discounts on mortgage assets by changing actual and projected principal prepayments. Our mortgage assets normally have an overall net premium balance, which results in more amortization when mortgage rates fall and less amortization when mortgage rates rise. Interest rates affect the amortization of Bond concessions by changing the amount of Bonds we call before maturity; when Bonds are called, remaining concessions are recognized immediately.
Net amortization decreased in 2009 versus 2008 and increased in 2008 versus 2007. Although interest rates trended downward in the last three years, which normally increases net amortization, some quarters had sufficient increases in mortgage rates to result in partial reductions in amortization. Most of 2009’s amortization was due to Bond concessions, as we economically retired over $14 billion of Bonds before their final maturities. Amortization in 2008 was approximately evenly split between mortgages and Bonds. Most of the year-over-year volatility in amortization was due to differences in mortgage amortization, not amortization of Bond concessions. The largest amortization in the last three years occurred in 2008 because of the relatively large decreases in mortgage rates in the first and fourth quarters of 2008.
Prepayment Fees on Advances. Although Advance prepayment fees can be, and in the past have been, significant, they were moderate in each of the last three years. Prepayment fees depend mostly on the actions and preferences of members to continue holding our Advances. Fees in one period do not necessarily indicate a trend that will continue in future periods.

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Other Components of Net Interest Rate Spread. Excluding net amortization and Advance prepayment fees, the other components of the net interest rate spread increased $73 million in 2009 compared to 2008 and increased $24 million in 2008 compared to 2007. Several factors, discussed below in estimated order of impact from largest to smallest, were primarily responsible for these increases.
     2009 Versus 2008
  §   Re-issuing called Consolidated Bonds at lower debt costs—Favorable: Between the fourth quarter of 2008 and the end of 2009, the reductions in intermediate- and long-term interest rates enabled us to retire (call) approximately $17 billion of unswapped Bonds before their final maturities and replace them with new Consolidated Obligations, many at significantly lower interest rates. Most of the called Bonds funded mortgage assets. By contrast, the amount of mortgage paydowns, which we reinvested in assets with lower rates, was substantially less than the amount of Bonds called. In addition, Bond calls and replacements with new debt enabled us to favorably alter the distribution of liability maturities, which raised earnings given the sharply upward sloping yield curve, without materially affecting market risk exposure.
 
  §   Wider portfolio spreads on LIBOR Advances—Favorable: We use Discount Notes to fund a large amount (normally between $10 billion and $20 billion) of LIBOR-indexed Advances. In the first six months of 2009, average portfolio spreads on LIBOR-indexed Advances relative to their Discount Note funding were substantially wider than the 18 to 20 basis points historical average and wider than the average spreads in 2008. Spreads widened because the financial crisis raised the cost of inter-bank lending (represented by LIBOR) relative to other short-term interest costs such as our Discount Notes. In some months, LIBOR rose as other short-term market rates fell. The spreads were particularly wide in the fourth quarter of 2008 (which benefited 2009’s earnings) and the first quarter of 2009.
 
      Early in the third quarter of 2009, short-term LIBOR decreased and the spread between LIBOR and Discount Notes reverted back to approximately its long-term historical level. The spread reversion, which lowered the cost of inter-bank lending relative to Discount Notes, appears to have been due to the market’s perception that the financial crisis had eased combined with the effects of the massive amounts of government liquidity injected into the financial system.
 
  §   Increase in benefit from short funding from steeper yield curve—Favorable: Market yield curves became significantly steeper in late 2008 and 2009 as short-term interest rates fell to historical lows of close to zero. This benefited earnings due to our use of a modest amount of short-term debt Obligations to fund long-term assets (short funding). In addition, differences in principal paydowns of long-term assets versus liabilities, including muted acceleration of mortgage prepayments, caused the amount of short funding to increase in the first three quarters of 2009, before we reduced the amount of short funding in the fourth quarter to protect future earnings against the potential for large increases in long-term interest rates.
 
  §   Decrease in financial leverage due to lower Advance balances—Unfavorable: The average principal balance of Advances was $16.3 billion lower in 2009 compared to 2008, which reduced our financial leverage. Although many Advance programs experienced reductions in balances, much of the decrease occurred from repayment and maturities of LIBOR Advances. Because, as explained above, we had funded many of these LIBOR Advances with Discount Notes at elevated spreads until the third quarter of 2009, the loss of these Advances decreased net interest income even more. We did not replace the lower Advance balances with sufficient increases in other asset balances to fully offset the lost income.

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2008 Versus 2007
For 2008 versus 2007, the following other components of the net interest rate spread combined to increase net interest income by $24 million, which partially offset the reduction in the earnings from capital and increase in net amortization. Overall, net interest income was down sharply (by $57 million) in 2008.
  §   Favorable Factors: Annual average spreads between LIBOR Advances and Discount Notes widened in 2008 compared to 2007, as the financial crisis took hold. We called over $7.0 billion of Bonds and replaced them with Consolidated Obligations at lower interest costs. Average total assets expanded by $10.1 billion. The average amount of capital grew by $221 million, which we invested in interest-earnings assets.
 
  §   Unfavorable Factors: A large amount of low cost debt matured, most of which we replaced with new Bonds at higher interest costs. We carried a large amount of overnight Advances and money market investments funded mostly with longer-term Discount Notes, and the sharp reductions in overnight interest rates decreased earnings by causing the overnight assets to reprice at the lower rates sooner than the funding. Finally, we lowered market risk exposure to protect against the potential for increases in interest rates by issuing more long-term Bonds. This decreased earnings given the steep upward sloping debt curves and the reductions in short-term interest rates.

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Average Balance Sheet and Yield/Rates
The following table provides yields/rates and average balances for major balance sheet accounts. All data include the impact of interest rate swaps, which we allocate to each asset and liability category according to their designated hedging relationship.
                                                                         
    2009   2008   2007
    Average             Average     Average             Average     Average             Average  
(Dollars in millions)   Balance     Interest     Rate(1)     Balance     Interest     Rate(1)     Balance     Interest     Rate(1)  
Assets
                                                                       
 
                                                                       
Advances
  $ 44,504     $ 578       1.30 %   $ 60,499     $ 1,895       3.13 %   $ 49,362     $ 2,592       5.25 %
 
                                                                       
Mortgage loans held for portfolio (2)
    9,570       484       5.06       8,683       437       5.03       8,817       467       5.30  
 
                                                                       
Federal funds sold and securities purchased under resale agreements
    8,382       12       0.15       8,181       159       1.95       6,737       346       5.14  
 
                                                                       
Other short-term investments
    1,281       3       0.19       25       1       2.93       693       37       5.33  
 
                                                                       
Interest-bearing deposits in banks (3) (4)
    8,503       27       0.31       4,000       69       1.73       6,157       325       5.28  
 
                                                                       
Mortgage-backed securities
    12,118       578       4.77       12,593       627       4.98       12,100       580       4.79  
 
                                                                       
Other long-term investments
    11       -       4.20       16       1       5.01       19       1       5.72  
 
                                                                       
Loans to other FHLBanks
    19       -       0.13       18       -       1.79       7       -       4.70  
 
                                                           
 
                                                                       
Total earning assets
    84,388       1,682       2.00       94,015       3,189       3.39       83,892       4,348       5.18  
 
                                                                       
Allowance for credit losses on mortgage loans
    -                       -                       -                  
Other assets
    282                       342                       401                  
 
                                                                 
 
                                                                       
Total assets
  $ 84,670                     $ 94,357                     $ 84,293                  
 
                                                                 
 
                                                                       
Liabilities and Capital
                                                                       
 
                                                                       
Term deposits
  $ 123       1       0.94     $ 103       3       2.87     $ 131       7       5.15  
 
                                                                       
Other interest bearing deposits (4)
    1,613       1       0.04       1,346       23       1.69       932       44       4.78  
 
                                                                       
Short-term borrowings
    35,272       112       0.32       40,356       947       2.35       24,763       1,235       4.99  
 
