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EX-32.2 - EXHIBIT 32.2 - Federal Home Loan Bank of Des Moinesc97831exv32w2.htm
EX-31.1 - EXHIBIT 31.1 - Federal Home Loan Bank of Des Moinesc97831exv31w1.htm
EX-12.1 - EXHIBIT 12.1 - Federal Home Loan Bank of Des Moinesc97831exv12w1.htm
EX-10.7 - EXHIBIT 10.7 - Federal Home Loan Bank of Des Moinesc97831exv10w7.htm
EX-31.2 - EXHIBIT 31.2 - Federal Home Loan Bank of Des Moinesc97831exv31w2.htm
EX-32.1 - EXHIBIT 32.1 - Federal Home Loan Bank of Des Moinesc97831exv32w1.htm
EX-10.5 - EXHIBIT 10.5 - Federal Home Loan Bank of Des Moinesc97831exv10w5.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
Commission File Number: 000-51999
 
FEDERAL HOME LOAN BANK OF DES MOINES
(Exact name of registrant as specified in its charter)
     
Federally chartered corporation
(State or other jurisdiction of incorporation or organization)
  42-6000149
(I.R.S. employer identification number)
     
Skywalk Level
801 Walnut Street, Suite 200
Des Moines, IA

(Address of principal executive offices)
  50309
(Zip code)
Registrant’s telephone number, including area code: (515) 281-1000
 
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
Name of Each Exchange on Which Registered: None
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) of the Act. 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 (s 229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment of this Form 10-K. þ
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):
             
Large accelerated filer o   Accelerated filer o   Non-accelerated filer þ   Smaller reporting company o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). o Yes þ No
Registrant’s stock is not publicly traded and is only issued to members of the registrant. Such stock is issued and redeemed at par value, $100 per share, subject to certain regulatory and statutory limits. At June 30, 2009, the aggregate par value of the stock held by members of the registrant was approximately $2,923,406,000. At February 28, 2010, 23,883,944 shares of stock were outstanding.
 
 

 

 


 

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 Exhibit 10.5
 Exhibit 10.7
 Exhibit 12.1
 Exhibit 31.1
 Exhibit 31.2
 Exhibit 32.1
 Exhibit 32.2

 

 


Table of Contents

SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS
Statements contained in this annual report on Form 10-K, including statements describing objectives, projections, estimates, or future predictions in our operations, may be forward-looking statements. These statements may be identified by the use of forward-looking terminology, such as believes, projects, expects, anticipates, estimates, intends, strategy, plan, may, and will or their negatives or other variations on these terms. By their nature, forward-looking statements involve risk or uncertainty, and actual results could differ materially from those expressed or implied or could affect the extent to which a particular objective, projection, estimate, or prediction is realized. These risks and uncertainties include, but are not limited to, the following:
    Economic and market conditions;
 
    Demand for our advances;
 
    Timing and volume of market activity;
 
    The volume of eligible mortgage loans originated and sold to us by participating members through the Mortgage Partnership Finance (MPF) program (Mortgage Partnership Finance and MPF are registered trademarks of the FHLBank of Chicago);
 
    Volatility of market prices, rates, and indices that could affect the value of financial instruments or our ability to liquidate collateral expediently in the event of a default by an obligor;
 
    Political events, including legislative, regulatory, judicial, or other developments that affect us, our members, our counterparties, and/or our investors in the consolidated obligations of the 12 Federal Home Loan Banks (FHLBanks);
 
    Changes in the terms and investor demand for derivatives and similar instruments;
 
    Changes in the relative attractiveness of consolidated obligations as compared to other investment opportunities such as existing and newly created debt programs explicitly guaranteed by the U.S. Government;
 
    Risks related to the other 11 FHLBanks that could trigger our joint and several liability for debt issued by the other 11 FHLBanks; and
 
    Member failures.
We undertake no obligation to update or revise publicly any forward-looking statements, whether as a result of new information, future events, or otherwise. A detailed discussion of the risks and uncertainties that could cause actual results and events to differ from such forward-looking statements is included under “Item 1A. Risk Factors.”

 

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PART I
ITEM 1 — BUSINESS
Overview
The Federal Home Loan Bank of Des Moines (the Bank, we, us, or our) is a federally chartered corporation organized on October 31, 1932, that is exempt from all federal, state, and local taxation except real property taxes and is one of 12 district FHLBanks. The FHLBanks were created under the authority of the Federal Home Loan Bank Act of 1932 (FHLBank Act), which was amended by the Housing and Economic Recovery Act of 2008 (Housing Act). The FHLBanks are regulated by the Federal Housing Finance Agency (Finance Agency), whose mission is to provide effective supervision, regulation, and housing mission oversight of the FHLBanks to promote their safety and soundness, support housing and finance and affordable housing, and support a stable and liquid mortgage market. The Finance Agency establishes policies and regulations governing the operations of the FHLBanks. Each FHLBank operates as a separate entity with its own management, employees, and board of directors.
We are a cooperative. This means we are owned by our customers, whom we call members. Our members may include commercial banks, savings institutions, credit unions, insurance companies, and community development financial institutions (CDFIs) in Iowa, Minnesota, Missouri, North Dakota, and South Dakota. While not considered members, we also do business with state and local housing associates meeting certain statutory criteria.
Business Model
Our mission is to provide funding and liquidity for our members and eligible housing associates by providing a stable source of short- and long-term funding through advances, standby letters of credit, mortgage purchases, and targeted housing and economic development activities. Our vision is to be the preferred financial provider of our members in meeting the housing and economic development needs of the communities we serve together. We strive to achieve our vision within an operating principle that balances the trade-off between attractively priced products, reasonable returns on capital investments (dividends), and maintaining adequate capital and retained earnings based on the Bank’s risk profile as well as to support safe and sound business operations.
As a condition of membership, all of our members must purchase and maintain membership capital stock based on a percentage of their total assets as of the preceding December 31st. Each member is also required to purchase and maintain activity-based capital stock to support certain business activities with us. While eligible to borrow, housing associates are not members and, as such are not permitted to purchase capital stock. Our capital stock is not publicly traded and does not change in value. It is purchased by members at a par value of $100 per share and is redeemed by members at $100 per share. All stockholders are eligible to receive dividends on their capital investment when declared.

 

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Our primary source of funding and liquidity is the issuance of the FHLBank System’s unsecured debt securities, referred to as consolidated obligations, in the capital markets. Consolidated obligations are the joint and several obligations of all 12 FHLBanks, backed only by the financial resources of the 12 FHLBanks. A critical component to the success of our operations is the ability to issue debt securities regularly and frequently in the capital markets under a wide range of maturities, structures, and amounts, and at relatively favorable spreads to market interest rates, represented by U.S. Treasury securities and the London Interbank Offered Rate (LIBOR), compared to many other financial institutions.
Liquidity is also provided through our investment portfolio. Among other permissible investments, we invest in highly rated debt securities of financial institutions and the U.S. Government and in mortgage-related securities. In addition to liquidity, our investments provide income, support the business needs of our members, and support the housing market through the purchase of mortgage-related securities.
We manage our credit risk and establish collateral requirements to support safe and sound business operations. We manage this risk for our advance products by obtaining and maintaining security interests in eligible collateral, setting restrictions on borrowings, and performing continuous monitoring of borrowings and members’ financial condition. We also manage the credit risk on our mortgage loan portfolio by monitoring portfolio performance and the creditworthiness of our participating members. All loans we purchase must comply with underwriting guidelines which follow standards generally required in the conventional conforming mortgage market. Our MPF program involves several layers of legal loss protection including homeowner equity, credit risk sharing responsibilities between the Bank and our participating members, and mortgage insurance requirements. We manage counterparty credit risk related to derivatives and investments by transacting with highly rated counterparties, using master netting and bilateral collateral agreements for derivative counterparties, establishing collateral delivery requirements, and monitoring counterparty creditworthiness through internal and external analysis.
Our net income is attributable to the difference between the interest income we earn on our advances, mortgage loans, and investments and the interest expense we pay on our consolidated obligations and member deposits, as well as components of other income (loss) (i.e., gains and losses on derivative and hedging activities, investments, and debt extinguishments). We operate with narrow margins and expect to be profitable over the long-term based on our prudent lending standards, conservative investment strategies, and diligent risk management practices. Because we operate with narrow margins, our net income is sensitive to changes in market conditions that impact the interest we earn and pay.

 

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A portion of our annual earnings is used to make interest payments on debt issued by the Resolution Funding Corporation (REFCORP). REFCORP debt was issued by the U.S. Treasury to resolve troubled savings and loan institutions in the late 1980s and early 1990s. Additionally, by regulation, we are required to contribute ten percent of net earnings (net earnings represents income before assessments, and before interest expense on mandatorily redeemable capital stock, but after the assessment for REFCORP) each year to the Affordable Housing Program (AHP). Through the AHP, we provide grants and subsidized advances to members to support housing for households with incomes at or below 80 percent of the area median.
Our business model supports our mission and vision and is designed to be flexible in differing market conditions. For example, the recent financial crisis and continued market instability and volatility in 2009 presented both challenges and opportunities to our business model. Demand for our advance business declined in 2009 due to the availability of alternative funding options to our members as well as their increased deposit bases. Attractive short-term investment opportunities were limited due to the low interest rate environment and liquidity demand in the marketplace. We experienced a higher cost of long-term debt due to investors’ desires to primarily invest in shorter terms. Despite the challenges discussed above, longer-term investment opportunities were available as a result of government initiatives created to stimulate the economy, increasing the availability of higher-yielding, low risk investments. In addition, the low interest rate environment provided us with an opportunity to extinguish certain higher-cost debt and replace most of the debt with lower-cost debt.
The credit and liquidity crisis during 2009 also presented many challenges from a credit risk perspective. Due to our conservative collateral practices, counterparty monitoring, and risk mitigation tools, we did not experience any credit losses in 2009 on our advance portfolio, and only minimal credit related losses on our MPF portfolio.
The Bank concluded 2009 with net income totaling $145.9 million compared with $127.4 million for the same period in 2008. For additional discussion, refer to “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operation.”
Membership
Our membership is diverse and includes both small and large commercial banks, savings and loan associations, credit unions, and insurance companies. CDFIs were approved by the Finance Agency to apply for membership on February 4, 2010. The majority of institutions in our five-state district eligible for membership are currently members.
Our membership level declined as the number of members who consolidated or failed exceeded new membership. During 2009, while 18 financial institutions became members, we lost 27 members due to mergers and acquisitions out of district and ten members due to bank failures.

 

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The following table summarizes our membership, by type of institution, at December 31, 2009, 2008, and 2007:
                         
Institutional Entity   2009     2008     2007  
 
                       
Commercial Banks
    1,049       1,072       1,077  
Savings and Loan Associations
    73       77       77  
Credit Unions
    64       60       58  
Insurance Companies
    40       36       31  
 
                 
 
                       
Total members
    1,226       1,245       1,243  
 
                 
The following table summarizes our membership, by type of institution and asset size, for 2009, 2008, and 2007:
                         
Membership Asset Size   2009     2008     2007  
 
                       
Depository Institutions1
                       
Less than $100 million
    44.5 %     47.4 %     50.7 %
$100 million to $500 million
    41.8       40.2       38.5  
Greater than $500 million
    10.5       9.5       8.3  
Insurance Companies
                       
Less than $100 million
    0.2       0.3       0.3  
$100 million to $500 million
    0.7       0.7       0.7  
Greater than $500 million
    2.3       1.9       1.5  
 
                 
 
                       
Total
    100.0 %     100.0 %     100.0 %
 
                 
     
1   Depository institutions consist of commercial banks, savings and loan associations, and credit unions.
At December 31, 2009, 2008, and 2007, approximately 88 percent, 90 percent, and 91 percent of our members were Community Financial Institutions (CFIs). CFIs are defined under the Housing Act to include all Federal Deposit Insurance Corporation (FDIC) insured institutions with average total assets over the three prior years equal to or less than $1.0 billion. Beginning January 1, 2010, the Finance Agency adjusted the average total asset cap to $1.029 billion. Institutions designated as CFIs may pledge certain collateral types other members are not permitted to pledge, such as small business, small agri-business, and small farm loans.

 

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Business Segments
We have identified two primary operating segments based on our products and services as well as our method of internal reporting: Member Finance and Mortgage Finance.
The Member Finance segment includes advances, investments (excluding mortgage-backed securities (MBS), Housing Finance Authority (HFA) investments, and Small Business Administration (SBA) investments), and the funding and hedging instruments related to those assets. Member deposits are also included in this segment. Net interest income for the Member Finance Segment is derived primarily from the difference, or spread, between the yield on the assets in this segment and the cost of the member deposit and funding related to those assets.
The Mortgage Finance segment includes mortgage loans purchased through the MPF program, MBS, HFA investments, and SBA investments and the funding and hedging instruments related to those assets. Net interest income for the Mortgage Finance segment is derived primarily from the difference, or spread between the yield on these assets and the cost of the funding related to those assets.
Capital is allocated to the Member Finance and Mortgage Finance segments based on each segment’s amount of capital stock, retained earnings, and accumulated other comprehensive loss.
We evaluate performance of our segments based on adjusted net interest income after providing for a mortgage loan credit loss provision. Adjusted net interest income includes the interest income and expense on economic hedge relationships included in other income (loss) and concession expense on fair value option bonds included in other expense and excludes basis adjustment amortization/accretion on called and extinguished debt included in interest expense.
For further discussion of these business segments, see “Item 8. Financial Statements and Supplementary Data — Note 17 — Segment Information” and “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operation — Results of Operations — Net Interest Income by Segment.”
Products and Services — Member Finance
Advances
We carry out our mission primarily through lending funds which we call advances to our members and eligible housing associates (collectively, borrowers). These advances are secured by eligible collateral.

 

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Borrowers use our various advance products as sources of funding for mortgage lending, affordable housing and other community lending (including economic development), and general asset-liability management. Advances are also used by CFIs for loans to small businesses, small farms, and small agribusinesses. Additionally, advances can provide competitively priced wholesale funding to borrowers who may lack diverse funding sources. Our primary advance products include the following:
    Overnight advances are used primarily to fund the short-term liquidity needs of our borrowers. These advances are automatically renewed until the borrower pays off the advances. Interest rates are set daily.
 
    Fixed rate advances are available over a variety of terms to meet borrower needs. Short-term fixed rate advances are used primarily to fund the short-term liquidity needs of our borrowers. Long-term fixed rate advances are an effective tool to help manage long-term lending and investment risks of our borrowers.
 
    Variable rate advances provide a source of short- and long-term financing where the interest rate changes in relation to a specified interest rate index such as LIBOR.
 
    Callable advances may be prepaid by the borrower on pertinent dates (call dates). Mortgage matched advances are a type of callable advance with fixed rates and amortizing balances. Using a mortgage matched advance, a borrower may make predetermined principal payments at scheduled intervals throughout the term of the loan to manage the interest rate risk associated with long-term fixed rate assets. Also included in callable advances are fixed and variable rate member owned option advances that are non-amortizing. Member owned option advances provide borrowers a source of long-term financing with prepayment flexibility.
 
    Putable advances may, at our discretion, be terminated at predetermined dates prior to the stated maturity dates of the advances and the borrower is required to repay the advance. Should an advance be terminated, replacement funding at then current market rates and terms is offered, based on our available advance products and subject to our normal credit and collateral requirements. A putable advance carries an interest rate lower than a comparable maturity advance that does not have the putable feature.
 
    Community investment advances are below-market rate funds used by borrowers in both affordable housing projects and community development. These advances are provided at interest rates that represent our cost of funds plus a markup to cover our administrative expenses. This markup is determined by our Asset-Liability Committee. Our Board of Directors annually establishes limits on the total amount of funds available for community investment advances and the total amount of community investment advances that may be outstanding at any point in time.
For additional information on advances, including our largest borrowers, see “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operation — Statements of Condition — Advances.”

 

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Housing Associates
The FHLBank Act permits us to make advances to eligible housing associates. Housing associates are approved mortgagees under Title II of the National Housing Act that meet certain criteria, including: chartered under law and have succession; subject to inspection and supervision by some governmental agency; and lending their own funds as their principal activity in the mortgage field. Because housing associates are not members, they are not subject to certain provisions of the FHLBank Act applicable to members and cannot own our capital stock. The same regulatory lending requirements that apply to our members generally apply to housing associates. Because housing associates are not members, eligible collateral is limited to Federal Housing Administration (FHA) mortgages or Government National Mortgage Association (Ginnie Mae) securities backed by FHA mortgages for pledged collateral. State housing associates may pledge additional collateral such as cash deposited in the Bank, or certain residential mortgage loans, including securities backed by such mortgages, for advances facilitating residential or commercial mortgage lending to benefit low- and moderate-income individuals or families.
Prepayment Fees
We price advances at a spread over our cost of funds. We may charge a prepayment fee for advances that terminate prior to their stated maturity or outside a predetermined call or put date. The fees charged are priced to make us economically indifferent to the prepayment of the advance.
Collateral
We are required by regulation to obtain and maintain a security interest in eligible collateral at the time we originate or renew an advance and throughout the life of the advance. Eligible collateral includes whole first mortgages on improved residential property or securities representing a whole interest in such mortgages; securities issued, insured, or guaranteed by the U.S. Government or any of the government-sponsored housing enterprises (GSE), including without limitation MBS issued or guaranteed by Federal National Mortgage Association (Fannie Mae), Federal Home Loan Mortgage Corporation (Freddie Mac), or Ginnie Mae; cash deposited with us; guaranteed student loans made under the Department of Education’s Federal Family Education Loan Program (FFELP); and other real estate-related collateral, acceptable by us provided such collateral has a readily ascertainable value and we can perfect a security interest in such property. Additionally, CFIs may pledge collateral consisting of secured small business, small farm, or small agribusiness loans, including secured business and agri-business lines of credit. As additional security, the FHLBank Act provides that we have a lien on each borrower’s capital stock in the Bank; however, capital stock cannot be pledged as collateral to secure credit exposures.