                                                                       
Unswapped fixed-rate Consolidated Bonds
    25,539       1,059       4.15       25,469       1,175       4.62       25,875       1,178       4.55  
 
                                                                       
Unswapped adjustable-rate Consolidated Bonds
    3,623       33       0.90       9,638       301       3.12       4,670       244       5.23  
 
                                                                       
Swapped Consolidated Bonds
    12,677       80       0.63       12,030       368       3.06       22,948       1,210       5.27  
 
                                                                       
Mandatorily redeemable capital stock
    211       9       4.43       127       8       6.45       132       9       6.90  
 
                                                                       
Other borrowings
    1       -       0.07       1       -       1.64       -       -       -  
 
                                                           
 
                                                                       
Total interest-bearing liabilities
    79,059       1,295       1.64       89,070       2,825       3.17       79,451       3,927       4.94  
 
                                                                 
 
                                                                       
Non-interest bearing deposits
    5                       4                       14                  
 
                                                                       
Other liabilities
    1,405                       1,155                       921                  
 
                                                                       
Total capital
    4,201                       4,128                       3,907                  
 
                                                                 
 
                                                                       
Total liabilities and capital
  $ 84,670                     $ 94,357                     $ 84,293                  
 
                                                                 
 
                                                                       
Net interest rate spread
                    0.36 %                     0.22 %                     0.24 %
 
                                                                       
 
                                                           
Net interest income and net interest margin
          $ 387       0.46 %           $ 364       0.39 %           $ 421       0.50 %
 
                                                           
 
                                                                       
Average interest-earnings assets to interest-bearing liabilities
                    106.74 %                     105.55 %                     105.59 %
 
                                                                 
  (1)   Amounts used to calculate average rates are based on dollars in thousands. Accordingly, recalculations based upon the disclosed amounts (millions) may not produce the same results.
 
  (2)   Nonperforming loans are included in average balances used to determine average rate. There were none for the periods displayed.
 
  (3)   Includes securities classified as available-for-sale, based on their amortized costs. The yield information does not give effect to changes in fair value that are reflected as a component of stockholders’ equity for available-for-sale securities.
 
  (4)   Amounts include certificates of deposits and bank notes that are classified as available-for-sale or held-to-maturity securities in the Statements of Condition. Additionally, the average balance amounts include the rights or obligations to cash collateral, which are included in the fair value of derivative assets or derivative liabilities on the Statements of Condition at period end.

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From 2008 to 2009, all accounts had reductions in their average rates, except for Mortgage Loans Held in Portfolio (i.e, the Mortgage Purchase Program). The accounts with the largest reductions in average rates have short-term maturities or adjustable-rate interest resets, as expected given the sharp reductions in average short-term rates. The Mortgage Purchase Program had a slight increase in average rate because its net amortization was $29 million, or 0.30 percentage points of balance, lower in 2009 than in 2008.
Volume/Rate Analysis
Changes in both average balances (volume) and interest rates influence changes in net interest income and net interest margin. The following table summarizes these changes and trends in interest income and interest expense.
                                                 
(In millions)                  2009 over 2008     2008 over 2007  
    Volume (1)(3)     Rate (2)(3)     Total     Volume (1)(3)     Rate (2)(3)     Total  
                     
Increase (decrease) in interest income
                                               
Advances
  $ (409 )   $ (908 )   $ (1,317 )   $ 500     $ (1,197 )   $ (697 )
Mortgage loans held for portfolio
    45       2       47       (7 )     (23 )     (30 )
Federal funds sold and securities
purchased under resale agreements
    4       (151 )     (147 )     62       (249 )     (187 )
Other short-term investments
    3       (1 )     2       (24 )     (12 )     (36 )
Interest-bearing deposits in banks
    41       (83 )     (42 )     (88 )     (168 )     (256 )
Mortgage-backed securities
    (23 )     (26 )     (49 )     24       23       47  
Other long-term investments
    (1 )     -       (1 )     -       -       -  
Loans to other FHLBanks
    -       -       -       -       -       -  
                     
 
                                               
Total
    (340 )     (1,167 )     (1,507 )     467       (1,626 )     (1,159 )
                     
Increase (decrease) in interest expense
                                               
Term deposits
    -       (2 )     (2 )     (2 )     (2 )     (4 )
Other interest-bearing deposits
    4       (26 )     (22 )     15       (36 )     (21 )
Short-term borrowings
    (106 )     (729 )     (835 )     554       (842 )     (288 )
Unswapped fixed-rate Consolidated Bonds
    4       (120 )     (116 )     (19 )     16       (3 )
Unswapped adjustable-rate Consolidated Bonds
    (125 )     (143 )     (268 )     184       (127 )     57  
Swapped Consolidated Bonds
    18       (306 )     (288 )     (447 )     (395 )     (842 )
Mandatorily redeemable capital stock
    4       (3 )     1       -       (1 )     (1 )
Other borrowings
    -       -       -       -       -       -  
                     
 
                                               
Total
    (201 )     (1,329 )     (1,530 )     285       (1,387 )     (1,102 )
                     
 
                                               
Increase (decrease) in net interest income
  $ (139 )   $ 162     $ 23     $ 182     $ (239 )   $ (57 )
                     
(1)   Volume changes are calculated as the change in volume multiplied by the prior year rate.
 
(2)   Rate changes are calculated as the change in rate multiplied by the prior year average balance.
 
(3)   Changes that are not identifiable as either volume-related or rate-related, but rather are equally attributable to both volume and rate changes, have been allocated to the volume and rate categories based upon the proportion of the absolute value of the volume and rate changes.
Effect of the Use of Derivatives on Net Interest Income
As explained elsewhere, the primary reason we use derivatives, most of which are interest rate swaps, is to hedge the market risk exposure including earnings volatility resulting from the fixed interest rates of certain Advances and Consolidated Obligations and from certain embedded options in assets and liabilities. The following table shows the effect of using derivatives on net interest income.
                         
(In millions)   2009     2008     2007  
       
 
                       
Advances (1)
  $ (505 )   $ (189 )   $ 63  
Mortgage purchase commitments (2)
    3       -       2  
Consolidated Obligations (1)
    158       69       (103 )
       
 
                       
Decrease in net interest income
  $ (344 )   $ (120 )   $ (38 )
       
  (1)   Represents interest rate swap interest.
 
  (2)   Represents the amortization of derivative fair value adjustments.
The derivatives synthetically convert the fixed interest rates on the swapped Advances and Consolidate Obligations to adjustable-coupon rates tied to short-term LIBOR (mostly three-month), which normally have lower interest rates than the fixed rates. Using derivatives decreased net interest income in each of the last three years because the fixed interest rates on the swapped Advances were higher than the fixed interest rates on the swapped Obligations.

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The swapped Advances are normally financed with short-term adjustable-rate liabilities and the swapped Obligations normally finance short-term or adjustable-rate Advances. Therefore, use of derivatives resulted in, as we intended, a much closer match of interest rate cash flows between assets and liabilities than would have occurred without their use. If we had not used derivatives, net interest would have been higher by the amounts indicated, however, earnings and market risk exposure to changes in interest rates would have experienced an unacceptable amount of volatility.
The effect on net interest income from derivatives activity represents the net effects of:
  §   the economic cost of hedging purchased options embedded in Advances;
 
  §   converting fixed-rate Regular Advances and Advances with below-market coupons and purchased options to at-market coupons tied to adjustable-rate LIBOR; and
 
  §   converting fixed-rate coupons to an adjustable-rate LIBOR coupon on swapped Obligations.
In general, the relative magnitude of each factor depends on changes in both short-term LIBOR and in the net notional principal amounts of swapped Advances versus swapped Obligations. The larger reduction in net interest income in 2009 from use of derivatives was primarily due to the significantly lower short-term LIBOR in 2009 versus 2008. See the section “Use of Derivatives in Market Risk Management” in “Quantitative and Qualitative Disclosures About Risk Management” for further information.
Non-Interest Income and Non-Interest Expense
The following table presents non-interest income and non-interest expense for each of the last three years.
                         
          (Dollars in millions)   2009     2008     2007  
           
 
 
Other Income (Loss)
                       
Net gains on held-to-maturity securities
  $ 12     $ -     $ -  
Net gain (loss) on derivatives and hedging activities
    18       2       (12 )
Other non-interest income, net
    8       7       6  
           
 
                       
Total other income (loss)
  $ 38     $ 9     $ (6 )
           
 
                       
Other Expense
                       
Compensation and benefits
  $ 34     $ 26     $ 25  
Other operating expense
    15       13       13  
Finance Agency
    3       3       3  
Office of Finance
    3       3       3  
Other expenses
    4       6       4  
           
 
                       
Total other expense
  $ 59     $ 51     $ 48  
           
 
                       
Average total assets
  $ 84,670     $ 94,357     $ 84,293  
Average regulatory capital
    4,417       4,260       4,044  
 
                       
Total other expense to average total assets (1)
    0.07%       0.05%       0.06%  
Total other expense to average regulatory capital (1)
    1.33%       1.18%       1.20%  
  (1)   Amounts used to calculate percentages are based on dollars in thousands. Accordingly, recalculations based upon the disclosed amounts (millions) may not produce the same results.
For both 2009 versus 2008 and 2008 versus 2007, the net gain on derivatives and hedging activities represented unrealized market value adjustments resulting primarily from the reductions in interest rates and the amortization of market value gains from the replacement of terminated interest rate swaps in September 2008 that had been outstanding with Lehman Brothers. The changes in the market values as a percentage of notional principal were modest, less than 0.10 percentage points. We consider the amount of volatility in the last three years to be moderate and consistent with the close hedging relationships of our derivative transactions.
The increase in 2009 other non-interest income included a $12 million gain on sales of $457 million of mortgage-backed securities in the first and fourth quarters. We may from time to time sell mortgage-backed securities when their remaining principal balance is below 15 percent of their original balances.

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Total other expense increased $8 million (17 percent) in 2009. Most of the increase came from compensation and benefits, in particular funding of pension programs in the volatile financial environment. See Note 17 of the Notes to Financial Statement for further discussion. We continue to maintain a sharp focus on controlling operating costs. The increase in these expenses lowered ROE approximately 0.15 percentage points in 2009.
REFCORP and Affordable Housing Program Assessments
Currently, the combined assessments for REFCORP and the Affordable Housing Program equate to an approximately 27 percent effective annualized net assessment rate. Depending on the level of the FHLBank System’s earnings, the REFCORP assessment is currently expected to be statutorily retired in the next several years. Lower FHLBank System earnings would extend the retirement date and higher earnings would accelerate the date.
In 2009, assessments totaled $98 million, which reduced ROE by 2.33 percentage points. In 2008, assessments were $86 million, which reduced ROE by 2.09 percentage points. The relative burden of assessments was higher in 2009 than in 2008 because net income before assessments rose 13 percent while average capital rose only 2 percent; this means a larger assessment was applied to a relatively stable capital base.
Analysis of Quarterly ROE
The following table summarizes the components of 2009’s quarterly ROE and provides quarterly ROE for 2008 and 2007.
                                         
       
    1st Quarter     2nd Quarter     3rd Quarter     4th Quarter     Total  
       
Components of 2009 ROE:
                                       
Net interest income:
                                       
Other net interest income
    8.37 %     7.43 %     6.66 %     6.24 %     7.20 %
Net (amortization)/accretion
    (0.90 )     (0.23 )     (0.60 )     (0.62 )     (0.58 )
Prepayment fees
    0.26       0.07       0.12       0.07       0.13  
               
 
                                       
Total net interest income
    7.73 %     7.27 %     6.18 %     5.69 %     6.75 %
 
                                       
Net gain on derivatives
and hedging activities
    0.31       0.23       0.33       0.36       0.31  
Other non-interest income
    0.56       0.12       0.16       0.60       0.35  
               
 
                                       
Total non-interest income
    0.87       0.35       0.49       0.96       0.66  
               
 
                                       
Total revenue
    8.60       7.62       6.67       6.65       7.41  
 
                                       
Total other expense
    (0.82 )     (0.84 )     (0.97 )     (1.54 )     (1.03 )
Assessments
    (a )     (a )     (a )     (a )     (a )
               
 
                                       
2009 ROE
    7.78 %     6.78 %     5.70 %     5.11 %     6.38 %
               
 
                                       
2008 ROE
    5.06 %     6.38 %     6.26 %     5.19 %     5.73 %
               
 
                                       
2007 ROE
    6.63 %     7.11 %     6.80 %     6.96 %     6.87 %
               
  (a)   The effect on ROE of the REFCORP and Affordable Housing Program assessments is pro-rated within the other categories.
Quarterly ROE in 2009 was volatile, ranging from 5.11 percent to 7.78 percent, while one of the main earnings drivers, short-term interest rates, was relatively stable. The fact that the level of quarterly ROE was significantly higher than short-term interest rates enabled us to distribute quarterly dividends to stockholders that were less volatile than ROE.
ROE fell in each quarter of 2009. The first quarter benefitted from the widest spreads on LIBOR-indexed Advances to Discount Note funding, the largest amount of short funding, 0.26 percentage points of Advance prepayment fees, and 0.56 percentage points of other non-interest income, principally from a gain on sales of mortgage-backed securities. On the unfavorable side, net amortization was high and the full impact of our Bond calls had not occurred.

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The decrease in 2009’s second quarter ROE compared to the first quarter reflected further reductions in Advance balances, the beginning of the dissipation of the wide LIBOR to Discount Note spread, a decrease in Advance prepayment fees, and no gains on securities sales. These unfavorable factors were offset partially by an increase in the benefit from calling Bonds and replacing them with lower rate debt and less net amortization.
The decrease in 2009’s third quarter ROE compared to the second quarter reflected reversal of the LIBOR to Discount Note spread to historical levels, even lower Advance balances, and higher net amortization. These unfavorable factors were partially offset by the continued benefit from calling Bonds.
The decrease in 2009’s fourth quarter ROE compared to the third quarter reflected a decrease in the amount of short funding in order to reduce market risk exposure to higher interest rates and further reductions in Advance balances. These unfavorable factors were partially offset by the cumulative benefit from calling Bonds and a gain on sales of mortgage-backed securities.
Segment Information
Note 18 of the Notes to Financial Statements presents information on our two operating business segments. It is important to note that we manage financial operations and market risk exposure primarily at the level, and within the context, of the entire balance sheet, rather than exclusively at the level of individual segments. Under this approach, the market risk/return profile of each segment may not match, or possibly even have the same trends as, what would occur if we managed each segment on a stand-alone basis.
The table below summarizes each segment’s operating results for each of the last three years.
(Dollars in millions)
                         
    Traditional     Mortgage        
    Member     Purchase        
    Finance     Program     Total  
2009
                       
 
                       
Net interest income
  $ 276     $ 111     $ 387  
 
                 
Net income
  $ 193     $ 75     $ 268  
 
                 
Average assets
  $ 75,054     $ 9,616     $ 84,670  
 
                 
Assumed average capital allocation
  $ 3,724     $ 477     $ 4,201  
 
                 
 
 
Return on Average Assets (1)
    0.26 %     0.78 %     0.32 %
 
                 
Return on Average Equity (1)
    5.19 %     15.65 %     6.38 %
 
                 
 
                       
2008
                       
 
                       
Net interest income
  $ 305     $ 59     $ 364  
 
                 
Net income
  $ 196     $ 40     $ 236  
 
                 
Average assets
  $ 85,593     $ 8,764     $ 94,357  
 
                 
Assumed average capital allocation
  $ 3,745     $ 383     $ 4,128  
 
                 
 
 
Return on Average Assets (1)
    0.23 %     0.46 %     0.25 %
 
                 
Return on Average Equity (1)
    5.24 %     10.51 %     5.73 %
 
                 
 
                       
2007
                       
 
                       
Net interest income
  $ 331     $ 90     $ 421  
 
                 
Net income
  $ 208     $ 61     $ 269  
 
                 
Average assets
  $ 74,226     $ 10,067     $ 84,293  
 
                 
Assumed average capital allocation
  $ 3,441     $ 466     $ 3,907  
 
                 
 
                       
Return on Average Assets (1)
    0.28 %     0.61 %     0.32 %
 
                 
Return on Average Equity (1)
    6.03 %     13.10 %     6.87 %
 
                 
  (1)   Amounts used to calculate returns are based on numbers in thousands. Accordingly, recalculations based upon the disclosed amounts (millions) may not produce the same results.