 

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Under the FHLBank Act, any security interest granted to us by any of our members, or any affiliate of any such member, has priority over the claims and rights of any party (including any receiver, conservator, trustee, or similar party having the rights of a lien creditor), other than claims and rights that (i) would be entitled to priority under otherwise applicable law and (ii) are held by actual bona fide purchasers for value or by parties secured by actual perfected security interests. We perfect our security interest in accordance with applicable state laws by filing Uniform Commercial Code financing statements or taking possession of collateral.
We generally make advances to borrowers under a blanket lien, which grants us a security interest in all eligible assets of the member to fully secure the member’s indebtedness to us. We generally perfect our security interest in the collateral pledged. Other than securities collateral and cash deposits, we do not initially take delivery of collateral pledged by blanket lien borrowers. In the event of deterioration in the financial condition of a blanket lien borrower, we have the ability to require delivery of pledged collateral sufficient to secure the borrower’s indebtedness to us.
With respect to nonblanket lien borrowers (typically insurance companies and housing associates), we generally take control of collateral through the delivery of cash, securities or mortgages to us or our custodian. For additional information on our collateral requirements, refer to “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operation — Risk Management — Credit Risk — Advances.”
Standby Letters of Credit
We issue letters of credit on behalf of our members and housing associates to facilitate business transactions with third parties. Letters of credit may be used to facilitate residential housing finance or other housing activity, facilitate community lending, assist with asset-liability management, and support tax-exempt state and local bond issuances. Members and housing associates must fully collateralize letters of credit with eligible collateral.
Investments
The Member Finance investment portfolio is comprised of both short- and long-term investments. Our short-term portfolio includes, but is not limited to, interest bearing deposits, Federal funds, commercial paper, obligations of GSEs, and securities purchased under agreements to resell. Our long-term portfolio includes, but is not limited to, obligations of GSEs and state and local housing associates as well as Temporary Liquidity Guarantee Program (TLGP) debt and bonds issued by municipalities or agencies under the Build America Bond program. The longer-term investment portfolio generally provides higher returns than those available in the short-term money markets.

 

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Under Finance Agency regulations, we are prohibited from investing in certain types of securities, including:
    Instruments such as common stock that represent an ownership interest in an entity other than stock in small business investment companies and certain investments targeted to low income persons or communities.
 
    Instruments issued by non-U.S. entities other than those issued by U.S. branches and agency offices of foreign commercial banks.
 
    Noninvestment-grade debt instruments other than certain investments targeted to low income persons or communities and instruments downgraded after we purchased them.
 
    Non-U.S. dollar securities.
We do not have any subsidiaries. With the exception of a limited partnership interest in Small Business Investment Company (SBIC), we have no equity position in any partnerships, corporations, or off-balance sheet special purpose entities. Our investment in SBIC was $3.8 million at December 31, 2009.
Deposits
We accept deposits from our members and housing associates. We offer several types of deposit programs, including demand, overnight, and term deposits. Deposit programs provide us funding while providing members a low-risk interest earning asset.
Products and Services — Mortgage Finance
Mortgage Loans
We invest in mortgage loans through the MPF program, which is a secondary mortgage market structure under which we purchase eligible mortgage loans from participating financial institution members (PFIs) (MPF loans). The FHLBank of Chicago (MPF Provider) developed the MPF program in order to help fulfill the housing mission of the FHLBanks.
MPF loans are conforming conventional and government-insured (i.e., insured or guaranteed by the FHA, Veterans Administration, and U.S. Department of Agriculture) fixed rate mortgage loans secured by one-to-four family residential properties with maturities ranging from five to 30 years. We may also purchase MPF loans through participations with other FHLBanks.

 

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Participating Financial Institution Agreement
Our members (or eligible housing associates) must apply to become a PFI. We review the general eligibility of the member’s servicing qualifications and ability to supply documents, data, and reports required to be delivered by PFIs under the MPF program. We also review the member’s financial condition as it relates to their ability to meet the obligations of a PFI. The member and the Bank sign an MPF program PFI Agreement creating a relationship framework for the PFI to do business with us. The PFI Agreement provides the terms and conditions for the origination of the MPF loans to be purchased by us and establishes the terms and conditions for servicing the MPF loans.
Typically, a PFI will sign a master commitment to cover all the conventional MPF loans it intends to deliver to us in a year or other time period specified in the master commitment agreement. However, a PFI may also sign a master commitment for original MPF government loans and choose to deliver MPF loans under more than one conventional product, or it may choose to use different servicing options and have several master commitments opened at any one time. Master commitments may be for shorter periods than one year and may be extended or increased by agreement of us and the PFI up to a maximum of two years.
Under the Finance Agency’s Acquired Member Asset regulation, the PFI must “bear the economic consequences” of certain losses with respect to a master commitment based upon the MPF product and other criteria. To comply with these regulations, MPF purchases and fundings are structured so the credit risk associated with MPF loans is shared with PFIs. The master commitment defines the pool of MPF loans for which the credit enhancement obligation is set so the risk associated with investing in such pool of MPF loans is equivalent to investing in an AA rated asset. See discussion in “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operation — Risk Management — Credit Risk — Mortgage Assets.”
MPF Loan Types
There are currently six MPF loan products from which PFIs may choose. Four of these products (Original MPF, MPF 125, MPF Plus, and Original MPF Government) are closed loan products in which we purchase loans acquired or closed by the PFI. MPF 100 is a loan product in which we “table fund” MPF loans; that is, we provide the funds through the PFI as our agent to make the MPF loan to the borrower. Additionally, effective February 26, 2009, the MPF program was expanded to include an off-balance sheet product called MPF Xtra (MPF Xtra is a trademark of the FHLBank of Chicago). Under this product, we assign 100 percent of our interest in PFI master commitments to the FHLBank of Chicago. The FHLBank of Chicago then purchases mortgage loans from our PFIs and sells those loans to Fannie Mae. Only PFIs retaining servicing for their MPF loans are eligible for the MPF Xtra product.

 

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Under all of the above MPF loan products, the PFI performs all traditional retail loan origination functions. With respect to the MPF 100 product, we are considered the originator of the MPF loan for accounting purposes since the PFI is acting as our agent when originating the MPF loan; however, we do not collect any origination fees.
The MPF program is designed to allocate the risks of MPF loans among the MPF Banks and PFIs and to take advantage of the PFIs’ strengths. PFIs have direct knowledge of their mortgage markets and have developed expertise in underwriting and servicing residential mortgage loans. By allowing PFIs to originate MPF loans, whether through retail or wholesale operations, the MPF program gives the PFIs control of these functions that most impact credit quality. The Finance Agency requires all pools of MPF loans to have a credit risk sharing arrangement with our PFIs limiting our credit risk exposure to an AA or higher investment grade instrument from a nationally recognized statistical rating organization (NRSRO). The MPF Banks are responsible for managing the interest rate risk, prepayment risk, and liquidity risk associated with owning MPF loans.
For conventional MPF loan products, PFIs retain a portion of the credit risk on the MPF loans they fund and sell to an MPF Bank by providing credit enhancement either through a direct liability to pay credit losses up to a specified amount or through a contractual obligation to provide supplemental mortgage insurance (SMI). The PFI’s maximum credit enhancement obligation for MPF loan losses is specified in the master commitment. PFIs are paid a credit enhancement fee for managing credit risk, and in some instances all or a portion of the credit enhancement fee may be performance based. We utilize an allowance for credit losses to absorb any credit related losses we may incur.
For a detailed discussion and analysis of our mortgage portfolio, see “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operation — Statements of Condition — Mortgage Loans.” A detailed discussion of the different MPF loan products we offer and their related credit risk is provided in “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operation — Risk Management — Credit Risk — Mortgage Assets.”
MPF Provider
The MPF Provider maintains the structure of MPF loan products and the eligibility rules for MPF loans as established by the FHLBanks participating in the MPF program. In addition, the MPF Provider manages the pricing and delivery mechanism for MPF loans and the back-office processing of MPF loans in its role as master servicer and master custodian. The MPF Provider has engaged Wells Fargo Bank N.A. (Wells Fargo) as the vendor for master servicing and as the primary custodian for the MPF program. The MPF Provider has also contracted with other custodians meeting MPF program eligibility standards at the request of certain PFIs.
The MPF Provider publishes and maintains the MPF Origination Guide, MPF Underwriting Guide, and MPF Servicing Guide, which detail the requirements PFIs must follow in originating, underwriting, or selling and servicing MPF loans. The MPF Provider maintains the infrastructure through which MPF Banks may fund or purchase MPF loans through their PFIs. In exchange for providing these services, the MPF Provider receives a fee from each of the MPF Banks.

 

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The FHLBanks established an MPF program Governance Committee comprised of representatives from each of the six participating MPF Banks. The Governance Committee provides guidance for the strategic decisions of the MPF program, including but not limited to, changes in pricing methodology. All day-to-day policy and operating decisions remain the responsibility of the MPF Provider.
MPF Servicing
PFIs selling MPF loans may either retain the servicing or transfer the servicing (excluding MPF Xtra). If a PFI chooses to retain the servicing, they receive a servicing fee to manage the servicing activities. If the PFI chooses to transfer servicing rights to an approved third-party provider, the servicing is transferred concurrently with the sale of the MPF loan to us and the servicing fee is paid to the third-party provider.
Throughout the servicing process, the master servicer monitors the PFI’s compliance with MPF program requirements and makes periodic reports to the MPF Provider.
Loan Modifications
Effective August 1, 2009, we introduced a temporary loan payment modification plan for participating PFIs, which will be available until December 31, 2011. Homeowners with conventional loans secured by their primary residence originated prior to January 1, 2009 are eligible for the modification plan. This modification plan is available to homeowners currently in default or imminent danger of default. The modification plan states specific eligibility requirements that must be met and procedures the PFIs must follow to participate in the modification plan.
Investments
The Mortgage Finance investment portfolio includes investments in MBS, HFA securities, and SBA securities. By regulation, we are permitted to invest in the following asset types, among others:
    Obligations, participations, or other instruments of or issued by Fannie Mae or Ginnie Mae.
 
    Mortgages, obligations, or other securities that are, or ever have been, sold by Freddie Mac pursuant to 12 U.S.C. 1454 or 1455.
 
    Instruments we determined are permissible investments for fiduciary or trust funds under the laws of the state of Iowa.
We limit our investments in MBS to those guaranteed by the U.S. Government, issued by a GSE, or that carry the highest investment grade rating by any NRSRO at the time of purchase.

 

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We participated in the MPF shared funding program, which provides a means to distribute both the benefits and the risks of the mortgage loans among a number of parties. Under the MPF shared funding program, a participating member of the FHLBank of Chicago sponsored a trust (trust sponsor) and transferred into the trust loans eligible to be MPF loans that the participating member of the FHLBank of Chicago originated or acquired. Upon transfer of the assets into the trust, the trust issued certificates with tranches that have credit risk characteristics consistent with the MPF program policy and are compliant with the applicable regulations. The tranches are backed by the underlying mortgage loans and all or nearly all of the tranches receive public credit ratings determined by an NRSRO.
The senior tranches (A Certificates) have a credit rating of AA or AAA and may have different interest rate risk profiles and durations. The A Certificates, which may be structured to present risk and investment characteristics attractive to different types of investors, were sold to the FHLBank of Chicago, either directly by the trust or by the trust sponsor. The lower-rated tranches (B Certificates) provide the credit enhancement for the A Certificates and are sold to the trust sponsor. The FHLBank of Chicago may subsequently sell some or all of its A Certificates to its members and other FHLBanks and their members. We purchased A Certificates of the MPF shared funding program and hold approximately $33.2 million at December 31, 2009. No residuals are created or retained on the Statements of Condition of the FHLBank of Chicago or any other FHLBank.
Under Finance Agency regulations, we are prohibited from investing in whole mortgages or other whole loans other than:
    those acquired under our MPF program described above.
 
    certain investments targeted to low income persons or communities.
 
    certain marketable direct obligations of state, local, or tribal government units or agencies having at least the second highest credit rating from an NRSRO.
 
    MBS or asset-backed securities backed by manufactured housing loans or home equity loans.
 
    certain foreign housing loans authorized under section 12(b) of the FHLBank Act.

 

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The Finance Agency’s Financial Management Policy (FMP) further limits our investment in MBS and asset-backed securities. This policy requires the total book value of our MBS owned to not exceed 300 percent of our capital at the time of purchase. The Finance Agency has excluded MPF shared funding certificates from this FMP limit. The Finance Agency passed a resolution on March 24, 2008, authorizing the FHLBanks to increase their purchases of agency MBS from 300 percent of regulatory capital to 600 percent of regulatory capital, effective until March 31, 2010. In 2008, our Board approved a strategy to increase our investments in additional agency MBS in accordance with the Finance Agency resolution up to 450 percent of regulatory capital. At December 31, 2009 and 2008 the book value of our MBS owned, excluding MPF shared funding certificates, represented approximately 380 percent and 292 percent of regulatory capital.
We are prohibited from purchasing the following types of securities:
    Interest-only or principal-only stripped MBS.
 
    Residual interest or interest accrual classes of collateralized mortgage obligations and real estate mortgage investment conduits.
 
    Fixed rate or variable rate MBS, collateralized mortgage obligations, and real estate mortgage investment conduits that on the trade date are at rates equal to their contractual caps and have average lives varying by more than six years under an assumed instantaneous interest rate change of plus or minus 300 basis points.
Standby Bond Purchase Agreements
We enter into standby bond purchase agreements with housing associates within our district whereby we agree to purchase HFA bonds under circumstances defined in each agreement. We may be requested to hold investments in the HFA bonds until the designated remarketing agent can find a suitable investor or the housing associate repurchases the bonds according to a schedule established by the standby agreement. When purchased, these HFA bonds are classified as available-for-sale investments in the Statements of Condition. The bond purchase commitments entered into by us expire after seven years, currently no later than 2016. For additional details on our standby bond purchase agreements, refer to “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operation — Off-Balance Sheet Arrangements.”
Products and Services — Member Finance and Mortgage Finance
We use consolidated obligations and derivatives in the same manner for both Member Finance and Mortgage Finance as part of our funding and interest rate risk management strategies.

 

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Consolidated Obligations
Our primary source of funds to support our business is the sale of consolidated obligations in the capital markets. Consolidated obligations are the joint and several obligations of, and are backed only by the financial resources of the FHLBanks. Consolidated obligations are not obligations of the U.S. Government, and the U.S. Government does not guarantee them. At February 28, 2010, Moody’s Investors Service, Inc. (Moody’s) rated the consolidated obligations Aaa/P-1 and Standard & Poor’s Ratings Services, a division of McGraw-Hill Companies, Inc. (S&P) rated them AAA/A-1+.
Although we are primarily liable for the portion of consolidated obligations issued on our behalf, we are also jointly and severally liable with the other 11 FHLBanks for the payment of principal and interest on all consolidated obligations of each of the FHLBanks. The Finance Agency, at its discretion, may require any FHLBank to make principal or interest payments due on any consolidated obligation whether or not the consolidated obligation represents a primary liability of such FHLBank. Although it has never happened, to the extent an FHLBank makes any payment on a consolidated obligation on behalf of another FHLBank that is primarily liable for such consolidated obligation, Finance Agency regulations provide that the paying FHLBank is entitled to reimbursement from the noncomplying FHLBank for any payments made on behalf of the noncomplying FHLBank and other associated costs (including interest to be determined by the Finance Agency). If, however, the Finance Agency determines the noncomplying FHLBank is unable to satisfy its repayment obligations, the Finance Agency may allocate the outstanding liabilities of the noncomplying FHLBank among the remaining FHLBanks on a pro rata basis in proportion to each FHLBank’s participation in all consolidated obligations outstanding. The Finance Agency reserves the right to allocate the outstanding liabilities for the consolidated obligations between the FHLBanks in any other manner it may determine to ensure the FHLBanks operate in a safe and sound manner.
Finance Agency regulations govern the issuance and servicing of consolidated obligations. Those regulations established the Office of Finance to facilitate the issuance and servicing of consolidated obligations on behalf of the FHLBanks. The FHLBanks, through the Office of Finance as their agent, are the issuers of consolidated obligations for which they are jointly and severally liable. No FHLBank is permitted to issue individual debt without Finance Agency approval.

 

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Pursuant to Finance Agency regulations, the Office of Finance has adopted policies and procedures for consolidated obligations issued by the FHLBanks. The policies and procedures relate to the frequency and timing of issuance of consolidated obligations, issue size, minimum denomination, selling concessions, underwriter qualifications and selection, currency of issuance, interest rate change or conversion features, call or put features, principal amortization features, and selection of clearing organizations and outside counsel. The Office of Finance has responsibility for facilitating and approving the issuance of the consolidated obligations in accordance with these policies and procedures. In addition, the Office of Finance has the authority to restrict or deny the FHLBanks’ requests to issue consolidated obligations otherwise allowed by its policies and procedures if the Office of Finance determines such action would be inconsistent with the Finance Agency requirement that consolidated obligations be issued efficiently and at the lowest all-in cost over time. The Office of Finance’s authority to restrict or prohibit our requests for issuance of consolidated obligations has not adversely impacted our ability to finance our operations.
Consolidated obligations are generally issued with either fixed or variable rate payment terms using a variety of indices for interest rate resets including LIBOR, Constant Maturity Treasury, and the Federal funds rate. To meet the specific needs of certain investors in consolidated obligations, both fixed and variable rate obligations may also contain certain embedded features resulting in complex coupon payment terms and call features. When such consolidated obligations are issued on our behalf, we may concurrently enter into derivative agreements containing offsetting features effectively altering the terms of the bond to a simple variable rate tied to an index. The Office of Finance may coordinate communication between underwriters, the Bank, and financial institutions entering into interest rate exchange agreements to facilitate issuance.
The Office of Finance may also coordinate transfers of FHLBank consolidated obligations among other FHLBanks. We may, from time to time, assume the outstanding primary liability of another FHLBank rather than issue new consolidated obligations for which we are the primary obligor. If an FHLBank has acquired excess funding, that FHLBank may offer its debt to the other 11 FHLBanks at the current market rate of interest consistent with what may be expected in the auction process. We may choose to assume the outstanding primary liability of another FHLBank as it would have a known price compared with issuing debt through the auction process where actual pricing is unknown prior to issuance.

 

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Finance Agency regulations require each FHLBank to maintain the following types of assets, free from any lien or pledge, subject to such regulations, restrictions, and limitations as may be prescribed by the Finance Agency, in an amount at least equal to the amount of that FHLBank’s participation in the total consolidated obligations outstanding:
    Cash,
 
    Obligations of or fully guaranteed by the U.S.,     
 
    Secured advances,     
 
    Mortgages having any guarantee, insurance, or commitment from the U.S. or any agency of the U.S.,
 
    Investments described in section 16(a) of the FHLBank Act, which, among other items, include investments a fiduciary or trust fund may purchase under the laws of the state of Iowa, and
 
    Other securities rated Aaa by Moody’s, AAA by S&P, or AAA by Fitch, Inc. (Fitch).
We were in compliance with this requirement at December 31, 2009 and 2008. See discussion in “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operation - Liquidity and Capital Resources — Liquidity Requirements — Statutory Requirements.”
In addition to being responsible for facilitating and executing the issuance of consolidated obligations, the Office of Finance services all outstanding debt. It also collects information on the FHLBank System’s unsecured credit exposure to individual counterparties, serves as a source of information for the FHLBanks on capital market developments, manages the FHLBank System’s relationship with the rating agencies for consolidated obligations, and prepares the FHLBank System’s Combined Financial Reports.
The consolidated obligations the FHLBanks may issue consist of bonds and discount notes.
Bonds
Bonds satisfy our intermediate- and long-term funding requirements. Typically, the maturity of these securities ranges from one to 30 years, but the maturity is not subject to any statutory or regulatory limit.
We work with a variety of authorized securities dealers and the Office of Finance to meet our debt issuance needs. Depending on the amount and type of funding needed, bonds may be issued through a competitive bid auction process (TAP program and callable auction), on a negotiated basis, or through a debt transfer between FHLBanks.