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Traditional Member Finance Segment
The decrease in 2009’s net income and ROE, compared to 2008, reflected the unfavorable effects of the reduction in the earnings from capital, the lower Advance balances, and a $13 million decrease in net accretion of purchase discounts on mortgage-backed securities. These factors were offset only partially by calls of Consolidated Bonds funding mortgage-backed securities; the wider average spreads on LIBOR-indexed Advances relative to Discount Note funding; the steeper yield curve which improved earnings derived from short funding; the increase in Advance prepayment fees; and the larger gain on derivatives’ market value adjustments.
The most important factors in 2008’s decreased net income and ROE, compared to 2007, were the reduction in the earnings from capital and the maturity of a large amount of low cost debt.
Mortgage Purchase Program Segment
The profitability of the Mortgage Purchase Program continued to be favorable, while not significantly raising market risk and maintaining limited credit risk. The Program ended the year at 13 percent of total assets but accounted for approximately 28 percent of earnings in 2009. The increase in 2009’s profitability compared to 2008 resulted from replacing a large amount of called Bonds with lower cost debt, the steeper yield curve which improved earnings derived from short funding, and a reduction in net amortization of purchase premiums. The reduction in 2008’s net income and ROE, compared to 2007, resulted primarily from a $24 million increase in net amortization of purchase premiums and the maturity of a large amount of low cost debt.
Although this segment can exhibit more earnings volatility relative to short-term interest rates than the Traditional Member Finance segment, we believe the Mortgage Purchase Program will continue to provide competitive risk-adjusted returns and augment earnings available to pay as dividends. As discussed elsewhere, mortgage assets are the largest source of our market risk, but we believe we have managed it prudently over time and that it does not significantly raise overall market risk exposure. The effect of market risk exposure from the mortgage-backed securities in the Traditional Member Finance segment is diluted by that segment’s Advances and money market investments, which each have a small amount of residual market risk.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT RISK MANAGEMENT
Overview
Residual risk is defined as the risk exposure to our mission and corporate objectives remaining after applying policies, controls, decisions, and procedures to manage and mitigate risk. Normally, our most significant residual risks are business/strategic risk and market risk. Currently, we believe the most significant risk is business/strategic risk, which we define as the potential adverse impact on corporate objectives from external factors and events over which we have limited control or influence. The current business/strategic risks arise primarily from:
  §   residual effects from the economic recession;
 
  §   residual effects from the financial crisis;
 
  §   the various actual and potential actions of the federal government, including the Federal Reserve, Treasury Department and FDIC, to attempt to mitigate the financial crisis and recession;
 
  §   potentially unfavorable actions regarding the ultimate financial, legislative and regulatory disposition of issues involving the GSEs, especially actions related to Fannie Mae and Freddie Mac with whom the FHLBanks share a common regulator; and
 
  §   the ongoing concerns about some other FHLBanks’ capital adequacy and profitability.
We believe that the residual exposures for our other risks—collectively market risk, capital adequacy, credit risk, and operational risk—continued to be modest in 2009. Market risk exposure continued to be moderate and at a level consistent with our cooperative business model. We have always maintained compliance with our capital requirements and we believe we hold a sufficient amount of retained earnings to protect our capital stock against earnings losses and impairment risk. We continue to conclude that we do not need a loss reserve for any asset class and that no assets are impaired. We did not experience any material operating risk event.

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We also believe the funding/liquidity risk subsided as 2009 progressed. Although we can make no assurances, we believe the possibility of a liquidity or funding crisis in the FHLBank System that would impair our FHLBank’s ability to service our debt or pay competitive dividends is remote. The impact of the financial crisis on our debt issuance capabilities and funding costs lessened, as our long-term funding costs relative to LIBOR and U.S. Treasuries showed a relative improvement and less volatility.
Market Risk
Management of Market Risk Exposure
Market risk exposure is the risk of fluctuations in both the economic (i.e., market) value of our stockholders’ capital investment in the FHLBank and the level of future earnings from unexpected changes and volatility in the market environment (most importantly interest rates) and our business operating conditions. There is normally a tradeoff between long-term market risk exposure and shorter-term exposure. We attempt to minimize long-term market risk exposure while earning a competitive return on members’ capital stock investment. Effective management of both components is important in order to attract and retain members and capital and to support growth in Mission Asset Activity.
The primary challenges in managing the level and volatility of long-term earnings exposure—i.e., market risk exposure—arise from 1) the tradeoff between earning a competitive return and correlating profitability with short-term interest rates and 2) the market risk exposure of owning mortgage assets for which we have sold prepayment options that tend to change unfavorably when interest rates change. We mitigate the market risk of mortgage assets with a portfolio of long-term unswapped fixed-rate callable and noncallable Consolidated Bonds that have expected cash flows similar to the aggregate cash flows expected from mortgage assets under a wide range of interest rate and prepayment environments. We have not used derivatives to manage the market risk of mortgage assets, except for hedging a portion of commitments in the Mortgage Purchase Program. Because it is normally cost-prohibitive to completely mitigate mortgage prepayment risk, a residual amount of market risk typically remains after funding and hedging activities.
We analyze market risk using numerous analytical measures under a variety of interest rate scenarios, including stressed scenarios, and perform sensitivity analysis on the many variables that can affect market risk, using several market risk models from third-party software companies. These models employ rigorous valuation techniques for the optionality that exists in mortgage prepayments, call and put options, and caps/floors. We regularly assess the effects of different assumptions, techniques and methodologies on the measurements of market risk exposure, including comparisons to alternative models and information from brokers/dealers. After thorough research and consideration, we may also update these models and our assumptions and methods when market conditions and/or our business conditions change significantly. For example, throughout the last two years, we enhanced modeling of mortgage prepayment projections to respond to the historical stresses in the housing and mortgage markets.
Regulatory and Policy Limits on Market Risk Exposure
The FHLBank has five sets of policy limits regarding market risk exposure, which primarily address long-term market risk exposure. We determine compliance with our policy limits at every month-end or more frequently if market or business conditions change significantly. We complied with each of our policy limits for market risk exposure in each month of 2009 and 2008, except for one minor policy limit violation in March of 2009.
  §   Market Value of Equity Sensitivity. The market value of equity for the entire balance sheet in two hypothetical interest rate scenarios (up 200 basis points and down 200 basis points from the current interest rate environment) must be between positive and negative 15 percent of the current balance sheet’s market value of equity. The interest rate movements are “shocks,” defined as instantaneous, permanent, and parallel changes in interest rates in which every point on the yield curve is changed by the same amount.
 
  §   Duration of Equity. The duration of equity for the entire balance sheet in the current (“flat rate” or “base case”) interest rate environment must be between positive and negative six years. In addition, the duration of equity in up and down 200 basis points interest rate shocks must be within positive and negative eight years.
 
  §   Market Capitalization. The market capitalization ratio (defined as the ratio of the market value of equity to the par value of regulatory stock) must be 95 percent in the current rate environment and must be above 85 percent in each of two stressful interest rate shocks.

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  §   Mortgage Assets Portfolio. The net market value of the mortgage assets portfolio as a percentage of the book value of portfolio assets must be between positive three percent and negative three percent in each of the up and down 200 basis points interest rate shocks. Net market value is defined here as the market value of assets minus the market value of liabilities, with no assumed capital allocation.
 
  §   Mortgage Assets as a Multiple of Regulatory Capital. The amount of mortgage assets must be less than seven times the amount of regulatory capital.
In addition, Finance Agency Regulations and our Financial Management Policy provide controls on market risk exposure by restricting the types of mortgage loans, mortgage-backed securities and other investments we can hold. Historically, we have not purchased a large amount of mortgage-backed securities of private-label issuers, which we believe can have more volatility in prepayment speeds than GSE mortgage-backed securities. We have tended to purchase the front-end prepayment tranches of collateralized mortgage obligations, which can have less prepayment volatility than other tranches. We also manage market risk exposure by charging members prepayment fees on many Advance programs where an early termination of an Advance would result in an economic loss to us.
Market Value of Equity and Duration of Equity – Entire Balance Sheet
Two key measures of long-term market risk exposure are the sensitivities of the market value of equity and the duration of equity to changes in interest rates and other variables. The market value of equity is the present value of the long-term economic value of current capital, measured as the estimated market value of assets minus the estimated market value of liabilities. The market value of equity does not measure the value of our company as a going concern because it does not consider future new business activity, risk management strategies, or the net profitability of assets after funding costs.
The duration of equity is a second way to measure long-term market risk exposure. Duration is a measure of price volatility. It indicates the expected percentage change in an instrument’s market value from a small movement in interest rates. The duration of equity can be computed as the duration of liabilities plus the product of the amount of capital leverage and the duration gap (which is the difference between the duration of assets and the duration of liabilities). For example, a positive five duration of equity indicates that the market value of equity is expected to change inversely with interest rates, such that, for example, a 100 basis points increase in all interest rates would be expected to decrease the market value of equity by 5.0 percent. The duration of equity will change as interest rates move because there will be changes in the expected cash flows of instruments with options.
The following table presents the sensitivity profiles for the market value of equity and the duration of equity for the entire balance sheet under interest rate shocks (in basis points). Average results are compiled using data for each month end.
Market Value of Equity
                                                         
(Dollars in millions)
  Down 200   Down 100   Down 50   Flat Rates   Up 50   Up 100   Up 200
     
 
                                                       
Average Results
                                                       
 
                                                       
2009 Full Year
                                                       
Market Value of Equity
  $ 4,146     $ 4,247     $ 4,324     $ 4,404     $ 4,446     $ 4,442     $ 4,334  
% Change from Flat Case
    (5.9 )%     (3.6 )%     (1.8 )%     -       1.0 %     0.9 %     (1.6 )%
 
                                                       
2008 Full Year
                                                       
Market Value of Equity
  $ 3,698     $ 3,907     $ 3,979     $ 4,010     $ 3,998     $ 3,956     $ 3,840  
% Change from Flat Case
    (7.8 )%     (2.6 )%     (0.8 )%     -       (0.3 )%     (1.3 )%     (4.2 )%
 
                                                       
 
 
                                                       
Month-End Results
                                                       
 
                                                       
December 31, 2009
                                                       
Market Value of Equity
  $ 4,184     $ 4,251     $ 4,271     $ 4,280     $ 4,256     $ 4,208     $ 4,066  
% Change from Flat Case
    (2.2 )%     (0.7 )%     (0.2 )%     -       (0.6 )%     (1.7 )%     (5.0 )%
 
                                                       
December 31, 2008
                                                       
Market Value of Equity
  $ 3,831     $ 3,965     $ 4,060     $ 4,153     $ 4,180     $ 4,136     $ 3,924  
% Change from Flat Case
    (7.8 )%     (4.5 )%     (2.2 )%     -       0.7 %     (0.4 )%     (5.5 )%

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Duration of Equity
                                                         
(In years)
  Down 200   Down 100   Down 50   Flat Rates   Up 50   Up 100   Up 200
     
 
                                                       
Average Results
                                                       
 
                                                       
2009 Full Year
    (2.3 )     (3.3 )     (3.8 )     (2.9 )     (0.7 )     1.3       3.5  
 
                                                       
2008 Full Year
    (5.7 )     (4.3 )     (2.4 )     (0.2 )     1.6       2.6       3.1  
 
                                                       
 
 
                                                       
Month-End Results
                                                       
 
                                                       
December 31, 2009
    (0.8 )     (0.7 )     (0.6 )     0.6       1.8       2.8       4.1  
 
                                                       
December 31, 2008
    (4.2 )     (4.5 )     (4.6 )     (3.1 )     0.6       3.6       6.4  
These measures indicate that in 2009 residual market risk exposure continued to be moderate and at levels consistent with the historical market risk profile. Based on these market risk metrics, as well as analysis of cash flows and earnings simulations, we do not expect that profitability would decrease to uncompetitive levels if interest rates were to change by a substantial amount, unless long-term rates were to increase immediately and permanently by 4.00 percentage points or more or short-term rates were to increase immediately and permanently to at least eight percent. This amount of extreme change in interest rates would not result in negative earnings, unless possibly coupled with many other market and business variables experiencing extremely unfavorable changes, and would not threaten the impairment of capital stock.
Regarding lower mortgage rates, we called approximately $17 billion of unswapped Bonds between the fourth quarter of 2008 and the end of 2009 and replaced them with new Consolidated Obligations at significantly lower interest costs. Mortgage prepayments did not increase proportionately to the amount of the Bonds called, in part due to the credit conditions—especially falling home prices—that have made refinancing difficult for many homeowners. The amount of Bonds we called will substantially mitigate—but not completely offset—the lower earnings resulting from a possible large acceleration in mortgage prepayment speeds if mortgage rates decrease again substantially.
On December 31, 2009, the mortgage asset portfolio had a net premium balance of $76 million. For a 1.00 percentage decrease to the currently low mortgage rates, we project there would be a $13 million immediate one-time increase in net amortization on mortgage asset net premiums (which would lower earnings), while for a 2.00 percentage shock increase to mortgage rates, there would be a $7 million immediate one-time decrease in net amortization (which would raise earnings). This amount of volatility would not materially affect profitability.
Market Capitalization Ratios
The ratio of the market value of equity to the book value of regulatory capital indicates the theoretical net market value of portfolio assets after subtracting the theoretical net market cost of liabilities, as a percent of regulatory capital. To the extent the ratio is lower than 100 percent, it reflects a potential reduction in future earnings from the current balance sheet. The market values used in the ratio can represent potential real economic losses, unrealized opportunity losses, or temporary fluctuations. However, the ratio does not measure the market value of equity from the perspective of an ongoing business. We also track the ratio of the market value of equity to the par value of regulatory capital stock. This ratio excludes retained earnings in the denominator and therefore shows the ability of the market value of equity to protect the value of stockholders’ investment in our company.
The following table presents both ratios for the current (flat rate) interest rate environment. Because both ratios were at or above 100 percent in 2009, they support the assessment that we have a moderate amount of market risk exposure.
                         