 

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Bonds issued through the TAP program are generally fixed rate, noncallable structures issued with standard maturities of 18 months or two, three, five, seven, or ten years. The goal of the TAP program is to aggregate frequent smaller issues into a larger bond issue for greater market liquidity. We may participate in the TAP program to provide funding for our portfolio.
We may request specific amounts of certain bonds to be offered by the Office of Finance for sale via competitive auction conducted with underwriters of a bond selling group. One or more FHLBanks may also request amounts of those same bonds to be offered for sale for their benefit via the same auction. Auction structures are determined by the FHLBanks in consultation with the Office of Finance and the securities dealer community. We may receive zero to 100 percent of the proceeds of the bonds issued via competitive auction depending on (i) the amounts and costs for the bonds bid by underwriters; (ii) the maximum costs we or other FHLBanks participating in the same issue, if any, are willing to pay for the obligations; and (iii) the guidelines for allocation of bond proceeds among multiple participating FHLBanks administered by the Office of Finance.
We may participate in the Global Debt Program coordinated by the Office of Finance. The Global Debt Program allows the FHLBanks to diversify their funding sources to include overseas investors. Global Debt Program bonds may be issued in maturities ranging from one to 30 years and can be customized with different terms and currencies. FHLBanks participating in the program approve the terms of the individual issues.
We may issue Amortizing Prepayment Linked Securities (APLS). APLS principal balances pay down consistent with a specified reference pool of mortgages determined at issuance and have a final stated maturity of four to 15 years. APLS can be issued in a wide variety of sizes and maturities to meet numerous portfolio objectives. Like all consolidated obligations, APLS carry the highest ratings from both Moody’s and S&P (Aaa/AAA) and are not obligations of the U.S. Government, and the U.S. Government does not guarantee them.
For further analysis of our bonds, see “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operation — Statements of Condition — Consolidated Obligations” and “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operation - Liquidity and Capital Resources — Sources of Liquidity.”
Discount Notes
Discount notes satisfy our short-term funding needs. These securities have maturities of up to 365/366 days and are offered daily through a discount note selling group and through other authorized underwriters. Discount notes are sold at a discount and mature at par.

 

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On a daily basis, we may request specific amounts of certain discount notes with specific maturity dates to be offered by the Office of Finance at a specific cost for sale to underwriters in the discount note selling group. One or more FHLBanks may also request amounts of those same discount notes to be offered for sale for their benefit the same day. The Office of Finance commits to issue discount notes on behalf of the participating FHLBanks when underwriters in the selling group submit orders for the specific discount notes offered for sale. We may receive zero to 100 percent of the proceeds of the discount notes issued via this sales process depending on (i) the maximum costs we or other FHLBanks participating in the same issue, if any, are willing to pay for the discount notes; (ii) the order amounts for the discount notes submitted by underwriters; and (iii) the guidelines for allocation of discount note proceeds among multiple participating FHLBanks administered by the Office of Finance.
Twice weekly, we may request specific amounts of discount notes with fixed terms to maturity ranging from four weeks to 26 weeks to be offered by the Office of Finance for sale via competitive auction conducted with underwriters in the discount note selling group. One or more FHLBanks may also request amounts of those same discount notes to be offered for sale for their benefit via the same auction. The discount notes offered for sale via competitive auction are not subject to a limit on the maximum costs the FHLBanks are willing to pay. We may receive zero to 100 percent of the proceeds of the discount notes issued via competitive auction depending on (i) the amounts of the discount notes bid by underwriters and (ii) the guidelines for allocation of discount note proceeds among multiple participating FHLBanks administered by the Office of Finance.
For further analysis of our discount notes see “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operation — Statements of Condition — Consolidated Obligations” and “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operation — Liquidity and Capital Resources — Sources of Liquidity.”
Derivatives
We use derivatives to manage our exposure to interest rate and prepayment risks. The Finance Agency’s regulations and our Enterprise Risk Management Policy (ERMP) establish guidelines for derivatives. We can use interest rate swaps, swaptions, interest rate cap and floor agreements, calls, puts, and futures and forward contracts as part of our interest rate and prepayment risk management and funding strategies for both business segments. The Finance Agency’s regulations and our policies prohibit trading in or the speculative use of these instruments and limit exposure to credit risk arising from the instruments.
We primarily use derivatives to manage our exposure to changes in interest rates. The goal of our interest rate risk management strategy is not to eliminate interest rate risk, but to manage it within appropriate limits. One key way we manage interest rate risk is to acquire and maintain a portfolio of assets and liabilities which, together with their associated derivatives, are conservatively matched with respect to the expected repricings of the assets and liabilities.

 

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We use derivatives as a fair value hedge of an underlying financial instrument and/or as an economic hedge, which does not qualify for hedge accounting treatment but serves as an asset-liability management tool. We also use derivatives to manage embedded options in assets and liabilities to hedge the market value of existing assets, liabilities, and anticipated transactions.
A more detailed discussion regarding our use of derivatives is located in “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operation — Statements of Condition — Derivatives” and in “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operation — Risk Management — Credit Risk — Derivatives.”
Capital and Dividends
Capital
Our Capital Plan requires each member to own capital stock in an amount equal to the aggregate of a membership stock requirement and an activity-based stock requirement. Our Board of Directors may adjust these requirements within ranges established in the Capital Plan. All stock issued is subject to a five year notice of redemption.
Our capital stock has a par value of $100 per share, and all shares are issued, exchanged, redeemed, and repurchased only by us at its stated par. We have two subclasses of capital stock; membership capital stock and activity-based capital stock. Each member must purchase and hold membership capital stock equal to a percentage of its total assets as of the preceding December 31st. Each member is also required to purchase activity-based capital stock equal to a percentage of its outstanding transactions and commitments and to hold that activity-based capital stock as long as the transactions and commitments remain outstanding.
Although we do not redeem activity-based capital stock prior to the expiration of the five year notice period prescribed under our Capital Plan, we, in accordance with our Capital Plan, automatically, but at our option, repurchase excess activity-based capital stock that exceeds an operational threshold on at least a monthly basis, subject to the limitations set forth in our Capital Plan. To review our Capital Plan, see Exhibit 4.1 to our Form 8-K/A, filed on March 31, 2009.
On December 22, 2008, we suspended our practice of voluntarily repurchasing excess activity-based capital stock to preserve capital during an uncertain economic environment. As a result of improved market conditions during 2009, we resumed our normal practice of voluntarily repurchasing excess activity-based capital stock on December 18, 2009.

 

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Dividends
Our Board of Directors may declare and pay dividends in either cash or capital stock or a combination thereof; however, historically, we have only paid cash dividends. Under Finance Agency regulations, we are prohibited from paying a dividend in the form of additional shares of capital stock if, after the issuance, the outstanding excess capital stock would be greater than one percent of our total assets. By regulation, we may pay dividends from current earnings or retained earnings, but we may not declare a dividend based on projected or anticipated earnings. Our Board of Directors may not declare or pay dividends if it would result in our non-compliance with capital requirements. Per regulation, we may not declare or pay a dividend if the par value of the stock is impaired or is projected to become impaired after paying such dividend.
Our ERMP requires a minimum retained earnings level. If actual retained earnings fall below the retained earnings minimum, we are required to establish an action plan, approved by our Board of Directors, which may include a dividend cap at less than the current earned dividend, to enable us to return to our targeted level of retained earnings within twelve months. At December 31, 2009, our actual retained earnings were above the retained earnings minimum, and therefore no action plan was necessary. Further discussion on our risk management metrics are discussed in “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operation — Risk Management.”
Our dividend philosophy is to pay out a sustainable dividend equal to or above the average three-month LIBOR rate for the covered period. While three-month LIBOR is the Bank’s dividend benchmark, the actual dividend payout is impacted by Board of Director policies, regulatory requirements, financial projections, and actual performance. Therefore, the actual dividend rate may be higher or lower than three-month LIBOR.
Dividend payments are discussed in further detail in “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operation — Liquidity and Capital Resources — Capital — Dividends.”
Competition
In general, the current competitive environment presents a challenge to achieving our financial goals. We continuously reassess the potential for success in attracting and retaining customers for our products and services.

 

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Demand for our advances is affected by, among other things, the cost of other available sources of funds for our borrowers. We compete with other suppliers of secured and unsecured wholesale funding including investment banks and dealers, commercial banks, other GSEs or government agencies such as the Farm Credit System, FDIC, Federal Reserve, and, in certain circumstances, other FHLBanks. Certain holding companies have subsidiary institutions located in various states that may be members of different FHLBanks. To the extent a holding company has access through multiple subsidiaries to more than one FHLBank, the holding company can choose the most cost effective advance product available from among the FHLBanks to which it has access. Under this scenario, FHLBanks may compete with each other to fund advances to members in different FHLBank districts. The availability of alternative funding sources to our members and their deposit levels, can significantly influence the demand for our advances and can vary as a result of a number of factors including market conditions, member creditworthiness and size, and availability of collateral.
Recent legislative and regulatory actions have provided members with additional funding alternatives. For instance, the FDIC announced its TLGP, through which the FDIC provides a guarantee on certain newly issued senior unsecured debt, including promissory notes, commercial paper, interbank funding, and unsecured portions of secured debt in the event the issuing institution subsequently fails or its holding company files for bankruptcy. These additional funding alternatives increased competition with our advance products as well as contributed to our increased long-term cost of funds.
Our primary source of funding is through the issuance of consolidated obligations. We compete with the U.S. Government, Fannie Mae, Freddie Mac, Farm Credit System, and other GSEs as well as corporate, sovereign, and supranational entities for funds raised through the issuance of unsecured debt in the national and global debt markets. In the absence of increased demand, increased supply of competing debt products may result in higher debt costs or lesser amounts of debt issued at the same cost. In addition, the availability and cost of funds raised through the issuance of certain types of unsecured debt may be adversely affected by regulatory initiatives or other government actions. Although our debt issuances have kept pace with the funding needs of our members, there can be no assurance that this will continue to be the case.
In addition, the sale of callable debt and the simultaneous execution of callable derivative agreements that mirror the debt have been an important source of competitive funding for us. The availability of markets for callable debt and derivative agreements may be an important determinant of our relative cost of funds. There can be no assurance the current breadth and depth of these markets will be sustained.

 

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Our cost of funds was also adversely affected by changes in investor perception of the systemic risks associated with the housing GSEs. Issues relating to Fannie Mae, Freddie Mac, and the FHLBanks have, at times, created pressure on debt pricing, as investors have perceived such obligations as bearing greater risk than some other debt products. In response to investor and financial concerns, in September 2008, the Finance Agency placed Fannie Mae and Freddie Mac in conservatorship. Additionally, the U.S. Treasury put in place a set of financing agreements, which expired on December 31, 2009, to ensure that Fannie Mae, Freddie Mac, and the FHLBanks continue to meet their obligations to holders of bonds that they have issued or guaranteed.
The purchase of mortgage loans through the MPF program is subject to competition on the basis of prices paid for mortgage loans, customer service, and ancillary services such as automated underwriting. We compete primarily with other GSEs, such as Fannie Mae, Freddie Mac, and other financial institutions and private investors for acquisition of conventional fixed rate mortgage loans.
Taxation
We are exempt from all federal, state and local taxation except for real estate property taxes, which is a component of our lease payments for office space or on real estate we own.
Assessments
Affordable Housing Program
To fund their respective AHPs, the FHLBanks each must set aside the greater of 10 percent of the FHLBank’s current year net earnings to fund next year’s AHP obligation, or the FHLBank’s pro rata share of an aggregate of $100 million to be contributed in total by the FHLBanks. Such proration is made on the basis of current year net earnings. The required annual AHP contribution for an FHLBank shall not exceed its current year net earnings. The exclusion of interest expense related to mandatorily redeemable capital stock is a regulatory interpretation of the Finance Agency. The AHP and REFCORP assessments are calculated simultaneously because of their interdependence on each other. We accrue our AHP assessment on a monthly basis and reduce the AHP liability as program funds are distributed.
Resolution Funding Corporation
Congress requires each FHLBank annually pay to the REFCORP 20 percent of net income calculated in accordance with GAAP after the assessment for AHP, but before the assessment for the REFCORP. We accrue our REFCORP assessment on a monthly basis.
The FHLBanks’ obligation to the REFCORP will terminate when the aggregate actual quarterly payments made by all of the FHLBanks exactly equal the present value of a $300 million annual annuity commencing on the date on which the first obligation of the REFCORP was issued and ends on April 15, 2030. The Finance Agency determines the discounting factors to use in this calculation in consultation with the Department of Treasury.

 

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The Finance Agency is required to shorten the term of the FHLBanks’ obligation to the REFCORP for each calendar quarter in which there is an excess quarterly payment. An excess quarterly payment is the amount by which the actual quarterly payment exceeds $75 million. The Finance Agency is required to extend the term of the FHLBanks’ obligation to the REFCORP for each calendar quarter in which there is a deficit quarterly payment. A deficit quarterly payment is the amount by which the actual quarterly payment falls short of $75 million.
Because the FHLBanks’ cumulative REFCORP payments have generally exceeded $300 million per year, those extra payments have defeased $2.3 million of the $75 million benchmark payment due on April 15, 2012 and all payments due thereafter. The defeased benchmark payment (or portion thereof) can be reinstated if future actual REFCORP payments fall short of the $75 million benchmark in any quarter. Cumulative amounts to be paid by the FHLBanks to the REFCORP cannot be determined at this time because the amount is dependent upon future net income of each FHLBank and interest rates.
Liquidity Requirements
We utilize liquidity to satisfy member demand for short- and long-term funds, to repay maturing consolidated obligations, and to meet other business obligations. We are required to maintain liquidity in accordance with certain Finance Agency regulations and with policies established by the Board of Directors. See additional discussion in “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operation — Liquidity and Capital Resources — Liquidity Requirements.”
Regulatory Oversight, Audits, and Examinations
The Finance Agency is an independent agency in the U.S. Government responsible for supervising and regulating the FHLBanks, Fannie Mae, and Freddie Mac. The Housing Act establishes the position of Director of the Finance Agency as the head of such agency. The Finance Agency Director is appointed by the President for a five year term. The Finance Agency Director is authorized to issue rules, regulations, guidance, and orders affecting the FHLBanks.
To assess our safety and soundness, the Finance Agency conducts annual, on-site examinations as well as periodic off-site reviews. Additionally, we are required to submit monthly financial information including the statements of condition, results of operations, and various other reports.
The Finance Agency requires we satisfy certain minimum liquidity and capital requirements. Liquidity requirements are discussed in “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operation — Liquidity and Capital Resources — Liquidity Requirements — Statutory Requirements.” Capital requirements are discussed in “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operation — Liquidity and Capital Resources — Capital — Capital Requirements.”

 

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The Finance Agency has broad authority to bring administrative and supervisory actions against an FHLBank and/or its directors and/or executive officers. The Finance Agency may initiate proceedings to suspend or remove FHLBank directors and/or executive officers for cause. The Finance Agency may issue a notice of charges seeking the issuance of a temporary or permanent cease and desist order to an FHLBank or any director or executive officer if the Finance Agency determines any such party is engaging in, has engaged in, or the Finance Agency has cause to believe the party is about to engage in:
    any unsafe or unsound practices in conducting the business of the FHLBank.
 
    any conduct that violates any provision of the FHLBank Act or any applicable law, order, rule, or regulation.
 
    any conduct that violates conditions imposed in writing by the Finance Agency in connection with the granting of any application or other request by the FHLBank or any written agreement between the FHLBank and the Finance Agency.
The Finance Agency may issue a notice seeking the assessment of civil monetary penalties against an FHLBank or, in some cases, any director or executive officer that:
    violates any provision of the FHLBank Act or any order, rule, or regulation issued under the FHLBank Act.
 
    violates any final or temporary cease and desist order issued by the Finance Agency pursuant to the FHLBank Act.
 
    violates any written agreement between an FHLBank and the Finance Agency.     
 
    engages in any conduct that causes or is likely to cause a loss to an FHLBank.     
The Finance Agency is funded through assessments levied against the FHLBanks and other regulated entities. No tax dollars or other appropriations from the U.S. Government support the operations of the Finance Agency. The Finance Agency allocates its applicable operating and capital expenditures to the FHLBanks based on each FHLBank’s percentage of total FHLBank capital. Unless otherwise instructed in writing by the Finance Agency, each FHLBank pays the Finance Agency its pro rata share of an assessment in semi–annual installments during the annual period covered by the assessment.

 

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The Comptroller General of the U.S. Government has authority under the FHLBank Act to audit or examine the Finance Agency and the FHLBanks and to decide the extent to which they fairly and effectively fulfill the purposes of the FHLBank Act. Further, the Government Corporation Control Act provides the Comptroller General may review any audit of the financial statements conducted by an independent public accounting firm. If the Comptroller General conducts such a review, he/she must report the results and provide his/her recommendations to the Congress, the Office of Management and Budget, and the FHLBank in question. The Comptroller General may also conduct his/her own audit of any financial statements of the FHLBanks.
We submit annual management reports to the Congress, the President of the U.S., the Office of Management and Budget, and the Comptroller General. These reports include statements of condition, statements of income, statements of changes in capital, statements of cash flows, a statement of internal accounting and administrative control systems, and the report of the independent auditors on the financial statements.
We are required to file with the Securities and Exchange Commission (SEC) an Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, and current reports on Form 8-K. The SEC maintains a website containing these reports and other information regarding our electronic filings located at www.sec.gov. These reports may also be read and copied at the SEC’s Public Reference Room at 100 F Street, NE, Washington, DC 20549. Further information about the operation of the Public Reference Room may be obtained by calling 1-800-SEC-0330.
We also make our quarterly reports, annual financial reports, current reports, and amendments to all such reports filed with or furnished to the SEC available on our Internet Website at www.fhlbdm.com as soon as reasonably practicable after such reports are available. Quarterly and annual reports for the FHLBanks on a combined basis are also available at the Website of the Office of Finance as soon as reasonably practicable after such reports are available. The Internet Website address to obtain these filings is www.fhlb-of.com.
Information contained in the above mentioned website, or that can be accessed through that website, is not incorporated by reference into this annual report on Form 10-K and does not constitute a part of this or any report filed with the SEC.
Personnel
As of February 28, 2010, we had 223 full-time equivalent employees. Our employees are not covered by a collective bargaining agreement.
ITEM 1A — RISK FACTORS
The following discussion summarizes the most significant risks we face. This discussion is not exhaustive of all risks, and there may be other risks we face which are not described below. The risks described below, if realized, could negatively affect our business operations, financial condition, and future results of operations and, among other things, could result in our inability to pay dividends on our capital stock.