            Monthly Average    
            Year Ended    
    December 31, 2009   December 31, 2009   December 31, 2008
Market Value of Equity to
Book Value of Regulatory Capital
    103 %     100 %     94 %
 
                       
Market Value of Equity to
Par Value of Regulatory Capital Stock
    114 %     111 %     102 %

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Both ratios increased in 2009, due to a combination of generally lower mortgage rates, narrower market spreads on new mortgage assets, the Bond calls discussed above and throughout this filing, repurchase of a material amount of excess capital stock in September 2009, and, for the second ratio, the large increase in retained earnings.
Market Risk Exposure of the Mortgage Assets Portfolio
The mortgage assets portfolio accounts for almost all of our market risk exposure because of prepayment volatility that we cannot completely hedge while maintaining positive net spreads. We closely analyze the mortgage assets portfolio both together with and separately from the entire balance sheet. The portfolio includes mortgage-backed securities; loans and commitments under the Mortgage Purchase Program; Consolidated Obligations we have issued to finance and hedge these assets; to-be-announced mortgage-backed securities we have sold short to hedge the market risk of Mandatory Delivery Contracts; overnight assets or funding for balancing the portfolio; and allocated capital.
The following table presents the sensitivities of the market value of equity for the mortgage assets portfolio under interest rate shocks (in basis points). Average results are compiled using data for each month end. We allocate equity to this portfolio using the entire balance sheet’s regulatory capital-to-assets ratio. This allocation is not what would necessarily result from an economic allocation of equity to the mortgage assets portfolio but, because it uses the same regulatory capital-to-assets ratio as the entire balance sheet, the results are comparable to the sensitivity results for the entire balance sheet.
% Change in Market Value of Equity—Mortgage Assets Portfolio
                                                         
    Down 200   Down 100   Down 50   Flat Rates   Up 50   Up 100   Up 200
     
Average Results
                                                       
 
                                                       
2009 Full Year
    (25.0 )%      (14.8 )%     (7.5 )%     -       4.0 %     4.0 %     (4.7 )%
 
                                                       
2008 Full Year
    (47.4 )%     (16.5 )%     (5.4 )%     -       (0.4 )%     (4.6 )%     (17.7 )%
 
                                                       
 
 
                                                       
Month-End Results
                                                       
 
                                                       
December 31, 2009
    (8.0 )%     (2.4 )%     (0.7 )%     -       (1.9 )%     (5.8 )%     (17.3 )%
 
                                                       
December 31, 2008
    (49.4 )%     (27.4 )%     (13.4 )%     -       5.2 %     0.8 %     (25.0 )%
The table shows that, for 2009 and 2008, the market risk exposure of the mortgage assets portfolio had similar directional trends across interest rate shocks as those of the entire balance sheet although, as expected, the mortgage assets portfolio had substantially greater risk than the entire balance sheet.
Earnings Volatility
We focus on managing expected and unexpected earnings volatility. An important measure of potential earnings volatility is earnings-at-risk simulations over a multi-year horizon under various interest rate scenarios, balance sheet projections, asset spreads, risk management strategies and sensitivities of mortgage prepayment speeds. We expect our business will continue to generate a competitive return on member stockholders’ capital investment across a wide range of business and market economic environments. The most significant earnings risk occurs from a scenario of a large, rapid and sustained increase in short-term interest rates, especially if coupled with a flatter yield curve, and a scenario of a large, rapid, and sustained decrease in long-term interest rates. Earnings simulations performed during 2009 using a three to five year time horizon indicated that short-term interest rates would have to increase to eight percent or more, and persist for an extended period of time at those levels, before profitability would be uncompetitive.
Use of Derivatives in Market Risk Management
As with our participation in debt issuances, derivatives help us hedge market risk created by Advances and mortgage commitments. Derivatives related to Advances most commonly hedge:
  §   the market risk exposure on Putable and Convertible Advances for which members have sold us options embedded within the Advances;
 
  §   the market risk exposure of options we have sold that are embedded with Advances; and
 
  §   Regular Fixed Rate Advances when it may not be as advantageous to issue Obligations or when it may improve our market risk management.

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We also use derivatives to hedge the market risk created by commitment periods of Mandatory Delivery Contracts in the Mortgage Purchase Program.
Derivatives help us intermediate between the normal preferences of capital market investors for intermediate-and- long-term fixed-rate debt securities and the normal preferences of our members for shorter-term or adjustable-rate Advances. We can satisfy the preferences of both groups by issuing long-term fixed-rate Bonds and entering into an interest rate swap that synthetically converts the Bonds to an adjustable-rate LIBOR funding basis that matches up with the short-term and adjustable-rate Advances, thereby preserving a favorable interest rate spread.
The following table presents the notional principal amounts of the derivatives used to hedge other financial instruments.
                       
            December 31,
(In millions)
          2009     2008
 
Hedged Item
  Hedging Instrument              
 
Consolidated Obligations
  Interest rate swap   $ 15,523     $ 10,140
Convertible Advances
  Interest rate swap     2,816       3,478
Putable Advances
  Interest rate swap     7,037       6,981
Advances with purchased
caps and/or floors
  Interest rate swap           1,400
Regular Fixed Rate Advances
  Interest rate swap     3,469       5,808
Mandatory Delivery
  Commitments to sell to-be-announced              
Contracts
  mortgage-backed securities           386
 
                 
 
Total based on Hedged Item (1)
  $ 28,845     $ 28,193
 
                 
 
(1)   We enter into Mandatory Delivery Contracts (commitments to purchase loans) in the normal course of business and economically hedge them with interest rate forward agreements (commitments to sell to-be-announced mortgage-backed securities). Therefore, the Mandatory Delivery Contracts (which are derivatives) are the objects of the hedge (the Hedged Item) and are not listed as a Hedging Instrument in this table.
The following table presents the notional principal amounts of derivatives according to their accounting treatment and hedge relationship. This table differs from the one above in that it displays all derivatives, including Mandatory Delivery Contracts (the hedged item) and to-be-announced mortgage-backed securities (their hedging instrument).
                   
    December 31,  
(In millions)
  2009     2008  
 
Shortcut (Fair Value) Treatment
               
Advances
  $ 5,733     $ 8,246  
Consolidated Obligations
    450       860  
 
           
 
Total
    6,183       9,106  
 
Long-haul (Fair Value) Treatment
               
Advances
    7,405       7,790  
Consolidated Obligations
    14,873       8,935  
 
           
 
Total
    22,278       16,725  
 
Economic Hedges
               
Advances
    184       1,631  
Consolidated Obligations
    200       345  
Mandatory Delivery Contracts
    79       918  
To-be-announced mortgage-backed securities hedges
          386  
 
           
 
Total
    463       3,280  
 
           
 
Total Derivatives
  $ 28,924     $ 29,111  
 
           

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The overall changes shown did not represent new hedging or risk management strategies or a change in accounting treatment of existing hedges. Interest rate swaps associated with Consolidated Obligations increased in 2009, as we allocated short-term funding needs between these transactions and Discount Notes. The decrease in the amount of Advance hedges (except for Putable Advances) reflects the overall reduction in Advance balances. The increase in long-haul treatment of Consolidated Obligations reflects greater incremental use of these types of derivatives for short-term funding.
Effective July 1, 2009, in light of the continued evolution of more rigid accounting interpretations surrounding shortcut accounting treatment and to minimize the related accounting risk, we decided to account for all new derivatives hedging Advances using the long-haul treatment. We expect this to result in minor additional earnings volatility. An economic hedge is a derivative that hedges a financial instrument but that is deemed to not qualify for hedge accounting treatment. The decrease in economic hedges in 2009 from 2008 was due primarily to the maturity of a large Advance that had been hedged with an interest rate swap and to a reduction in Mandatory Delivery Contracts at year end.
Capital Adequacy
Capital Leverage
Prudent risk management dictates that we maintain effective financial leverage to minimize risk to our capital stock while preserving profitability and that we hold an adequate amount of retained earnings. Pursuant to these objectives, Finance Agency Regulations stipulate that we must comply with three limits on capital leverage and risk-based capital.
  §   We must maintain at least a 4.00 percent minimum regulatory capital-to-assets ratio.
 
  §   We must maintain at least a 5.00 percent minimum leverage ratio of capital divided by total assets, which includes a 1.5 weighting factor applicable to permanent capital. Because all of our Class B stock is permanent capital, this requirement is met automatically if we satisfy the 4.00 percent unweighted capital requirement.
 
  §   We are subject to a risk-based capital rule, as discussed below.
We have always complied with each capital requirement. See the “Capital Resources” section of “Analysis of Financial Condition” for information on the most important requirement, the minimum regulatory capital-to-assets ratio.
Retained Earnings
Our Retained Earnings Policy sets forth a range for the amount of retained earnings we believe is needed to mitigate impairment risk and augment dividend stability in light of the material risks we face. The Policy conservatively establishes a range of adequate retained earnings from $140 million to $285 million, with a target level of $170 million. On December 31, 2009, we had $412 million of retained earnings. Our methodology of establishing thresholds for retained earnings results in a higher amount of required retained earnings than we believe actually is needed to protect against impairment risk. In particular, we assume that all unfavorable scenarios and conditions occur simultaneously, implying that each dollar of retained earnings can serve as protection against only one risk event. This scenario is extremely unlikely to occur. However, we believe that, given the recent financial and regulatory environment, an abundance of caution is prudent and therefore in the last several years we have been carrying a greater amount of retained earnings than required by our policy.
Components of Capital Plan That Promote Capital Adequacy
The GLB Act and our Capital Plan strongly promote the adequacy of our capital to absorb financial losses in three ways:
  §   the five-year redemption period for Class B stock;
 
  §   the option we have to call on members to purchase additional capital if required to preserve safety and soundness; and
 
  §   the limitations on our ability to honor requested redemptions of capital if we are at risk of not maintaining safe and sound operations.
These combine to give member stockholders a clear incentive to require us to minimize our risk profile.

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Risk-Based Capital Regulatory Requirement
We must hold sufficient capital to protect against exposure to market risk, credit risk, and operational risk. The GLB Act and Finance Agency Regulations require total permanent capital, which includes retained earnings and the regulatory amount of Class B capital stock, to be at least equal to the amount of risk-based capital. Risk-based capital is the sum of market risk, credit risk, and operational risk as specified by the Regulations. The following table shows the amount of risk-based capital required based on the measurements, the amount of permanent capital, and the amount of excess permanent capital.
                                                   
(Dollars in millions)   Year End 2009   Monthly Average 2009   Year End 2008
 
Market risk-based capital
    $      116       $      232       $      237  
Credit risk-based capital
    184       216       181  
Operational risk-based capital
    90       134       125  
 
                       
Total risk-based capital requirement
    390       582       543  
Total permanent capital
    4,151       4,417       4,399  
 
                       
Excess permanent capital
    $   3,761       $   3,835       $   3,856  
 
                       
Risk-based capital as a
percent of permanent capital
    9 %     13 %     12 %
 
                       
The risk-based capital calculation has historically not been a constraint on operations and we do not use the risk-based capital requirement to actively manage any of our risks. It has normally ranged from 10 to 20 percent, which is significantly less than the amount of permanent capital. The amount of risk-based capital was at one of its lowest points at the end of 2009 due to volatility in the statistical measurement methods of the market risk component in different market environments and reductions in asset levels which reduced the credit risk requirement. The operational risk requirement decreased at the end of 2009 because that is defined to be 30 percent of the sum of the other two requirements.
Credit Risk
Overview
We assume a substantial amount of inherent credit risk exposure in our dealings with members, purchases of investments, and transactions of derivatives. Credit risk is the risk of monetary loss due to failure of any obligor to meet the terms of any contract with us. Most importantly, credit risk arises from delayed receipt, or no receipt, of principal and interest on assets lent to or purchased from members or investment counterparties, or due to counterparties’ nonpayment of interest due on derivative transactions. We focus on credit risk arising from Advances, loans in the Mortgage Purchase Program, investments, and derivative transactions. For the reasons detailed below, we believe we have a minimal amount of residual credit risk exposure.
Credit Services
Overview. We have numerous policies and practices to manage credit risk exposure from our secured lending activities, which include Advances and Letters of Credit. The objective of our credit risk management is to equalize risk exposure across members and counterparties to a zero level of expected losses. Despite deterioration in the credit conditions of many of our members and in the value of some pledged collateral, we believe that we have a minimal amount of residual credit risk exposure in our secured lending activities. We base this assessment on the following factors:
  §   a conservative approach to collateralizing credit that results in significant over-collateralization. This includes 1) systematically raising collateral margins and collateral status as the financial condition of a member or of the collateral pledged deteriorates, and 2) adjusting collateral margins for subprime and nontraditional mortgage loans that we have identified and determined are not properly underwritten;
 
  §   close monitoring of members’ financial conditions and repayment capacities;
 
  §   a risk focused process for reviewing and verifying the quality, documentation, and administration of pledged loan collateral;
 
  §   our belief that we have a moderate level of exposure to poorly performing subprime and nontraditional mortgages pledged as collateral; and
 
  §   a history of never experiencing a credit loss or delinquency on any Advance.
Because of these factors, we have never established a loan loss reserve for Credit Services.

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Collateral. We require each member to provide us a security interest in eligible collateral before it can undertake any secured borrowing. One of our most important policy parameters is that each member must overcollateralize its borrowings and must maintain borrowing capacity in excess of its credit outstanding. As of December 31, 2009, the over-collateralization resulted in total collateral pledged of $152.2 billion with total borrowing capacity of $100.0 billion. Lower borrowing capacity results after downward adjustments are made to the collateral pledged to recognize collateral risks that may affect its realizable value in the event it must be liquidated. Over-collateralization by one member is not applied to another member.
We assign each member one of four levels of collateral status—Blanket, Securities, Listing, and Physical Delivery— based on our credit rating (described below) that reflects our view of the member’s current financial condition, capitalization, level of problem assets, and other credit risk factors.
Blanket collateral status is the least restrictive and is available for lower risk institutions. We assign it to approximately 85 percent of members and borrowing nonmembers. Under a Blanket status, the borrowing member is not required to provide loan level detail on pledged loans. We monitor eligible collateral pledged under Blanket status using quarterly regulatory financial reports or periodic collateral “Certification” documents submitted by all significant borrowers. Lower risk members that choose not to pledge loan collateral are assigned Securities status. Under Listing collateral status, a member must pledge and provide us information on specifically identified individual loans that meet certain minimum qualifications. Physical Delivery is the most restrictive collateral status, which we assign to members experiencing significant financial difficulties, most insurance companies pledging loans, and newly chartered institutions. We require borrowers assigned to Physical Delivery to deliver into our possession securities and/or original notes, mortgages or deeds of trust. The instruments we accept are highly restrictive and subject to a conservative valuation process.
For insurance company members and for newly chartered institutions, in addition to requiring physical delivery of collateral, we apply more conservative collateral requirements. We generally require insurance companies to deliver us collateral because they do not have the backing of the FDIC or other deposit insurance funds controlled by a regulator. Newly chartered institutions are required to deliver collateral until they have developed a solid financial history that trends strongly towards being profitable.
The table below identifies the major types of collateral we accept and shows the allocation of pledged collateral as of December 31, 2009.
                 
    Percent of Total   Collateral Amount
    Pledged Collateral   ($ Billions)
 
1-4 Family Residential
    62 %     $     94.0  
Home Equity Loans
    18       27.6  
Commercial Real Estate
    9       14.0  
Bond Securities
    9       14.0  
Multi-Family
    2       2.1  
Farm Real Estate
    (a )     0.5  
 
               
 
Total
    100 %     $   152.2  
 
               
 
(a)   Less than one percent of total pledged collateral.
1-4 family residential collateral represents whole first mortgages on residential property or securities representing a whole interest in such mortgages. We value listed and physically delivered loan collateral at the lesser of par or our internally estimated market value. Securities collateral is valued using two third-party providers. The market value of loan collateral pledged under a Blanket status is assumed to equal the outstanding unpaid principal balance.
We determine borrowing capacity against pledged collateral by applying Collateral Maintenance Requirements (CMRs), which are informally referred to as over-collateralization rates or “haircuts.” CMRs are intended to capture market, credit, liquidity, and prepayment risks that may affect the realizable value of each pledged asset in the event we must liquidate collateral. CMRs are percentage adjustments (i.e., discounts) applied to the estimated market value of pledged collateral, and therefore their application results in borrowing capacity that is less than the amount of pledged collateral.

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The discounts are determined by dividing one by the CMR; for example, a CMR of 150 percent translates into a discount of 66.7 percent, which means that 66.7 percent of the market value is eligible for borrowing. The table below shows the range of discounts resulting from the CMR process for each major collateral type segregated by collateral status.
         