 

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The FHLBanks are Subject to Complex Laws and Regulations Such That Legislative and Regulatory Changes Could Negatively Affect our Business
The FHLBanks are GSEs, organized under the authority of the FHLBank Act, and, as such are governed by federal laws and regulations promulgated, adopted, and applied by the Finance Agency. Congress may amend the FHLBank Act or other statutes in ways that significantly affect (i) the rights and obligations of the FHLBanks, and (ii) the manner in which the FHLBanks carry out their housing-finance mission and business operations. New or modified legislation enacted by Congress or regulations adopted by the Finance Agency or other financial services regulators could adversely impact our ability to conduct business or the cost of doing business.
As an example of the foregoing, the enactment of the Housing Act on July 31, 2008, and subsequent actions by the Finance Agency to adopt or modify regulations, orders or policies, could adversely impact our business operations, and/or financial condition. We cannot predict how any such action may adversely impact our business operations, and/or financial condition.
Additionally, the U.S. House of Representatives passed the Wall Street Reform and Consumer Protection Act (the Reform Act), which, if passed by the U.S. Senate and signed into law by the President, would, among other things: (i) create a Consumer Financial Protection Agency; (ii) create an inter-agency oversight council that will identify and regulate systemically-important financial institutions; (iii) regulate the over-the-counter derivatives market; (iv) reform the credit rating agencies; (v) provide shareholders with an advisory vote on the compensation practices of the entity in which they invest including for executive compensation and golden parachutes; (vi) revise the assessment base for FDIC deposit insurance assessments; (vii) require lenders to retain a portion of the credit risk of the mortgages that they originate and sell; and (viii) create a federal insurance office that will monitor the insurance industry. Depending on whether the Reform Act, or similar legislation, is signed into law and on the final content of any such legislation, our business operations, funding costs, rights, obligations, and/or the manner in which we carry out our housing-finance mission may be impacted.
We cannot predict whether additional regulations will be issued or whether additional legislation will be enacted, and we cannot predict the effect of any such additional regulations or legislation on our business operations and/or financial condition.
We Face Competition for Advances, Loan Purchases, and Access to Funding
Our primary business is making advances to our members. Demand for advances is impacted by, among other things, alternative sources of liquidity and loan funding for our members. We compete with other suppliers of secured and unsecured wholesale funding including investment banks and dealers, commercial banks, other GSEs, and, in certain circumstances, other FHLBanks. The availability of alternative funding sources to members can significantly influence the demand for our advances.

 

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Our funding costs also impact the pricing of our advances. We compete with the U.S. Government, Fannie Mae, Freddie Mac, and other GSEs, including other FHLBanks, as well as corporate entities, for funds raised through the issuance of debt in the national and global markets. Increases in supply of competing debt products may result in higher debt costs or lower amounts of debt issued at the same cost by the FHLBanks. Although the FHLBank System’s debt issuances have kept pace with the funding requirements of our members, there can be no assurance that this will continue.
Additionally, many of our competitors are not subject to the same body of regulation that we are, which enables those competitors to offer products and terms that we may not be able to offer. Efforts to effectively compete with other suppliers of wholesale funding by changing the pricing of our advances may result in a decrease in the profitability of our advance business. A decrease in the demand for advances, or a decrease in the profitability on advances would negatively affect our financial condition, results of operations, and value of the Bank to our membership.
Impact of Temporary Government Programs in Response to the Disruptions in the Financial Markets Have and may Continue to Have an Adverse Impact on our Business
In response to the economic downturn and the continuing recession, the U.S. Government enacted certain governmental programs. There have been adverse impacts to our business from these programs, including increased funding costs, decreased investment liquidity, and increased competition for advances. To the extent the U.S. Government extends these programs or creates new programs, they may have a material adverse impact on our financial condition, results of operations, and value of the Bank to our membership.
Changes in the FHLBank System’s Actual or Perceived Credit Rating May Adversely Affect our Ability to Issue Consolidated Obligations on Acceptable Terms
Our primary source of funds is the sale of consolidated obligations in the capital markets, including the short-term discount note market. Our access to funds in the capital markets may be affected by the actual or perceived credit rating of the FHLBank system or the U.S. Government. Negative perception or a downgrade in our credit rating may result in reduced investor confidence, which could adversely affect our cost of funds and the ability to issue consolidated obligations on acceptable terms. A higher cost of funds or an impaired ability to issue consolidated obligations on acceptable terms could also adversely affect the FHLBanks’ financial condition, results of operations, and value to our membership. While we do not believe the FHLBanks have suffered a material adverse impact on their ability to issue consolidated obligations, we cannot predict the effect of further changes in, or developments in regard to, these risks on our ability to raise funds in the marketplace or on other aspects of our operations.

 

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We Are Jointly and Severally Liable for Payment of Principal and Interest on the Consolidated Obligations Issued by the Other FHLBanks
Each of the FHLBanks relies upon the issuance of consolidated obligations as a primary source of funds. Consolidated obligations are the joint and several obligations of all FHLBanks, backed only by the financial resources of the FHLBanks. We are jointly and severally liable with the other FHLBanks for the consolidated obligations issued by the FHLBanks through the Office of Finance, regardless of whether we receive all or any portion of the proceeds from any particular issuance of consolidated obligations. The Finance Agency, at its discretion, may require any FHLBank to make principal or interest payments due on any consolidated obligation at any time, whether or not the FHLBank who was the primary obligor has defaulted on the payment of that obligation. Furthermore, the Finance Agency may allocate the liability for outstanding consolidated obligations among one or more FHLBanks on a pro rata basis or on any other basis the Finance Agency may determine. Accordingly, we could incur significant liability beyond our primary obligation under consolidated obligations. Moreover, we may not pay dividends to, or redeem or repurchase capital stock from, any of our members if timely payment of principal and interest on the consolidated obligations of the entire FHLBank System has not been made. As a result, our ability to pay dividends to our members or to redeem or repurchase shares of our capital stock may be affected not only by our own financial condition, but also by the financial condition of the other FHLBanks.
Additionally, due to our relationship with other FHLBanks, we could be impacted by events other than the default of a consolidated obligation. Events that impact other FHLBanks such as member failures, capital deficiencies, and other-than-temporary impairment charges may cause the Finance Agency, at its discretion, or the FHLBanks jointly, at their discretion, to require another FHLBank to either provide capital or buy assets of another FHLBank. If we were called upon by the Finance Agency to do either of these items, it may impact our financial condition.
We Could be Adversely Affected by Our Exposure to Credit Risk
We are exposed to credit risk if the market value of an obligation declines as a result of deterioration in the creditworthiness of the obligor or if the market perceives a decline in the credit quality of a security instrument. We assume secured and unsecured credit risk exposure in that a borrower or counterparty could default and we may suffer a loss if we are not able to fully recover amounts owed to us in a timely manner.

 

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We attempt to mitigate credit risk through collateral requirements and credit analysis of our counterparties. We require collateral on advances, mortgage loan credit enhancements which may include SMI, letters of credit, certain investments, and derivatives. Specifically, we require that all outstanding advances and member provided mortgage loan credit enhancements be fully collateralized. We evaluate the types of collateral pledged by our borrowers and assign a borrowing capacity to the collateral, generally based on a percentage of its estimated market value. If a member or counterparty fails, we would take ownership of the collateral covering our advances and mortgage loan credit enhancements. However, if the market price of the collateral is less than the obligation or there is not a market into which we can sell the collateral, we may incur losses that could adversely affect our financial condition, results of operations, and value to our membership.
Although management has policies and procedures in place to manage credit risk, we may be exposed because the outstanding advance value may exceed the liquidation value of our collateral. We mitigate this risk through applying collateral discounts, requiring most borrowers to execute a blanket lien, taking delivery of collateral, and limiting extensions of credit. We may incur losses that could adversely affect our financial condition, results of operations, and value to our membership.
Changes in Economic Conditions or Federal Monetary Policy Could Affect our Business and our Ability to Pay Dividends
We operate with narrow margins and expect to be profitable based on our prudent lending standards, conservative investment strategies, and diligent risk management practices. Because we operate with narrow margins, our net income is sensitive to general business and economic conditions that impact the interest we earn and pay. These conditions include, without limitation, short- and long-term interest rates, inflation, money supply, fluctuations in both debt and equity capital markets, and the strength of the U.S. economy and the local economies in which we conduct our business. Additionally, we may be affected by the fiscal and monetary policies of the federal government and its agencies, including the Federal Reserve Board. Significant changes in any one or more of these conditions could impact our ability to maintain our past or current level of net income, which could limit our ability to pay dividends or change the future level of dividends that, in our Board’s discretion, we may be willing to pay.
We Could be Adversely Affected by Our Exposure to Interest Rate Risk
We realize income primarily from the spread between interest earned on our outstanding advances, mortgage assets (including MPF, MBS, HFA and SBA investments), non-mortgage investments, and interest paid on our consolidated obligations, member deposits, and other liabilities as well as components of other income. We may experience instances when either our interest bearing liabilities will be more sensitive to changes in interest rates than our interest earning assets, or vice versa. In either case, interest rate movements contrary to our position could negatively affect our financial condition, results of operations, and value of the Bank to our membership.

 

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We Use Derivative Instruments to Reduce Our Interest-Rate Risk, And We May Not Be Able to Enter into Effective Derivative Instruments on Acceptable Terms
We use derivative instruments to reduce our interest rate and mortgage prepayment risk, but no hedging strategy can completely protect us from such risk. Our effective use of derivative instruments depends upon our ability to enter into these instruments with acceptable counterparties and terms, and upon our ability to determine the appropriate hedging positions by weighing our assets, liabilities, and prevailing and changing market conditions. The cost of entering into derivative instruments has increased dramatically as a result of (i) consolidations, mergers, and failures which have led to fewer counterparties, resulting in less liquidity in the derivatives market; (ii) increased volatility in the marketplace due to uncertain economic conditions; and (iii) increased uncertainty related to the potential change in regulations regarding over-the-counter derivatives. If we are unable to manage our hedging positions effectively, we may be unable to manage our interest rate and other risks, which may result in earnings volatility, and could adversely impact our financial condition, results of operations, and value of the Bank to our membership.
Some of our derivative instruments contain provisions that require us to post additional collateral with our counterparties if there is deterioration in our credit rating. If our credit rating is lowered by a major credit rating agency, we may be required to deliver additional collateral on derivative instruments in net liability positions.
Compliance with Regulatory Contingency Liquidity Guidance Could Adversely Impact our Earnings
We are required to maintain five calendar days of contingent liquidity per Finance Agency regulations. The guidance provided to the FHLBanks is designed to protect against temporary disruptions in access to the FHLBank debt markets in response to a rise in capital markets volatility. To satisfy this additional requirement, we have established a contingency liquidity plan in which we maintain balances in shorter-term investments, which may earn lower interest rates than alternate investment options and may, in turn, negatively impact net interest income. In addition, these investments are primarily recorded as trading securities and recorded at fair value with changes in fair value recorded in other income and therefore, this accounting treatment may cause income statement volatility. We manage our liquidity position in a prudent manner to ensure our ability to meet the needs of our members in a timely manner. However, our efforts to manage our liquidity position, including our contingency liquidity plan, may impact our ability to meet our obligations and the credit and liquidity needs of our members, which could adversely affect our interest income, financial condition, and results of operations.

 

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Changes in Economic Conditions Impacting the Value of Collateral Held by the Bank Could Negatively Impact Our Business
Advances to our members and eligible housing associates are secured by mortgages and other eligible collateral. Eligible collateral includes whole first mortgages on improved residential property or securities representing a whole interest in such mortgages; securities issued, insured, or guaranteed by the U.S. Government or any of the GSE’s, including without limitation MBS issued or guaranteed by Fannie Mae, Freddie Mac, or Ginnie Mae; cash deposited in the Bank; guaranteed student loans made under the Department of Education’s FFELP; and other real estate-related collateral acceptable to us provided such collateral has a readily ascertainable value and we can perfect a security interest in such property. Additionally, CFIs may pledge collateral consisting of secured small business, small farm, or small agribusiness loans, including secured business and agri-business lines of credit. We estimate the value of collateral securing each borrower’s obligations by using collateral discounts, or haircuts. Additionally, members can provide a blanket security agreement, pledging other assets as additional collateral.
Continued deterioration of economic conditions led to a significant decrease in real-estate property values in some parts of the country. As a result, real-estate collateral we hold from our members may have decreased in value. In order to remain fully collateralized, we required members to pledge additional collateral, when deemed necessary. This requirement may impact those members that lack additional assets to pledge as collateral. If members are unable to secure their obligations with us, our advance levels could decrease, negatively impacting our financial condition, results of operations, and value of the Bank to our membership.
Adverse Economic Conditions Impacting the Bank’s Financial Position Could Impact the Bank’s Ability to Redeem Capital Stock at Par
Our capital stock is not publicly traded. All members must purchase and maintain capital stock as a condition of membership. It can be issued, exchanged, redeemed, and repurchased only by us at par value of $100 per share. Generally, capital stock may be redeemed upon five years’ notice and excess capital stock may be voluntarily repurchased.
Continued deterioration of economic conditions may adversely impact our operations and, consequently, our ability to redeem capital stock at its stated par value of $100 per share. Additionally, our ability to meet regulatory capital requirements could be negatively impacted due to poor financial performance. If deemed necessary, we may be required to call upon our members to purchase additional capital stock to meet those regulatory capital requirements.

 

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Member Failures and Consolidations May Adversely Affect our Business
Over the last two years, the financial services industry has experienced increasing defaults on, among other things, home mortgage, commercial real estate, and credit card loans, which caused increased regulatory scrutiny and capital to cover non-performing loans. These factors have led to an increase in both the number of financial institution failures and the number of mergers and consolidations. During 2009, ten of our member institutions failed and 27 of our member institutions merged out-of-district. If this trend continues the number of current and potential members in our district will decrease. The resulting loss of business could negatively impact our business operations, financial condition, and results of operations.
Further, member failures may force us to liquidate pledged collateral if the outstanding advances are not repaid. The inability to liquidate collateral on terms acceptable to us may cause financial statement losses. Additionally, as members become financially distressed, in accordance with established policies, we may decrease lending limits or, in certain circumstances, cease lending activities. If member banks are unable to obtain sufficient liquidity from us it may cause further deterioration of those member institutions. This may negatively impact our reputation and, therefore, negatively impact our financial condition and results of operations.
Exposure to Option Risk in our Financial Assets and Liabilities Could Have an Adverse Effect on Our Business
Our mortgage assets provide homeowners the option to prepay their mortgages prior to maturity. The effect of changes in interest rates can exacerbate prepayment and extension risk, which is the risk that mortgage assets will be refinanced by the mortgagor in low interest rate environments or will remain outstanding longer than expected at below-market yields when interest rates increase. Our advances, consolidated obligations, and derivatives may provide us, the borrower, issuer, or counterparty with the option to call or put the asset or liability. These options leave us susceptible to unpredictable cash flows associated with our financial assets and liabilities. The exercise of the option and the prepayment or extension risk is dependent on general market conditions and if not managed appropriately could have a material effect on our financial condition, results of operations, and value of the Bank to our membership.
Reliance on Models to Value Financial Instruments and the Assumptions used may Have an Adverse Impact on our Financial Position and Results of Operations
We make use of business and financial models for managing risk. We also use models in determining the fair value of financial instruments for which independent price quotations are not available or reliable. Pricing models and their underlying assumptions are based on management’s best estimates for discount rates, prepayments, market volatility, and other assumptions. These assumptions may have a significant effect on the reported fair values of assets and liabilities, including derivatives, and the related income and expense.

 

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The information provided by these models is also used in making business decisions relating to strategies, initiatives, transactions and products, and in financial statement reporting. We have adopted many controls, procedures, and policies to monitor and manage assumptions used in these models. However, models are inherently imperfect predictors of actual results because they are based on assumptions about future performance. Changes in any models or in any of the assumptions, judgments or estimates used in the models may cause the results generated by the model to be materially different. If the models are not reliable due to inaccurate assumptions, we could make poor business decisions, including asset and liability management, or other decisions, which could result in an adverse financial impact.
Reliance on the FHLBank of Chicago, as MPF Provider, and Fannie Mae, as the Ultimate Investor in the MPF Xtra Product, Could have a Negative Effect on Our Business
As part of our business, we participate in the MPF program with the FHLBank of Chicago. As MPF Provider, the FHLBank of Chicago establishes the structure of MPF loan products and the eligibility rules for MPF loans. In addition, the MPF Provider administers the pricing and delivery mechanism for MPF loans and the back-office processing of MPF loans in its role as master servicer and master custodian. If the FHLBank of Chicago changes its MPF provider role or ceases to operate the program, this may have a negative impact on our mortgage finance business, financial condition, and results of operations. Additionally, if the FHLBank of Chicago, or its third party vendors, experience operational difficulties, such difficulties could have a negative impact on our financial condition, results of operations, and value of the Bank to our membership.
Effective February 26, 2009, we signed agreements to participate in a MPF loan product called MPF Xtra. Under this product, we assign 100 percent of our interests in PFI master commitments to the FHLBank of Chicago. The FHLBank of Chicago then purchases mortgage loans from our PFIs and sells those loans to Fannie Mae. Should the FHLBank of Chicago or Fannie Mae experience any operational difficulties, those difficulties could have a negative impact on the value of the Bank to our membership.
The Terms of Any Liquidation, Merger, Or Consolidation Involving the Bank May Have an Adverse Impact on Members’ Investment in the Bank
Under the FHLBank Act, holders of Class B stock own our retained earnings, paid-in surplus, undivided profits, and equity reserves, if any. With respect to liquidation, our Capital Plan provides that, after payment of creditors, holders of Class B stock shall receive the par value of their Class B stock as well as any retained earnings in an amount proportional to the holder’s share of total shares of Class B stock.