    Discount Range
1-4 Family Residential
    57-80 %
Home Equity Loans
    25-67 %
Commercial Real Estate
    20-67 %
Bond Securities
    0-49 %
Multi-Family
    40-80 %
Farm Real Estate
    29-67 %
We believe our CMR process results in conservative adjustments of borrowing capacity for all collateral types. Members and collateral with a higher risk profile, more risky credit quality, and/or less favorable performance are generally subjected to higher CMRs. Loans pledged under a Blanket status generally are haircut more aggressively than loans on which we have detailed loan structure and underwriting information, due to unknown factors which may result in the market value being significantly below the book value of the Blanket loans. In most cases, higher quality assets such as 1-4 family residential mortgage loans must be pledged before we will accept lower quality collateral such as commercial real estate loans.
At December 31, 2009, we had $7,623 million of Advances outstanding to former members that had been acquired by financial institutions who are not members of our FHLBank. Of this amount, $5,709 million is supported by subordination or other intercreditor security agreements with other FHLBanks, totaling $8,566 million of collateral based on our required collateral levels. The remainder is collateralized by $402 million of marketable securities and $2,963 million in loan collateral held in our custody. In accordance with the terms of the subordination agreements, each counterparty FHLBank is required to maintain sufficient collateral to cover our extensions of credit in accordance with the counterparty’s collateral policies and practices, all of which require overcollateralization and periodic verification of collateral levels. Subordination agreements mitigate our risk in the event of default by giving our claim to the value of collateral priority over the interests of the subordinating FHLBank, thus providing an incentive to ensure pledged collateral values are sufficient to cover all parties.
We also have an internal policy that, with certain exceptions granted on a case-by-case basis, we will not extend additional credit to any member (except under the Affordable Housing or the Community Investment and Economic Development Programs) that would result in total borrowings exceeding 50 percent of its total assets.
Perfection. With certain unlikely statutory exceptions, the FHLBank Act affords any security interest granted to us by a member, or by an affiliate of a member, priority over the claims and rights of any party, including any receiver, conservator, trustee, or similar party having rights of a lien creditor. As additional security for members’ indebtedness, we have a statutory lien on their FHLBank capital stock.
We perfect our security interest in collateral by 1) filing financing statements on each member pledging loan collateral, 2) taking possession or control of all pledged securities and cash collateral, and 3) taking physical possession of pledged loan collateral when we deem it appropriate based on a member’s financial condition. In addition, at our discretion and consistent with our Credit Policy, we are permitted to call on members to pledge additional collateral at any time during the life of a borrowing. Credit losses could occur should a regulatory agency, for an unknown reason, prevent us from liquidating our collateral position. Credit risk exposure also exists in cases of fraud by a failing institution or its employees.
Subprime and Nontraditional Mortgage Loan Collateral. We have policies and processes to identify subprime loans pledged by members to which we have high credit risk exposure or have extended significant credit. We perform on-site collateral reviews, sometimes engaging third parties, of members we deem to have high credit risk exposure. The reviews include identification of loans that meet our definitions of subprime and nontraditional. Our definitions of subprime loans and nontraditional mortgage loans (NTM) are expansive and conservative. During the review process, we estimate overall subprime and nontraditional mortgage exposure levels by performing random statistical sampling of residential loans in the members’ pledged portfolios.

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We have instituted a multi-year program to review all members for exposure to subprime and nontraditional collateral. The members on which we have performed on-site credit reviews to date have encompassed approximately half of the residential mortgage collateral pledged. Based on these reviews, we estimate that approximately 20 to 25 percent of pledged residential loan collateral has one or more subprime characteristics. Although we have estimated NTM exposure for some members, due to the fact this is a relatively new process, we have not yet reviewed a sufficient number of members to offer a statistically valid estimate of exposure.
We raise CMRs by up to 50 additional percentage points for the identified subprime and/or NTM segment of each pledged loan portfolio. We also apply separate adjustments to CMRs for pledged private-label residential mortgage-backed securities for which there is available information on subprime loan collateral. No security known to have more than one-third subprime collateral is eligible for pledge to support additional credit borrowings.
Internal Credit Ratings of Members. We assign each borrower an internal credit rating, based on a combination of internal credit analysis and consideration of available credit ratings from independent credit rating organizations. Analysis focuses on asset quality, financial performance and earnings quality, liquidity, and capital adequacy. In addition to the credit ratings process, we perform ongoing analyses of institutions that pose elevated credit risk, including problem institutions, insurance companies, and large borrowers. The following tables show the distribution of internal credit ratings we assigned to member and non-member borrowers.
December 31, 2009
     (Dollars in billions)
                                                   
        All Members and Borrowing                
        Nonmembers       All Borrowers
            Collateral-Based             Credit   Collateral-Based
Credit       Borrowing               Services   Borrowing
   Rating      Number Capacity       Number   Outstanding   Capacity
  1     66   $ 2.1    
 
    37     $ 0.3     $ 1.1
  2     129     36.6    
 
    82       14.4       35.9
  3     155     9.8    
 
    116       4.0       9.1
  4     202     39.7    
 
    176       15.6       39.3
  5     71     6.5    
 
    60       1.6       6.4
  6     80     3.3    
 
    73       2.4       3.3
  7     45     2.0    
 
    41       1.2       1.9
                         
Total   748   $ 100.0    
 
    585            $      39.5            $ 97.0
                         
                   
 
                     
December 31, 2008                                  
                   
 
                     
(Dollars in billions)
                                 
                   
 
                     
        All Members and Borrowing                
        Nonmembers       All Borrowers
            Collateral-Based             Credit   Collateral-Based
Credit       Borrowing               Services   Borrowing
   Rating      Number Capacity       Number   Outstanding   Capacity
  1     103   $ 32.7    
 
    69     $ 22.1     $ 31.8
  2     149     5.8    
 
    107       2.4       5.2
  3     223     23.9    
 
    196       15.3       23.4
  4     165     23.5    
 
    142       9.0       23.2
  5     35     10.1    
 
    26       7.2       10.0
  6     49     2.6    
 
    46       1.8       2.5
  7     16     4.5    
 
    14       2.9       4.5
                         
Total   740   $ 103.1    
 
    600     $ 60.7     $ 100.6
                         
The left table shows the borrowing capacity (Advances and Letters of Credit) of both members and non-member borrowers. The right side includes only institutions with outstanding credit activity, which includes Advances and Letter of Credit obligations, along with their total borrowing capacity. The lower the numerical rating, the higher our assessment of the member’s credit quality. A “4” rating is our assessment of the lowest level of satisfactory performance.

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Table of Contents

Many of our members continue to be unfavorably affected by the recent financial crisis, which has resulted in a continuing significant downward trend in our member credit ratings. This trend began in the second half of 2007 and accelerated throughout 2008 and 2009. As of December 31, 2009, 196 members and borrowing nonmembers (26 percent of the total) had credit ratings of 5 or below, with $11.8 billion of borrowing capacity. Between the end of 2007, when the recession and financial crisis began, and year-end 2009, we moved a net of 153 institutions and $5.0 billion of borrowing capacity into one of the three lowest credit rating categories, and there was a substantial movement (a net of 87) of members into the fourth highest rating category. The small amount of borrowing capacity at the end of 2009 for the 66 members and borrowing nonmembers with the highest credit rating reflects the fact that these are all small financial institutions.
A lower internal credit rating can cause us to 1) decrease the institution’s borrowing capacity via a higher collateral maintenance requirement, 2) require it to provide an increased level of detail on pledged collateral, 3) require it to deliver collateral to us in custody, and/or 4) prompt us to more closely and/or frequently monitor the institution using several established processes. The underwriting is largely performed in advance of individual extensions of credit and is reflected in an institution’s maximum borrowing capacity and, in some cases, maturity limits.
Member Failures, Closure, and Receiverships. Although nationwide in 2009 there were over 140 failures or FDIC closures of financial institutions, only two member institutions in o