 

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Our Capital Plan also provides that our Board of Directors shall determine the rights and preferences of our stockholders in connection with any merger or consolidation, subject to any terms and conditions imposed by the Finance Agency. We cannot predict how the Finance Agency might exercise its statutory authority with respect to liquidations, reorganizations, mergers, or consolidations or whether any actions taken by the Finance Agency in this regard would be inconsistent with the provisions of our Capital Plan or the rights of the holders of our Class B stock. Consequently, there can be no assurance that if any liquidation, merger, or consolidation were to occur involving us, that it would be consummated on terms that do not adversely affect our members’ investment in us.
Our Reliance on Information Systems and Other Technology Could have a Negative Effect on our Business
We rely heavily upon information systems and other technology to conduct and manage our business. If we were to experience a failure or interruption in any of our information systems or other technology, we may be unable to conduct and manage our business effectively. Although we have implemented processes, procedures, and a business resumption plan, they may not be able to prevent, timely and adequately address, or mitigate the negative effects of any failure or interruption. Any failure or interruption could significantly harm our customer relations, risk management, and profitability, which could have a negative effect on our financial condition, results of operations, and value of the Bank to our membership.
ITEM 1B — UNRESOLVED STAFF COMMENTS
None.
ITEM 2 — PROPERTIES
We executed a 20 year lease with an affiliate of our member, Wells Fargo, for approximately 43,000 square feet of office space commencing on January 2, 2007. The office space is located in a building at 801 Walnut Street, Suite 200, Des Moines, Iowa and is used for all our primary business functions.
We also maintain a leased, off-site back-up facility with approximately 4,100 square feet in Urbandale, Iowa.
ITEM 3 — LEGAL PROCEEDINGS
We are not currently aware of any pending or threatened legal proceedings against us that could have a material adverse effect on our financial condition, results of operations, or cash flows.
ITEM 4 — (REMOVED AND RESERVED)

 

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PART II
ITEM 5 — MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
Current members own the majority of our capital stock. Former members own the remaining capital stock to support business transactions still carried on our Statement of Condition. There is no established market for our capital stock and it is not publicly traded. Our capital stock may be redeemed with a five year notice from the member or voluntarily repurchased at par value, subject to certain limits. Par value of each share of capital stock is $100 per share. At February 28, 2010, we had 1,224 current members that held 23.8 million shares of capital stock. At February 28, 2010, we had 13 former members and one member who withdrew membership that held $8.1 million or 0.1 million shares of capital stock, which were classified as mandatorily redeemable capital stock.
The Board of Directors declared the following cash dividends in 2009 and 2008 (dollars in millions):
                                 
    2009     2008  
            Annual             Annual  
Quarter declared and paid   Amount1     Rate     Amount1     Rate  
 
                               
First quarter
  $ 7.6       1.00 %   $ 25.7       4.50 %
Second quarter
    7.0       1.00       26.6       4.00  
Third quarter
    14.4       2.00       30.1       4.00  
Fourth quarter
    14.9       2.00       24.3       3.00  
     
1   This table is based on the period of declaration and payment. The dividend applies to the financial performance for the quarter prior to the quarter declared and paid.
For additional information regarding our dividends, see “Item 1. Business — Capital and Dividends” and “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operation — Liquidity and Capital Resources — Capital — Dividends.”

 

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ITEM 6 — SELECTED FINANCIAL DATA
The following selected financial data should be read in conjunction with the financial statements and notes, and “Management’s Discussion and Analysis of Financial Condition and Results of Operation” included in this report. The financial position data at December 31, 2009 and 2008 and results of operations data for the three years ended December 31, 2009, 2008, and 2007 are derived from the financial statements and notes for those years included in this report. The financial position data at December 31, 2007, 2006, and 2005 and the results of operations data for the two years ended December 31, 2006 and 2005 are derived from financial statements and notes not included in this report.
                                         
    December 31,  
Statements of Condition   2009     2008     2007     2006     2005  
(Dollars in millions)                              
Investments1
  $ 20,790     $ 15,369     $ 9,244     $ 8,219     $ 10,227  
Advances
    35,720       41,897       40,412       21,855       22,283  
Mortgage loans2
    7,719       10,685       10,802       11,775       13,019  
Total assets
    64,657       68,129       60,736       42,028       45,657  
Consolidated obligations
                                       
Discount notes
    9,417       20,061       21,501       4,685       4,067  
Bonds
    50,495       42,723       34,564       33,066       37,130  
Total consolidated obligations3
    59,912       62,784       56,065       37,751       41,197  
Mandatorily redeemable capital stock
    8       11       46       65       85  
Capital stock — Class B putable
    2,461       2,781       2,717       1,906       1,932  
Retained earnings
    484       382       361       344       329  
Accumulated other comprehensive loss
    (34 )     (146 )     (26 )     (1 )     (1 )
Total capital
    2,911       3,017       3,052       2,249       2,260  
                                         
    Years Ended December 31,  
Statements of Income   2009     2008     2007     2006     2005  
(Dollars in millions)                              
Net interest income4
  $ 197.4     $ 245.6     $ 171.1     $ 154.3     $ 293.6  
Provision for (reversal of) credit losses on mortgage loans
    1.5       0.3             (0.5 )      
Other income (loss)5
    55.8       (27.8 )     10.3       8.7       46.8  
Other expense
    53.1       44.1       42.4       41.5       39.0  
Net income before change in accounting principle
    145.9       127.4       101.4       89.4       221.2  
Change in accounting principle6
                            6.5  
Net income
    145.9       127.4       101.4       89.4       227.7  
                                         
    Years Ended December 31,  
Selected Financial Ratios   2009     2008     2007     2006     2005  
Net interest margin7
    0.28 %     0.35 %     0.37 %     0.35 %     0.62 %
Return on average equity
    4.46       3.88       4.25       3.91       9.57  
Return on average assets
    0.21       0.18       0.21       0.20       0.48  
Average equity to average assets
    4.63       4.71       5.04       5.21       5.04  
Regulatory capital ratio8
    4.57       4.66       5.14       5.50       5.13  
Dividend payout ratio9
    30.05       83.81       83.13       83.21       26.88  

 

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1   Investments include: interest-bearing deposits, securities purchased under agreements to resell, Federal funds sold, trading securities, available-for-sale securities, and held-to-maturity securities.
 
2   Represents the gross amount of mortgage loans prior to the allowance for credit losses. The allowance for credit losses was $1.9 million, $0.5 million, $0.3 million, $0.3 million, and $0.8 million at December 31, 2009, 2008, 2007, 2006, and 2005.
 
3   The par amount of the outstanding consolidated obligations for all 12 FHLBanks was $930.5 billion, $1,251.5 billion, $1,189.6 billion, $951.7 billion, and $937.4 billion at December 31, 2009, 2008, 2007, 2006, and 2005, respectively.
 
4   Net interest income is before provision for (reversal of) credit losses on mortgage loans.
 
5   Other income (loss) includes, among other things, net gain (loss) on derivatives and hedging activities, net (loss) gain on extinguishment of debt, net gain on trading securities, and net loss on bonds held at fair value.
 
6   Effective January 1, 2005, we changed our method of accounting for premiums and discounts related to and received on mortgage loans and MBS. We recorded a $6.5 million gain after assessments to change the amortization period from estimated lives to contractual maturities.
 
7   Net interest margin is net interest income expressed as a percentage of average interest-earning assets.
 
8   Regulatory capital ratio is period-end regulatory capital expressed as a percentage of period-end total assets.
 
9   Dividend payout ratio is dividends declared in the stated period expressed as a percentage of net income in the stated period.

 

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ITEM 7 — MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION
Our Management’s Discussion and Analysis (MD&A) is designed to provide information that will help the reader develop a better understanding of our financial statements, key financial statement changes from year to year, and the primary factors driving those changes, as well as how recently issued accounting principles affect our financial statements. The MD&A is organized as follows:
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Forward — Looking Information
Statements contained in this annual report on Form 10-K, including statements describing objectives, projections, estimates, or future predictions in our operations, may be forward-looking statements. These statements may be identified by the use of forward-looking terminology, such as believes, projects, expects, anticipates, estimates, intends, strategy, plan, may, and will or their negatives or other variations on these terms. By their nature, forward-looking statements involve risk or uncertainty, and actual results could differ materially from those expressed or implied or could affect the extent to which a particular objective, projection, estimate, or prediction is realized. Refer to “Special Note Regarding Forward-Looking Statements” for a listing of these risks and uncertainties.
We undertake no obligation to update or revise publicly any forward-looking statements, whether as a result of new information, future events, or otherwise. A detailed discussion of these risks and uncertainties is included under “Item 1A. Risk Factors.”
Executive Overview
Our Bank is a member owned cooperative serving shareholder members in a five-state region (Iowa, Minnesota, Missouri, North Dakota, and South Dakota). Our mission is to provide funding and liquidity for our members and eligible housing associates by providing a stable source of short- and long-term funding through advances, standby letters of credit, mortgage purchases, and targeted housing and economic development activities. Our member institutions may include commercial banks, savings institutions, credit unions, insurance companies, and CDFIs.
We concluded 2009 with net income totaling $145.9 million compared with $127.4 million for the same period in 2008, an increase of 15 percent. The year ended December 31, 2009 presented both opportunities and challenges as a result of the recent financial crisis and continued market instability and volatility in 2009. Net income was primarily impacted by several events as described below.
During 2009 unique market conditions resulting from the financial crisis provided us with the opportunity to purchase investments in 30-year U.S. Treasury obligations that yielded returns above equivalent maturity LIBOR swap rates. We simultaneously entered into interest rate swaps to convert the fixed rate investments to three-month LIBOR plus a spread. At the time of execution, management determined that if and when the market showed signs of correcting this imbalance, prudent action to recognize large short-term gains was warranted through the subsequent sale and termination of the related interest rate swaps. For that reason, in 2009 we sold all $2.7 billion of U.S. Treasury obligations and terminated the related interest rate swaps. The overall impact of these transactions was a net gain of $70.9 million recorded as other income during the year ended December 31, 2009.
During 2009, in an effort to improve our risk position, we also sold $2.1 billion of mortgage loans to the FHLBank of Chicago, who immediately resold these loans to Fannie Mae. As a result of the sale, we recorded a net gain of approximately $1.8 million as other income.

 

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We utilized, in part, the proceeds from the U.S. Treasury and mortgage loan sale transactions described above to extinguish higher costing debt during 2009 and, as a result, recorded losses of approximately $89.9 million in other loss. Most of the extinguished debt was replaced with lower costing debt and we expect such losses will be offset in future periods through lower interest costs.
During the latter half of 2008, longer-term funding was expensive due to illiquidity in the market place and investors desire to invest short-term. While longer-term funding was expensive, discount note spreads relative to LIBOR were at historically wide levels. As a result, we funded longer-term assets with short-term debt. This funding methodology decreased our debt costs but introduced risks as a result of the maturity mismatch between our liabilities and assets. Therefore, to compensate for increased risks associated with this funding mismatch and the challenging market conditions creating unfavorable liquidity conditions and higher interest rate volatility, we added a risk/liquidity premium to our advance pricing beginning in September 2008. Improved market conditions during the second half of 2009 provided us with the opportunity to better match fund our longer-term assets with longer-term debt. Therefore, we were able to reduce the risk/liquidity premium on our advance pricing.
Net interest income decreased $48.2 million in 2009 when compared to 2008. The low interest rate environment driving a lower return on invested capital was the primary contributor for our decreased net interest income. In addition, decreased average advance volumes, limited short-term investment opportunities, and a negative spread on investments during the first quarter of 2009 as a result of us carrying additional liquidity during the fourth quarter of 2008 to comply with liquidity guidance provided by the Finance Agency contributed to our decreased net interest income. Average advance volumes decreased due to the availability of alternative wholesale funding options for member banks as well as increased deposit growth realized by many members. Short-term investment opportunities were limited in 2009 due to increased deposit levels and the availability of various government funding programs for financial institutions serving as our counterparties for short-term investments. The low growth market environment and the relative improvement in available funding sources resulted in decreased interest spreads on investments. Although we continue to explore new investment opportunities that provide more favorable returns, the compressed spreads added to the decreased net interest income during 2009 when compared to 2008.

 

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Conditions in the Financial Markets
Financial Market Conditions
During the year ended December 31, 2009, average market interest rates were lower when compared with 2008. The following table shows information on key average market interest rates for the years ended December 31, 2009 and 2008 and key market interest rates at December 31, 2009 and 2008:
                                 
    December 31,     December 31,              
    2009     2008     December 31,     December 31,  
    12-Month     12-Month     2009     2008  
    Average     Average     Ending Rate     Ending Rate  
 
                               
Federal funds target1
    0.16 %     1.93 %     0.05 %     0.14 %
Three-month LIBOR1
    0.69       2.93       0.25       1.43  
2-year U.S. Treasury1
    0.94       1.99       1.14       0.77  
10-year U.S. Treasury1
    3.24       3.64       3.84       2.21  
30-year residential mortgage note 1
    5.05       6.05       5.14       5.14  
     
1   Source is Bloomberg.
 
The Federal Reserve lowered its key interest rate, the Federal funds target, to a range of 0 to 0.25 percent on December 16, 2008. This target range was unchanged throughout 2009. The Federal Reserve has maintained this accommodative stance to stimulate economic growth. Three-month LIBOR declined in early 2009 (following the movement of the Federal funds target) and remained low throughout 2009. While U.S. Treasury rates were stable for the first quarter of 2009, intermediate and longer term U.S. Treasury rates increased rapidly during the second quarter of 2009 following an increase in economic activity. The result was a significantly higher spread between 2-year and 10-year U.S. Treasury rates. Mortgage rates were relatively stable during the year as the Federal Reserve continued their Agency MBS Purchase Program, purchasing approximately $1.1 trillion of agency MBS.
As a result of the recent financial crisis, the U.S. Government, the Federal Reserve, and a number of foreign governments and foreign central banks took significant actions to stabilize the global financial markets. At its January 27, 2010 Open Market Committee meeting, the Federal Reserve noted that inflation is expected to remain subdued for some time and that the Open Market Committee intends to maintain the target range for the Federal funds rate at 0 to 0.25 percent for an extended period. Significant debate continues regarding how the Federal Reserve and foreign central banks will remove excess liquidity from the financial system. On February 19, 2010, the Federal Reserve increased the discount rate, the rate at which banks may borrow directly from the Federal Reserve, from 0.50 percent to 0.75 percent. In addition, the market is closely monitoring the impact the conclusion of the Federal Reserve’s Agency MBS Purchase Program may have, currently set to expire on March 31, 2010.

 

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Agency Spreads
                                                 
    Fourth     Fourth     Year-to-date     Year-to-date              
    Quarter     Quarter     December 31,     December 31,              
    2009     2008     2009     2008     December 31,     December 31,  
    3-Month     3-Month     12-Month     12-Month     2009     2008  
    Average     Average     Average     Average     Ending Spread     Ending Spread  
FHLB spreads to LIBOR
(basis points)1
                                               
3-month
    (14.8 )     (154.5 )     (46.4 )     (73.0 )     (12.1 )     (131.5 )
2-year
    (11.5 )     60.7       1.8       7.9       (10.2 )     19.4  
5-year
    3.9       80.6       25.8       23.9       (1.7 )     73.1  
10-year
    53.2       124.2       81.3       47.4       41.9       109.1  
     
1   Source is Office of Finance.
Given that rates will not be set below zero, the relative performance of our funding using three-month discount notes was less favorable in 2009 when compared to 2008. This is primarily due to the compression of rates toward zero. As shown in the table above, spreads on longer-term funding (2-years and greater) improved substantially during the fourth quarter of 2009 when compared to the same period in 2008. This was primarily due to the Federal Reserve purchasing agency securities and a more stable economic environment. The improvement in FHLBank longer-term spreads allowed us to extend the duration of our liabilities, which we have done by issuing bullets (primarily three years and shorter), callable, and structured debt. This funding mix allowed us to better match fund our longer-term assets with longer-term debt, thereby eliminating a majority of the basis risk we were exposed to through the funding mismatch.

 

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Results of Operations for the Years Ended December 31, 2009, 2008, and 2007
The following discussion highlights significant factors influencing our results of operations. Average balances are calculated on a daily weighted average basis. Amounts used to calculate percentage variances are based on numbers in thousands. Accordingly, recalculations may not produce the same results when the amounts are disclosed in millions.
Net Income
Net income was $145.9 million for the year ended December 31, 2009 compared with $127.4 million in 2008. The increase of $18.5 million was primarily due to activity reported in other income (loss), partially offset by decreased net interest income. These items are described in the sections that follow.
Net income increased $26.0 million for the year ended December 31, 2008 when compared to the same period in 2007. The increase was primarily due to increased net interest income, partially offset by activity reported in other income (loss).
Net Interest Income
Net interest income was $197.4 million for the year ended December 31, 2009, compared with $245.6 million in 2008, and $171.1 million in 2007. Our net interest income is impacted by changes in average asset and liability balances, and the related yields and costs, as well as returns on invested capital. Net interest income is managed within the context of tradeoff between market risk and return. Due to our cooperative business model and low risk profile, our net interest margin tends to be relatively low compared to other financial institutions.

 

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The following table presents average balances and rates of major interest rate sensitive asset and liability categories for the years ended December 31, 2009, 2008, and 2007. The table also presents the net interest spread between yield on total interest-earning assets and cost of total interest-bearing liabilities as well as net interest margin (dollars in millions).
                                                                         
    2009     2008     2007  
                    Interest                     Interest                     Interest  
    Average     Yield/     Income/     Average     Yield/     Income/     Average     Yield/     Income/  
    Balance1     Cost     Expense     Balance1     Cost     Expense     Balance1     Cost     Expense  
Interest-earning assets
                                                                       
Interest-bearing deposits
  $ 113       0.37 %   $ 0.4     $ 24       0.45 %   $ 0.1     $ 8       5.28 %   $ 0.4  
Securities purchased under agreements to resell
    1,165       0.16       1.8                         222       5.36       11.9  
Federal funds sold
    6,007       0.29       17.4       4,119       1.75       72.0       3,625       5.20       188.7  
Short-term investments2
    683       0.53       3.6       467       2.41       11.2       2,255       5.27       118.8  
Mortgage-backed securities2
    9,584       2.12       203.0       8,403       3.88       326.5       4,974       5.30       263.6  
Other investments2
    6,028       1.59       95.6       145       4.28       6.2       39       5.58       2.2  
Advances3, 4
    37,766       1.77       668.2       45,653       3.11       1,418.6       24,720       5.31       1,313.6  
Mortgage loans5
    9,190       4.83       443.6       10,647       5.01       533.7       11,248       4.99       561.6  
Loans to other FHLBanks
                      14       0.68       0.1                    
 
                                                     
Total interest-earning assets
    70,536       2.03 %   $ 1,433.6       69,472       3.41 %   $ 2,368.4       47,091       5.23 %   $ 2,460.8  
 
                                                           
Noninterest-earning assets
    165                       182                       270                  
 
                                                                 
Total assets
  $ 70,701                     $ 69,654                     $ 47,361                  
 
                                                                 
 
                                                                       
Interest-bearing liabilities
                                                                       
Deposits
  $ 1,296       0.18 %   $ 2.4     $ 1,354       1.64 %   $ 22.2     $ 1,072       4.79 %   $ 51.4  
Consolidated obligations
                                                                       
Discount notes4
    20,736       0.64       132.2       26,543       2.32       616.4       8,597       4.93       424.0  
Bonds4
    44,218       2.49       1,101.3       37,752       3.92       1,481.2       34,233       5.22       1,786.2  
Other interest-bearing liabilities
    38       0.80       0.3       68       4.43       3.0       478       5.87       28.1  
 
                                                     
Total interest-bearing liabilities
    66,288       1.86 %   $ 1,236.2       65,717       3.23 %   $ 2,122.8       44,380       5.16 %   $ 2,289.7  
 
                                                           
Noninterest-bearing liabilities
    1,142                       656                       595                  
 
                                                                 
Total liabilities
    67,430                       66,373                       44,975                  
Capital
    3,271                       3,281                       2,386                  
 
                                                                 
Total liabilities and capital
  $ 70,701                     $ 69,654                     $ 47,361                  
 
                                                                 
 
                                                                       
Net interest income and spread
            0.17 %   $ 197.4               0.18 %   $ 245.6               0.07 %   $ 171.1  
 
                                                           
 
                                                                       
Net interest margin6
            0.28 %                     0.35 %                     0.37 %        
 
                                                                 
 
                                                                       
Average interest-earning assets to interest-bearing liabilities
            106.41 %                     105.71 %                     106.11 %        
 
                                                                 
 
                                                                       
Composition of net interest income
                                                                       
Asset-liability spread
            0.20 %   $ 137.4               0.20 %   $ 140.7               0.11 %   $ 49.7  
Earnings on capital
            1.83 %     60.0               3.20 %     104.9               5.09 %     121.4  
 
                                                                 
Net interest income
                  $ 197.4                     $ 245.6                     $ 171.1  
 
                                                                 
     
1   Average balances do not reflect the effect of derivative master netting arrangements with counterparties.
 
2   The average balance of available-for-sale securities is reflected at amortized cost; therefore the resulting yields do not give effect to changes in fair value.
 
3   Advance interest income includes advance prepayment fee income of $10.3 million, $0.9 million, and $1.5 million for the years ended December 31, 2009, 2008, and 2007.
 
4   Average balances reflect the impact of hedging fair value and fair value option adjustments.
 
5   Nonperforming loans and loans held for sale are included in average balance used to determine average rate.
 
6   Net interest margin is net interest income expressed as a percentage of average interest-earning assets.

 

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The following table presents the changes in interest income and interest expense between 2009 and 2008 as well as between 2008 and 2007. Changes in interest income and interest expense that are not identifiable as either volume-related or rate-related, but rather equally attributable to both volume and rate changes, are allocated to the volume and rate categories based on the proportion of the absolute value of the volume and rate changes (dollars in millions).
                                                 
    Variance — 2009 vs. 2008     Variance — 2008 vs. 2007  
    Total Increase     Total     Total Increase     Total  
    (Decrease) Due to     Increase     (Decrease) Due to     Increase  
    Volume     Rate     (Decrease)     Volume     Rate     (Decrease)  
Interest income
                                               
Interest-bearing deposits
  $ 0.3     $     $ 0.3     $ 0.3     $ (0.6 )   $ (0.3 )
Securities purchased under agreements to resell
    1.8             1.8       (11.9 )           (11.9 )
Federal funds sold
    23.3       (77.9 )     (54.6 )     22.7       (139.4 )     (116.7 )
Short-term investments
    3.7       (11.3 )     (7.6 )     (63.9 )     (43.7 )     (107.6 )
Mortgage-backed securities
    40.8       (164.3 )     (123.5 )     147.0       (84.1 )     62.9  
Other investments
    95.7       (6.3 )     89.4       4.6       (0.6 )     4.0  
Advances
    (214.8 )     (535.6 )     (750.4 )     800.9       (695.9 )     105.0  
Mortgage loans
    (71.3 )     (18.8 )     (90.1 )     (30.1 )     2.2       (27.9 )
Loans to other FHLBanks
    (0.1 )           (0.1 )     0.1             0.1  
 
                                   
Total interest income
    (120.6 )     (814.2 )     (934.8 )     869.7       (962.1 )     (92.4 )
 
                                   
 
                                               
Interest expense
                                               
Deposits
    (0.9 )     (18.9 )     (19.8 )     11.0       (40.2 )     (29.2 )
Consolidated obligations
                                               
Discount notes
    (112.3 )     (371.9 )     (484.2 )     511.4       (319.0 )     192.4  
Bonds
    223.6       (603.5 )     (379.9 )     170.9       (475.9 )     (305.0 )
Other interest-bearing liabilities
    (1.0 )     (1.7 )     (2.7 )     (19.5 )     (5.6 )     (25.1 )
 
                                   
Total interest expense
    109.4       (996.0 )     (886.6 )     673.8       (840.7 )     (166.9 )
 
                                   
 
                                               
Net interest income
  $ (230.0 )   $ 181.8     $ (48.2 )   $ 195.9     $ (121.4 )   $ 74.5  
 
                                   
Our net interest income is made up of two components: asset-liability spread and earnings on capital. Our asset-liability spread equals the yield on total assets minus the cost of total liabilities. For the years ended December 31, 2009 and 2008, our asset-liability spread was 20 basis points compared to 11 basis points in 2007. The majority of our asset-liability spread is driven by our net interest spread. For the year ended December 31, 2009, our net interest spread was 17 basis points, compared to 18 basis points in 2008, and 7 basis points in 2007.
Although our asset-liability spread and net interest spread remained fairly constant for the years ended December 31, 2009 and 2008, our earnings on capital decreased significantly. We invest our capital to generate earnings, generally for the same repricing maturity as the assets being supported. For the years ended December 31, 2009 and 2008, our earnings on capital were 183 basis points and 320 basis points. The significant decrease in earnings on capital in 2009 when compared to 2008 was primarily due to the lower interest rate environment as well as the lack of attractive short-term investment opportunities. As short-term interest rates declined and short-term investment opportunities were limited, the earnings contribution from capital decreased, thereby decreasing net interest income. Our net interest income decreased $48.2 million in 2009 when compared to 2008.

 

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Our asset-liability spread and net interest spread increased for the year ended December 31, 2008 when compared to the same period in 2007, although our earnings on capital decreased. The increase in asset-liability spread was primarily due to lower debt costs and increased asset volumes, coupled with favorable interest rates. As a result, our net interest income increased $74.5 million in 2008 when compared to 2007.
Our net interest income was impacted by the following:
Advances
Interest income on our advance portfolio (including advance prepayment fees, net) decreased $750.4 million or 53 percent in 2009 when compared to 2008 primarily due to lower interest rates. For 2009, the average yield on our advances was 1.77 percent compared to 3.11 percent in 2008. In addition, average advance volumes decreased $7.9 billion or 17 percent in 2009 when compared to 2008 due to the availability of alternative wholesale funding options for member banks as well as increased deposit growth realized by many members.
Interest income on our advance portfolio (including advance prepayment fees, net) increased $105.0 million or eight percent in 2008 when compared to 2007 primarily due to increased average advance volumes, partially offset by declining interest rates.
Discount Notes
Interest expense on our discount notes decreased $484.2 million or 79 percent in 2009 when compared to 2008 primarily due to lower interest rates. For 2009, the average cost of our discount notes was 0.64 percent compared to 2.32 percent in 2008. In addition, average discount note volumes decreased $5.8 billion or 22 percent in 2009 when compared to 2008 as a result of us not replacing maturing discount notes due to decreased short-term funding needs as well as the ability to fund longer-term during the second half of 2009.
Interest expense on our discount notes increased $192.4 million or 45 percent in 2008 when compared to 2007. The increase was primarily due to increased average discount note volume in response to increased member advance activity. Additionally, during the last quarter of 2008, government interventions and weakening investor confidence adversely impacted our long-term cost of funds. As a result, we relied more heavily on the issuance of discount notes to fund both our short- and long-term assets.

 

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Bonds
Interest expense on our bonds decreased $379.9 million or 26 percent in 2009 when compared to 2008 due to lower interest rates, partially offset by increased average bond volumes. Capitalizing on the lower interest rates, we extinguished bonds with a total par value of $0.9 billion in 2009. Most of the extinguished debt was replaced with lower costing debt thereby lowering interest costs. Average bond volumes increased in 2009 when compared to 2008 as a result of increased average investments which were funded with bonds. Additionally, as spreads on our bonds became more favorable during the second half of 2009, we were able to issue longer-term bonds rather than discount notes to fund our longer-term assets.
Interest expense on our bonds decreased $305.0 million or 17 percent in 2008 when compared to 2007 primarily due to the lower interest rate environment.
Mortgage Loans
Interest income on our mortgage loans decreased $90.1 million or 17 percent in 2009 when compared to 2008 primarily due to lower volume resulting from the sale of mortgage loans during the second quarter of 2009. In addition, principal payments on mortgage loans exceeded originations throughout 2009.
Interest income on our mortgage loans decreased $27.9 million or five percent in 2008 when compared to 2007 primarily due to principal payments exceeding originations.
Federal Funds Sold
Interest income on our Federal funds sold decreased $54.6 million or 76 percent in 2009 when compared to 2008 and $116.7 million or 62 percent in 2008 when compared to 2007 primarily due to lower interest rates, partially offset by increased average Federal funds sold volumes.
Investments
Interest income on our investments decreased $41.7 million or 12 percent in 2009 when compared to 2008 primarily due to lower interest rates on our MBS. At December 31, 2009, $8.7 billion or 77 percent of our MBS portfolio was variable rate. Therefore, as interest rates decline, so does the associated interest income on the variable rate MBS. The decrease in interest income was partially offset by increased volume on our other investments. In 2009, we purchased other investments in an effort to improve investment income and replace mortgage assets sold.
Interest income on our investments decreased $40.7 million or 11 percent in 2008 when compared to 2007 primarily due to decreased volumes on our short-term investments coupled with lower interest rates. The decrease in interest income was partially offset by increased MBS purchases.

 

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Net Interest Income by Segment
We evaluate performance of our segments based on adjusted net interest income after providing for a mortgage loan credit loss provision. Adjusted net interest income includes the interest income and expense on economic hedge relationships included in other income (loss) and concession expense on fair value option bonds included in other expense and excludes basis adjustment amortization/accretion on called and extinguished debt included in interest expense. A description of these segments is included in “Item 1. Business — Business Segments.”
The following table shows our financial performance by operating segment and a reconciliation of financial performance to net interest income for the years ended December 31, 2009, 2008, and 2007 (dollars in millions):
                         
    2009     2008     2007  
Adjusted net interest income after mortgage loan credit loss provision
                       
 
                       
Member Finance
  $ 133.8     $ 122.2     $ 139.0  
Mortgage Finance
    81.8       133.0       30.2  
 
                 
 
                       
Total
  $ 215.6     $ 255.2     $ 169.2  
 
                 
 
                       
Reconciliation of operating segment results to net interest income
                       
 
                       
Adjusted net interest income after mortgage loan credit loss provision
  $ 215.6     $ 255.2     $ 169.2  
Net interest (income) expense on economic hedges
    (5.2 )     2.2       1.7  
Concession expense on fair value option bonds
    0.5              
Interest (expense) income on basis adjustment amortization/accretion of called debt
    (17.8 )     (12.1 )     0.2  
Interest income on basis adjustment accretion of extinguished debt
    2.8              
 
                 
 
                       
Net interest income after mortgage loan credit loss provision
  $ 195.9     $ 245.3     $ 171.1  
 
                 
 
                       
Other income (loss)
    55.8       (27.8 )     10.3  
Other expense
    53.1       44.1       42.4  
 
                 
 
                       
Income before assessments
  $ 198.6     $ 173.4     $ 139.0  
 
                 

 

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Member Finance
Member Finance adjusted net interest income increased $11.6 million in 2009 when compared to 2008. The increase was primarily attributable to higher asset-liability spread income, partially offset by lower returns on invested capital. Asset-liability spread income increased due to the segment’s average assets increasing $1.3 billion to $51.9 billion in 2009 when compared to 2008. The increase in average assets was primarily attributable to the purchase of non-MBS investments, including TLGP debt, Federal funds sold, U.S. Treasury obligations, taxable municipal bonds, and resale agreements. We increased our non-MBS investment purchases in an effort to improve investment income and replace mortgage assets sold in 2009. The increase was partially offset by lower returns on invested capital as a result of the low interest rate environment and lack of attractive short-term investment options.
Member Finance adjusted net interest income decreased $16.8 million in 2008 when compared to 2007. The decrease was primarily attributable to lower returns on invested capital as a result of the low interest rate environment, partially offset by higher asset-liability spread income. Asset-liability spread income increased due to the segment’s average assets increasing $19.5 billion to $50.6 in 2008 when compared to 2007 as a result of increased advance activities during 2008.
Mortgage Finance
Mortgage Finance adjusted net interest income decreased $51.2 million in 2009 when compared to 2008. The decrease was primarily attributable to lower asset-liability spread income, coupled with lower returns on invested capital as a result of the low interest rate environment. Asset-liability spread income decreased due to the segment’s average assets decreasing $0.2 billion to $18.8 billion in 2009 when compared to 2008. The segment’s average assets decreased primarily due to the sale of mortgage loans during the second quarter of 2009. The decrease was partially offset by the purchase of multi-family agency MBS with a portion of the proceeds from the mortgage loan sale. In addition, we purchased additional agency MBS during the fourth quarter of 2009.
As reflected in the Member Finance segment above, we used a portion of the proceeds from the mortgage loan sale to purchase TVA and FFCB bonds. These bonds were recorded under the Member Finance segment. As a result, the Mortgage Finance segment experienced lower adjusted net interest income in 2009 due to decreased average assets.
Mortgage Finance adjusted net interest income excludes basis adjustment expense related to called bonds. In 2009, we called $1.6 billion of higher cost par value bonds and consequently amortized $17.2 million of basis adjustment expense. A portion of these bonds was replaced with lower cost debt, therefore, we expect lower future interest costs will offset the basis adjustment amortization recorded in 2009.

 

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Mortgage Finance adjusted net interest income increased $102.8 million in 2008 when compared to 2007. The increase was primarily attributable to higher asset-liability spread income. Asset-liability spread income increased due to the segment’s average assets increasing $2.8 billion to $19.0 billion in 2008 when compared to 2007. The segment’s average assets increased primarily due to an increase in average MBS of $3.4 billion to $8.4 billion in 2008 when compared to 2007. Additionally, we purchased MBS at attractive spreads to LIBOR and funded the MBS with long-term debt issued at favorable rates, thereby enhancing the segment’s net interest income. Interest income from MBS increased $62.9 million in 2008 when compared to 2007.
Provision for Credit Losses on Mortgage Loans
We recorded a provision for credit losses of $1.5 million and $0.3 million in 2009 and 2008. The increased provision in 2009 was primarily due to increased delinquency and loss severity rates throughout 2009. In addition, credit enhancement fees available to recapture losses decreased in 2009 as a result of the mortgage loan sale and increased principal repayments.
Other Income (Loss)
The following table presents the components of other income (loss) for the years ended December 31, 2009, 2008, and 2007 (dollars in millions):
                         
    2009     2008     2007  
 
                       
Service fees
  $ 2.1     $ 2.4     $ 2.2  
Net gain on trading securities
    19.1       1.5        
Net realized loss on sale of available-for-sale securities
    (10.9 )            
Net realized gain on sale of held-to-maturity securities
          1.8       0.5  
Net loss on bonds held at fair value
    (4.4 )            
Net gains on loans held for sale
    1.3              
Net gain (loss) on derivatives and hedging activities
    133.8       (33.2 )     4.5  
Net (loss) gain on extinguishment of debt
    (89.9 )     0.7        
Other, net
    4.7       (1.0 )     3.1  
 
                 
 
                       
Total other income (loss)
  $ 55.8     $ (27.8 )   $ 10.3  
 
                 
Other income (loss) can be volatile from period to period depending on the type of financial activity recorded. In 2009, other income (loss) was primarily impacted by the following events.

 

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In 2009, we purchased and sold 30-year U.S. Treasury obligations on three separate occasions. On each occasion, we entered into interest rate swaps to convert these fixed rate investments to floating rate. The relationships were accounted for as a fair value hedge relationship with changes in LIBOR (benchmark interest rate) reported as hedge ineffectiveness through “net gain (loss) on derivative and hedging activities.” We subsequently sold these securities and terminated the related interest rate swaps. As a result, we recorded an $11.7 million net loss on the sale of the securities through “net realized loss on sale of available-for-sale securities” and an $82.6 million net gain on the termination of the interest rate swaps and normal ineffectiveness through “net gain (loss) on derivatives and hedging activities.” The overall impact of these transactions was a net gain of $70.9 million for the year ended December 31, 2009.
In 2009, we extinguished bonds with a total par value of $0.9 billion and recorded losses of $89.9 million through other loss. Most of these bonds were replaced with lower costing debt and we expect such losses will be offset in future periods through lower interest costs. These losses exclude basis adjustment accretion of $2.8 million recorded in net interest income. As a result, net losses recorded in the Statements of Income on the extinguishment of debt totaled $87.1 million in 2009.
We use economic hedges to manage interest rate and prepayment risks in our balance sheet. In 2009, we recorded net gains of $34.2 million on economic hedges through “net gain (loss) on derivatives and hedging activities.” Refer to “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operation — Results of Operations — Hedging Activities” for additional information on the impact of hedging activities to other income (loss).
At December 31, 2009, our trading securities portfolio consisted of $3.7 billion of par value TLGP debt and $0.8 billion of par value taxable municipal bonds. For the year ended December 31, 2009, we recorded net unrealized gains of $4.6 million on our trading securities. As trading securities are marked-to-market, changes in unrealized gains and losses are reflected in other income (loss). For the year ended December 31, 2009, we sold $2.2 billion of par value TLGP debt and realized a net gain of $14.5 million in other income (loss).
We also entered into derivatives to economically hedge against adverse changes in the fair value of a portion of our trading securities portfolio. For the year ended December 31, 2009, we recorded net gains on these economic derivatives of $12.0 million in “net gain (loss) on derivatives and hedging activities.”

 

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Hedging Activities
If a hedging activity qualifies for hedge accounting treatment, we include the periodic cash flow components of the hedging instrument related to interest income or expense in the relevant income statement caption consistent with the hedged asset or liability. In addition, we report as a component of other income (loss) in “Net gain (loss) on derivatives and hedging activities”, the fair value changes of both the hedging instrument and the hedged item. We report the amortization of certain upfront fees received on interest rate swaps and cumulative fair value adjustments from terminated hedges in interest income or expense.
If a hedging activity does not qualify for hedge accounting treatment, we report the hedging instrument’s components of interest income and expense, together with the effect of changes in fair value as a component of other income (loss) in “Net gain (loss) on derivatives and hedging activities”; however, there is no corresponding fair value adjustment for the hedged asset or liability.
As a result, accounting for derivatives and hedging activities affects the timing of income recognition and the effect of certain hedging transactions are spread throughout the Statements of Income in net interest income and other income (loss).

 

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The following table categorizes the net effect of hedging activities on net income by product for the years ended December 31, 2009, 2008, and 2007 (dollars in millions). The table excludes the interest component on derivatives that qualify for hedge accounting as this amount will be offset by the interest component on the hedged item within net interest income. Because the purpose of the hedging activity is to protect net interest income against changes in interest rates, the absolute increase or decrease of interest income from interest-earning assets or interest expense from interest-bearing liabilities is not as important as the relationship of the hedging activities to overall net income.
                                                 
    2009  
Net Effect of                   Mortgage     Consolidated     Balance        
Hedging Activities   Advances     Investments     Assets     Obligations     Sheet     Total  
Net (amortization) accretion
  $ (55.2 )   $     $ (1.7 )   $ 30.5     $     $ (26.4 )
 
                                   
Net realized and unrealized gains on derivatives and hedging activities
    2.6       82.8             14.2             99.6  
(Losses) Gains — Economic Hedges
    (0.5 )     12.0       (2.3 )     5.7       19.3       34.2  
 
                                   
Reported in Other Income (Loss)
    2.1       94.8       (2.3 )     19.9       19.3       133.8  
 
                                   
Total
  $ (53.1 )   $ 94.8     $ (4.0 )   $ 50.4     $ 19.3     $ 107.4  
 
                                   
 
                                               
                                                 
    2008  
Net Effect of                   Mortgage     Consolidated     Balance        
Hedging Activities   Advances     Investments     Assets     Obligations     Sheet     Total  
Net (amortization) accretion
  $ (44.6 )   $     $ (1.7 )   $ 27.5     $     $ (18.8 )
 
                                   
Net realized and unrealized gains (losses) on derivatives and hedging activities
    2.5                   (6.5 )           (4.0 )
Losses — Economic Hedges
    (3.5 )           (1.2 )     (1.4 )     (23.1 )     (29.2 )
 
                                   
Reported in Other Loss
    (1.0 )           (1.2 )     (7.9 )     (23.1 )     (33.2 )
 
                                   
Total
  $ (45.6 )   $     $ (2.9 )   $ 19.6     $ (23.1 )   $ (52.0 )
 
                                   
                                                 
    2007  
Net Effect of                   Mortgage     Consolidated     Balance        
Hedging Activities   Advances     Investments     Assets     Obligations     Sheet     Total  
Net amortization
  $ (1.0 )   $     $ (2.0 )   $ (34.1 )   $     $ (37.1 )
 
                                   
Net realized and unrealized gains on derivatives and hedging activities
    2.6                   0.5             3.1  
(Losses) Gains — Economic Hedges
    (0.6 )                 4.2       (2.2 )     1.4  
 
                                   
Reported in Other Income (Loss)
    2.0                   4.7       (2.2 )     4.5  
 
                                   
Total
  $ 1.0     $     $ (2.0 )   $ (29.4 )   $ (2.2 )   $ (32.6 )
 
                                   

 

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Net amortization/accretion. The effect of hedging on net amortization/accretion varies from period to period depending on our activities, including terminating hedge relationships and the amount of upfront fees received or paid on derivative transactions. In late 2008, we voluntarily terminated certain interest rate swaps that were being used to hedge both advances and consolidated obligations in an effort to reduce our counterparty risk profile. Additionally, during the latter half of 2008, as a result of Lehman Brothers Holdings Inc. filing bankruptcy, we chose to terminate all consolidated obligation and advance hedge relationships with counterparties that were an affiliate of Lehman Brothers Holdings Inc. This termination activity resulted in basis adjustments that are amortized/accreted level-yield over the remaining life of the advance or consolidated obligation. Advance basis adjustment amortization increased in 2009 when compared to 2008 due to amortization of these advance basis adjustments created during the latter half of 2008. Consolidated obligation basis adjustment accretion increased in 2009 when compared to 2008 primarily due to the extinguishment of debt. Consolidated obligation amortization decreased while advance amortization increased in 2008 when compared to 2007 primarily due to increased consolidated obligation and advance hedge relationship terminations.
Net realized and unrealized gains (losses) on derivatives and hedging activities. Hedge ineffectiveness occurs when changes in fair value of the derivative and the related hedged item do not perfectly offset each other. Hedge ineffectiveness is driven by changes in the benchmark interest rate and volatility. As the benchmark interest rate changes and the magnitude of that change intensifies, so will the impact on our net realized and unrealized gains (losses) on derivatives and hedging activities. Additionally, volatility in the marketplace may intensify this impact. Net realized and unrealized gains on derivatives and hedging activities in 2009 were primarily due to investment hedge relationships. In 2009, we sold $2.7 billion of U.S. Treasury obligations and terminated the related interest rate swaps recognizing gains on the derivative termination of $96.7 million and normal hedge ineffectiveness losses of $14.1 million. For additional information on the sale of U.S. Treasury obligations, refer to “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operation — Results of Operations — Other Income (Loss).” Hedge ineffectiveness gains on consolidated obligation hedge relationships increased $20.7 million in 2009 when compared to 2008 due primarily to increased hedge relationships and changes in interest rates. Hedge ineffectiveness losses on consolidated obligation hedge relationships increased $7.0 million in 2008 when compared to 2007 due primarily to decreased hedge relationships and changes in interest rates.

 

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Gains (Losses) — Economic Hedges. Economic hedges were used to manage interest rate and prepayment risks in our balance sheet in 2009, 2008 and 2007. Changes in gains (losses) on economic hedges are primarily driven by changes in our balance sheet profile, changes in interest rates and volatility, and the loss of hedge accounting for certain hedge relationships failing retrospective hedge effectiveness testing. Economic hedges do not qualify for hedge accounting and as a result we record a fair market value gain or loss on the derivative instrument without recording the corresponding loss or gain on the hedged item. In addition, the interest accruals on the hedges are recorded as a component of other income (loss) instead of a component of net interest income. Gains (losses) on economic hedges were impacted by the following activity:
    In 2009, we held interest rate caps on our balance sheet as economic hedges to protect against increases in interest rates on our variable rate assets with caps. Due to changes in interest rates, we recorded $19.3 million in gains on these interest rate caps in 2009 compared to $11.6 million in losses in 2008 and $1.5 million in gains in 2007. In 2008, we also held interest rate swaptions on our balance sheet as economic hedges and recorded losses of $11.5 million compared to $3.7 million in losses in 2007.
 
    We held interest rate swaps on our balance sheet as economic hedges against adverse changes in the fair value of a portion of our trading securities indexed to LIBOR. In 2009, we recorded $23.6 million in economic gains on these derivatives, partially offset by interest expense accruals on the hedges of $11.6 million. The net gain was offset by $17.2 million of unrealized losses on the trading securities recorded in “net gain on trading securities” in other income (loss).
 
    In 2009, gains on consolidated obligation economic hedges were impacted by economic hedges on fair value option bonds. During 2009, we had economic hedges protecting against changes in the fair value of both variable and fixed interest rate bonds elected under the fair value option. We recorded $6.5 million in economic gains on these derivatives, coupled with $7.8 million of interest income accruals on the hedges. These net gains were offset by $4.4 million of fair value losses on the variable and fixed interest rate bonds recorded in “net loss on bonds held at fair value” in other income (loss).
 
    In 2009, gains on consolidated obligation economic hedges were also impacted by the effect of failed retrospective hedge effectiveness tests. We perform retrospective hedge effectiveness testing at least quarterly on all hedge relationships. If a hedge relationship fails this test, we can no longer receive hedge accounting and the derivative is accounted for as an economic hedge. In 2009, we experienced losses of $20.9 million on consolidated obligation hedging relationships failing the retrospective hedge effectiveness tests compared to losses of $2.4 million in 2008 and gains of $5.6 million in 2007. The majority of losses in 2009 were due to consolidated obligation hedge relationships nearing maturity or having a short-duration. These losses and gains were partially offset by interest accruals on the hedges of $12.3 million, $1.0 million, and $1.4 million in 2009, 2008, and 2007.

 

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Other Expenses
The following table shows the components of other expenses for the three years ended December 31, 2009, 2008, and 2007 (dollars in millions):
                         
    2009     2008     2007  
 
                       
Compensation and benefits
  $ 31.9     $ 26.3     $ 24.8  
 
                       
Occupancy cost
    1.6       1.3       1.6  
Other operating expenses
    15.0       12.8       13.0  
 
                 
Total operating expenses
    16.6       14.1       14.6  
 
                       
Finance Agency
    2.4       1.9       1.5  
Office of Finance
    2.2       1.8       1.5  
 
                 
 
                       
Total other expense
  $ 53.1     $ 44.1     $ 42.4  
 
                 
Other expenses increased $9.0 million in 2009 when compared to 2008 and $1.7 million in 2008 when compared to 2007. The increase in both 2009 and 2008 was primarily due to increased compensation and benefits. Compensation and benefits increased due primarily to us funding our portion of the Pentegra Defined Benefit Plan for Financial Institutions (DB Plan) as well as making staff additions. Funding and administrative costs of the DB Plan were $5.7 million in 2009, $3.2 million in 2008, and $3.3 million in 2007. In 2009, funding and administrative costs included a one-time discretionary contribution of $3.3 million. In addition to increased compensation and benefits, other expense was impacted by increased assessments from the Finance Agency and Office of Finance in 2009 as a result of increased net income and increased fees for professional services.
Statements of Condition at December 31, 2009 and 2008
Financial Highlights
Our members are both stockholders and customers. Our primary business objective is to be a reliable source of low-cost liquidity to our members while safeguarding their capital investment. Due to our cooperative business model, our assets, liabilities, capital, and financial strategies reflect changes in member business activities with the Bank.
Our total assets decreased five percent to $64.7 billion at December 31, 2009 from $68.1 billion at December 31, 2008. Total liabilities decreased five percent to $61.7 billion at December 31, 2009 from $65.1 billion at December 31, 2008. Total capital decreased four percent to $2.9 billion at December 31, 2009 from $3.0 billion at December 31, 2008. The overall financial condition for the periods presented has been influenced by changes in member advances, investment purchases, mortgage loans, and funding activities. See further discussion of changes in our financial condition in the appropriate sections that follow.

 

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Advances
Our advance portfolio decreased $6.2 billion or 15 percent to $35.7 billion at December 31, 2009 from $41.9 billion at December 31, 2008. The decrease is primarily due to the availability of alternative wholesale funding options for member banks, as well as increased deposit growth realized by many members. This has driven demand for our advances down and provided incentive to our members to prepay their advances. In 2009, members prepaid approximately $4.9 billion of advances. A portion of the decrease in advances was offset by unique funding opportunities offered to our members in 2009. These unique funding opportunities increased advance demand and allowed members to borrow from us at discounted rates for particular advance products.
The FHLBank Act requires that we obtain sufficient collateral on advances to protect against losses. We have never experienced a credit loss on an advance to a member or eligible housing associate. Bank management has policies and procedures in place to appropriately manage this credit risk. Accordingly, we have not provided any allowance for credit losses on advances. See additional discussion regarding our collateral requirements in “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operation — Risk Management — Credit Risk — Advances.”

 

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The composition of our advances based on remaining term to scheduled maturity at December 31, 2009 and 2008 was as follows (dollars in millions):
                                 
    2009     2008  
            Percent of             Percent of  
    Amount     Total     Amount     Total  
Simple fixed rate advances
                               
Overdrawn demand deposit accounts
  $ *       * %   $ 1       * %
One month or less
    1,022       2.9       2,852       7.0  
Over one month through one year
    4,877       13.9       5,220       12.8  
Greater than one year
    10,330       29.5       10,108       24.9  
 
                       
 
    16,229       46.3       18,181       44.7  
Simple variable rate advances
                               
One month or less
                4       *  
Over one month through one year
    552       1.6       418       1.1  
Greater than one year
    3,510       10.0       4,560       11.2  
 
                       
 
    4,062       11.6       4,982       12.3  
Callable advances
                               
Fixed rate
    274       0.8       262       0.6  
Variable rate
    6,297       18.0       7,527       18.5  
Putable advances
                               
Fixed rate
    6,675       19.1       8,122       20.0  
Community investment advances
                               
Fixed rate
    963       2.7       1,000       2.5  
Variable rate
    72       0.2       104       0.3  
Callable — fixed rate
    64       0.2       62       0.1  
Putable — fixed rate
    396       1.1       423       1.0  
 
                       
Total par value
    35,032       100.0 %     40,663       100.0 %
 
                               
Hedging fair value adjustments
                               
Cumulative fair value gain
    590               1,082          
Basis adjustments from terminated and ineffective hedges
    98               152          
 
                           
 
                               
Total advances
  $ 35,720             $ 41,897          
 
                           
     
*   Amount is less than one million or 0.1 percent.
Cumulative fair value gains decreased $492 million at December 31, 2009 when compared to December 31, 2008 due primarily to changes in interest rates. All of the cumulative fair value gains on advances were offset by the net estimated fair value losses on the related derivative contracts during 2009. Basis adjustments decreased $54 million at December 31, 2009 when compared to December 31, 2008 due primarily to the normal amortization of basis adjustments created during the latter half of 2008. Refer to “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operation — Results of Operations — Hedging Activities” for additional information.

 

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The following tables show advance balances for our five largest member borrowers at December 31, 2009 and 2008 (dollars in millions):
                             
                        Percent of  
                2009     Total  
Name   City   State     Advances1     Advances  
 
                           
Transamerica Life Insurance Company2
  Cedar Rapids   IA   $ 5,450       15.6 %
Aviva Life and Annuity Company2
  Des Moines   IA     2,955       8.4  
TCF National Bank3
  Sioux Falls   SD     2,650       7.6  
Superior Guaranty Insurance Company4
  Minneapolis   MN     1,625       4.6  
ING USA Annuity and Life Insurance Company
  Des Moines   IA     1,304       3.7  
 
                       
 
                13,984       39.9  
 
                           
Housing associates
                455       1.3  
All others
                20,593       58.8  
 
                       
 
                           
Total advances (at par value)
              $ 35,032       100.0 %
 
                       
                             
                        Percent of  
                2008     Total  
Name   City   State     Advances1     Advances  
 
                           
Transamerica Life Insurance Company2
  Cedar Rapids   IA   $ 5,450       13.4 %
Aviva Life and Annuity Company2
  Des Moines   IA     3,131       7.7  
ING USA Annuity and Life Insurance Company
  Des Moines   IA     2,994       7.4  
TCF National Bank3
  Wayzata   MN     2,475       6.1  
Superior Guaranty Insurance Company4
  Minneapolis   MN     2,250       5.5  
 
                       
 
                16,300       40.1  
 
                           
Housing associates
                302       0.7  
All others
                24,061       59.2  
 
                       
 
                           
Total advances (at par value)
              $ 40,663       100.0 %
 
                       
     
1   Amounts represent par value before considering premiums, discounts, and hedging fair value adjustments.
 
2   Transamerica Life Insurance Company and Aviva Life and Annuity Company have not signed a new Advances, Pledge, and Security Agreement and therefore cannot initiate new advances. At December 31, 2009, the remaining weighted average life of advances held by Transamerica Life Insurance Company and Aviva Life and Annuity Company was 5.00 and 4.46 years.
 
3   Effective April 6, 2009, TCF National Bank relocated their charter from Wayzata, MN to Sioux Falls, SD.
 
4   Superior Guaranty Insurance Company (Superior) is an affiliate of Wells Fargo Bank, N.A.

 

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Mortgage Loans
The following table shows information at December 31, 2009 and 2008 on mortgage loans held for portfolio (dollars in millions):
                 
    2009     2008  
Single family mortgages
               
Fixed rate conventional loans
               
Contractual maturity less than or equal to 15 years
  $ 1,906     $ 2,408  
Contractual maturity greater than 15 years
    5,427       7,845  
 
           
Subtotal
    7,333       10,253  
 
               
Fixed rate government-insured loans
               
Contractual maturity less than or equal to 15 years
    2       2  
Contractual maturity greater than 15 years
    378       421  
 
           
Subtotal
    380       423  
 
           
 
               
Total par value
    7,713       10,676  
 
               
Premiums
    53       86  
Discounts
    (52 )     (81 )
Basis adjustments from mortgage loan commitments
    5       4  
Allowance for credit losses
    (2 )     *  
 
           
 
               
Total mortgage loans held for portfolio, net
  $ 7,717     $ 10,685  
 
           
     
*   Amount is less than one million.
Mortgage loans decreased approximately $3.0 billion at December 31, 2009 when compared to December 31, 2008. The decrease was primarily due to us selling $2.1 billion of mortgage loans to the FHLBank of Chicago, who immediately resold these loans to Fannie Mae during the second quarter of 2009.

 

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Excluding the mortgage loan sale transaction, mortgage loans decreased approximately $0.9 billion at December 31, 2009 when compared to December 31, 2008. This decrease in mortgage loans was driven by an increase in principal repayments, partially offset by an increase in originations. Total principal repayments amounted to $2.4 billion in 2009 compared to $1.3 billion in 2008. Total originations amounted to $1.5 billion in 2009 compared to $1.2 billion in 2008. The increase in principal repayments and originations were each a result of the decreased interest rate environment throughout 2009. During the second half of 2009, as interest rates increased and underwriting standards remained stringent, borrowers had less incentive to refinance, and as a result, we experienced fewer principal prepayments. The annualized weighted average pay-down rate for mortgage loans in 2009 was approximately 23 percent compared to 11 percent in 2008.
At December 31, 2009 and 2008, $4.4 billion and $7.9 billion of our mortgage loans outstanding were from Superior, an affiliate of Wells Fargo. The decrease in mortgage loans outstanding with Superior at December 31, 2009 when compared to December 31, 2008 was due to the mortgage loans sale transaction that took place during the second quarter of 2009.
Effective February 26, 2009, the MPF program was expanded to include a new off-balance sheet product called MPF Xtra (MPF Xtra is a registered trademark of the FHLBank of Chicago). Under this product, we assign 100 percent of our interests in PFI master commitments to the FHLBank of Chicago. The FHLBank of Chicago then purchases mortgage loans from our PFIs under the master commitments and sells those loans to Fannie Mae. Currently, only PFIs that retain servicing of their MPF loans are eligible for the MPF Xtra product. In 2009, the FHLBank of Chicago funded $150.1 million of MPF Xtra mortgage loans under the master commitments of our PFIs. We recorded approximately $0.1 million in MPF Xtra fee income from the FHLBank of Chicago in 2009. The fee is compensation to us for our continued management of the PFI relationship under MPF Xtra, including initial and ongoing training as well as enforcement of the PFIs representations and warranties as necessary under the PFI Agreement and MPF Guides.
For additional discussion regarding the MPF credit risk sharing arrangements, see “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operation — Risk Management — Credit Risk — Mortgage Assets.”

 

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Investments
The following table shows the book value of investments at December 31, 2009 and 2008 (dollars in millions):
                                 
    2009     2008  
            Percent of             Percent of  
    Amount     Total     Amount     Total  
Short-term investments
                               
Interest-bearing deposits
  $ 5       * %   $       %
Federal funds sold
    3,133       15.1       3,425       22.3  
Negotiable certificates of deposit
    450       2.2              
Commercial paper
                385       2.5  
 
                       
 
    3,588       17.3       3,810       24.8  
Long-term investments
                               
Mortgage-backed securities
                               
Government-sponsored enterprises
    11,147       53.6       9,169       59.7  
U.S. government agency-guaranteed
    43       0.2       52       0.3  
MPF shared funding
    33       0.1       47       0.3  
Other
    35       0.2       39       0.3  
 
                       
 
    11,258       54.1       9,307       60.6  
Non-mortgage-backed securities
                               
Interest-bearing deposits
    6       *              
Government-sponsored enterprise obligations
    806       3.9              
State or local housing agency obligations
    124       0.6       93       0.6  
TLGP
    4,260       20.5       2,151       14.0  
Taxable municipal bonds
    742       3.6              
Other
    6       *       8       *  
 
                       
 
    5,944       28.6       2,252       14.6  
 
                               
Total investments
  $ 20,790       100.0 %   $ 15,369       100.0 %
 
                       
 
                               
Investments as a percentage of total assets
            32.2 %             22.6 %
 
                           
     
*   Amount is less than 0.1 percent.
Investment balances increased $5.4 billion or 35 percent at December 31, 2009 when compared with December 31, 2008. The increase was primarily due to an increase in both non-MBS and MBS investments, including purchases of TLGP debt, GSE obligations, taxable municipal bonds, and GSE MBS. We purchased these investments throughout 2009 in an effort to improve investment income and replace mortgage assets sold.

 

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Despite our increase in total investments, short-term investments decreased at December 31, 2009 when compared with December 31, 2008. The decrease was primarily due to a lack of attractive interest spreads on investments. Short-term rates were low in 2009, primarily due to increased deposit levels and the availability of various government funding programs for financial institutions serving as our counterparties for short-term investments. As a result, it was more challenging for us to find favorable investment opportunities.
We evaluate our individual available-for-sale and held-to-maturity securities in an unrealized loss position for OTTI on at least a quarterly basis. As part of our evaluation of securities for OTTI, we consider our intent to sell each debt security and whether it is more likely than not that we will be required to sell the security before its anticipated recovery. If either of these conditions is met, we will recognize an OTTI charge to earnings equal to the entire difference between the security’s amortized cost basis and its fair value at the balance sheet date. For securities in unrealized loss position that meet neither of these conditions, we perform analysis to determine if any of these securities are other-than-temporarily impaired.
For our agency MBS, GSE obligations, and TLGP debt in an unrealized loss position, we determined that the strength of the issuers’ guarantees through direct obligations or support from the U.S. Government is sufficient to protect us from losses based on current expectations. For our state or local housing agency obligations in an unrealized loss position, we determined that all of these securities are currently performing as expected. For our MPF shared funding in an unrealized loss position, we determined that the underlying mortgage loans are eligible under the MPF program and the tranches owned are senior level tranches. As a result, we have determined that, as of December 31, 2009, all gross unrealized losses on our agency MBS, GSE obligations, TLGP debt, state or local housing agency obligations, and MPF shared funding are temporary.
Furthermore, the declines in market value of these securities are not attributable to credit quality. We do not intend to sell these securities, and it is not more likely than not that we will be required to sell these securities before recovery of their amortized cost bases. As a result, we do not consider any of these securities to be other-than-temporarily impaired at December 31, 2009.

 

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For our private-label MBS, we perform cash flow analyses to determine whether the entire amortized cost bases of these securities are expected to be recovered. During the second quarter of 2009, the FHLBanks formed an OTTI Governance Committee, which is comprised of representation from all 12 FHLBanks and is responsible for reviewing and approving the key modeling assumptions, inputs, and methodologies to be used by the FHLBanks to generate cash flow projections used in analyzing credit losses and determining OTTI for private-label MBS. In accordance with this methodology, we may engage another designated FHLBank to perform the cash flow analysis underlying our OTTI determination. In order to promote consistency in the application of the assumptions, inputs, and implementation of the OTTI methodology, the FHLBanks established control procedures whereby the FHLBanks performing the cash flow analysis select a sample group of private-label MBS and each perform cash flow analyses on all such test MBS, using the assumptions approved by the OTTI Governance Committee. These FHLBanks exchange and discuss the results and make any adjustments necessary to achieve consistency among their respective cash flow models.
Utilizing this methodology, we are responsible for making our own determination of impairment, which includes determining the reasonableness of assumptions, inputs, and methodologies used. At December 31, 2009, we obtained our cash flow analysis from our designated FHLBanks on all five of our private-label MBS. The cash flow analysis uses two third-party models.
The first third-party model considers borrower characteristics and the particular attributes of the loans underlying our securities, in conjunction with assumptions about future changes in home prices and interest rates, to project prepayments, defaults and loss severities. A significant input to the first model is the forecast of future housing price changes for the relevant states and core based statistical areas (CBSAs), which are based upon an assessment of the individual housing markets. CBSA refers collectively to metropolitan and micropolitan statistical areas as defined by the U.S. Office of Management and Budget; as currently defined, a CBSA must contain at least one urban area with a population of 10,000 or more people. Our housing price forecast assumed CBSA level current-to-trough home price declines ranging from 0 percent to 15 percent over the next 9 to 15 months. Thereafter, home prices are projected to remain flat in the first six months, and to increase 0.5 percent in the next six months, 3 percent in the second year and 4 percent in each subsequent year.
The month-by-month projections of future loan performance derived from the first model, which reflect projected prepayments, defaults, and loss severities, are then input into a second model that allocates the projected loan level cash flows and losses to the various security classes in the securitization structure in accordance with its prescribed cash flow and loss allocation rules. The scenario of cash flows determined based on the model approach described above reflects a best estimate scenario and includes a base case current to trough housing price forecast and a base case housing price recovery path described in the prior paragraph. If this estimate results in a present value of expected cash flows that is less than the amortized cost basis of the security (that is, a credit loss exists), an OTTI is considered to have occurred. If there is no credit loss and we do not intend to sell or it is not more likely than not we will be required to sell, any impairment is considered temporary.

 

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At December 31, 2009, our private-label MBS cash flow analysis did not project any credit losses. Even under an adverse scenario that delays recovery of the housing price index, no credit losses were projected. We do not intend to sell these securities and it is not more likely than not that we will be required to sell these securities before recovery of their amortized cost bases. As a result, we do not consider any of these securities to be other-than-temporarily impaired at December 31, 2009.
Consolidated Obligations
Consolidated obligations, which include discount notes and bonds, are the primary source of funds to support our advances, mortgage loans, and investments. We use derivatives to restructure interest rates on consolidated obligations to better manage our interest rate risk and reduce funding costs. This generally means converting fixed rates to variable rates. At December 31, 2009, the book value of the consolidated obligations issued on our behalf totaled $59.9 billion compared to $62.8 billion at December 31, 2008.
Discount Notes
The following table shows our discount notes, all of which are due within one year, at December 31, 2009 and 2008 (dollars in millions):
                 
    2009     2008  
 
               
Par value
  $ 9,419     $ 20,153  
Discounts
    (2 )     (92 )
 
           
 
               
Total discount notes
  $ 9,417     $ 20,061  
 
           
The decrease in discount notes was primarily due to decreased short-term funding needs in 2009 as a result of reduced demand for short-term advances and limited short-term investment opportunities. In addition, during the second half of 2009, spreads to LIBOR on our discount notes increased, thereby increasing the cost of discount notes. This resulted in lower amounts of discount note issuances and higher amounts of bond issuances during the second half of 2009.

 

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Bonds
The following table shows our bonds based on remaining term to maturity at December 31, 2009 and 2008 (dollars in millions):
                 
Year of Maturity   2009     2008  
 
               
2009
  $     $ 15,963  
2010
    23,040       6,159  
2011
    9,089       4,670  
2012
    5,337       2,231  
2013
    2,523       2,417  
2014
    1,422       501  
Thereafter
    6,962       7,908  
Index amortizing notes
    1,950       2,420  
 
           
 
               
Total par value
    50,323       42,269  
 
               
Premiums
    50       51  
Discounts
    (35 )     (41 )
Hedging fair value adjustments
               
Cumulative fair value loss
    149       348  
Basis adjustments from terminated and ineffective hedges
    *       95  
Fair value option adjustments
               
Net loss on bonds held at fair value
    4        
Change in accrued interest
    4        
 
           
 
               
Total bonds
  $ 50,495     $ 42,722  
 
           
     
*   Amount is less than one million.
Bonds outstanding included the following at December 31, 2009 and 2008 (dollars in millions):
                 
    2009     2008  
Par amount of bonds
               
Noncallable or nonputable
  $ 44,381     $ 39,214  
Callable
    5,942       3,055  
 
           
 
               
Total par value
  $ 50,323     $ 42,269  
 
           

 

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The increase in bonds was primarily due to improved spreads to LIBOR on our bonds during the second half of 2009. Improved spread to LIBOR decreased the cost of bonds and allowed us to better match fund our longer-term assets with longer-term debt. Cumulative fair value losses decreased $199 million at December 31, 2009 when compared to December 31, 2008. Substantially all of the cumulative fair value losses on bonds are offset by the net estimated fair value gains on the related derivative contracts. Basis adjustments decreased $95 million at December 31, 2009 when compared to December 31, 2008 as a result of us unwinding certain interest rate swaps.
The increase in bonds was partially offset by us calling and extinguishing debt in 2009. We called and extinguished higher-costing debt primarily to lower our relative cost of funds in the future. The following table summarizes the par value and weighted average interest rate of bonds called and extinguished for the years ended December 31, 2009, 2008, and 2007 (dollars in millions):
                         
    2009     2008     2007  
Bonds Called
                       
Par value
  $ 5,095     $ 7,302     $ 1,228  
Weighted average interest rate
    2.83 %     4.32 %     5.19 %
 
                       
Bonds Extinguished
                       
Par value
  $ 943     $ 510     $  
Weighted average interest rate
    5.33 %     2.55 %     %
 
                 
 
                       
Total par value
  $ 6,038     $ 7,812     $ 1,228  
 
                 
In addition, we elected the fair value option on approximately $6.0 billion of bonds that did not qualify for hedge accounting in 2009. These bonds, coupled with related derivatives, were unable to achieve hedge effectiveness. Therefore, in order to achieve some offset to the mark-to-market on the fair value option bonds, we executed economic derivatives. During 2009, we recorded $25.0 million of fair value adjustment losses on these fair value option bonds. These losses were partially offset by gains on the economic derivatives. Refer to “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operation — Results of Operations — Hedging Activities” for additional information on the impact of these economic derivatives.

 

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Deposits
The following table shows our deposits by product type at December 31, 2009 and 2008 (dollars in millions):
                                 
    2009     2008  
            Percent of             Percent of  
    Amount     Total     Amount     Total  
Interest-bearing
                               
Overnight
  $ 367       30.0 %   $ 694       46.4 %
Demand
    293       23.9       230       15.3  
Term
    484       39.5       465       31.1  
 
                       
Total interest-bearing
    1,144       93.4       1,389       92.8  
 
                               
Noninterest-bearing
    81       6.6       107       7.2  
 
                       
 
                               
Total deposits
  $ 1,225       100.0 %   $ 1,496       100.0 %
 
                       
Our deposits decreased $0.3 billion at December 31, 2009 when compared to December 31, 2008. The level of deposits will vary based on member alternatives for short-term investments.
The table below presents time deposits in denominations of $100,000 or more by remaining maturity at December 31, 2009 (dollars in millions):
                                 
            Over three     Over six        
    Three     months but     months but        
    months     within six     within 12        
    or less     months     months     Total  
Time deposits
  $ 62     $ 299     $ 123     $ 484  
 
                       
Capital
At December 31, 2009, total capital (including capital stock, retained earnings, and accumulated other comprehensive loss) was $2.9 billion compared with $3.0 billion at December 31, 2008. The decrease was primarily due to a decrease in activity-based capital stock as a result of lower advance and mortgage loan volumes. This decrease was partially offset by unrealized gains on available-for-sale securities recorded in accumulated other comprehensive loss, and increased retained earnings. Beginning on December 22, 2008 we suspended our normal practice of voluntarily repurchasing excess activity-based capital stock. This action was taken after careful consideration of the unstable market conditions and stressed economic environment at that time. Our Board of Directors and management felt this action was necessary to preserve capital that supports our service to members. As a result of improved market conditions during 2009, we resumed our normal practice of voluntarily repurchasing excess activity-based capital stock on December 18, 2009 and repurchased $569.6 million of excess activity-based capital stock from our members.

 

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Derivatives
The notional amount of derivatives reflects the volume of our hedges, but it does not measure our credit exposure because there is no principal at risk. The following table categorizes the notional amount of our derivatives at December 31, 2009 and 2008 (dollars in millions):
                 
    2009     2008  
Notional amount of derivatives
               
Interest rate swaps
               
Noncallable
  $ 34,158     $ 17,773  
Callable by counterparty
    9,386       9,261  
Callable by the Bank
    60       77  
 
           
 
    43,604       27,111  
 
               
Interest rate caps
    3,240       2,340  
Forward settlement agreements
    27       289  
Mortgage delivery commitments
    27       288  
 
           
 
               
Total notional amount
  $ 46,898     $ 30,028  
 
           
The notional amount of our derivative contracts increased approximately $16.9 billion at December 31, 2009 when compared to December 31, 2008. The increase was primarily due to the utilization of interest rate swaps to hedge consolidated obligations for interest rate management, thereby converting fixed rate debt to floating rate debt. In addition, in 2009 we swapped more fixed rate advances as a result of market conditions and the low interest rate environment. We also entered into interest rate swaps, treated as economic hedges, to hedge certain investments, including TLGP debt and taxable municipal bonds.

 

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The following table categorizes the notional amount and the estimated fair value of derivative instruments, excluding accrued interest, by product and type of accounting treatment. The category titled fair value represents hedges that qualify for fair value hedge accounting. The category titled economic represents hedges that do not qualify for hedge accounting. Amounts at December 31, 2009 and 2008 were as follows (dollars in millions):
                                 
    2009     2008  
            Estimated             Estimated  
    Notional     Fair Value     Notional     Fair Value  
Advances
                               
Fair value
  $ 13,204     $ (613 )   $ 11,501     $ (1,109 )
Economic
    746       (1 )     527       (5 )
Investments
                               
Fair value
    239       2              
Economic
    1,525       25              
Mortgage assets
                               
Forward settlement agreements
                               
Economic
    27       *       289       (2 )
Mortgage delivery commitments
                               
Economic
    27       *       288       2  
Consolidated obligations
                               
Bonds
                               
Fair value
    20,753       147       11,969       330  
Economic
    6,830       4       3,030       2  
Discount notes
                               
Economic
    307       *       84       1  
Balance Sheet
                               
Economic
    3,240       51       2,340       2  
 
                       
 
                               
Total notional and fair value
  $ 46,898     $ (385 )   $ 30,028     $ (779 )
 
                       
 
                               
Total derivatives, excluding accrued interest
            (385 )             (779 )
Accrued interest
            63               79  
Net cash collateral
            53               268  
 
                           
Net derivative balance
          $ (269 )           $ (432 )
 
                           
 
                               
Net derivative assets
            11               3  
Net derivative liabilities
            (280 )             (435 )
 
                           
Net derivative balance
          $ (269 )           $ (432 )
 
                           
     
*   Amount is less than one million.
Estimated fair values of derivative instruments will fluctuate based upon changes in the interest rate environment, volatility in the marketplace, as well as the volume of derivative activities. Changes in the estimated fair values are recorded as gains and losses in our Statements of Income. For fair value hedge relationships, substantially all of the net estimated fair value gains and losses on our derivative contracts are offset by net hedging fair value losses and gains on the related hedged items. Economic derivatives do not have an offsetting fair value adjustment as they are not associated with a hedged item, however, they do offset the mark-to-market on certain assets and liabilities (i.e., trading investments and fair value option bonds).

 

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Liquidity and Capital Resources
Our liquidity and capital positions are actively managed in an effort to preserve stable, reliable, and cost-effective sources of cash to meet current and projected future operating financial commitments, as well as regulatory and internal liquidity and capital requirements.
Sources of Liquidity
Our primary source of liquidity was proceeds from the issuance of consolidated obligations (bonds and discount notes) in the capital markets. Although we are primarily liable for our portion of consolidated obligations (i.e. those issued on our behalf), we are also jointly and severally liable with the other 11 FHLBanks for the payment of principal and interest on all consolidated obligations issued by the FHLBank System. The par amounts of outstanding consolidated obligations issued on behalf of other FHLBanks for which the Bank is jointly and severally liable were approximately $870.8 billion and $1,189.1 billion at December 31, 2009 and 2008.
Consolidated obligations of the FHLBanks are rated Aaa/P-1 by Moody’s and AAA/A-1+ by S&P. These are the highest ratings available for such debt from an NRSRO. These ratings measure the likelihood of timely payment of principal and interest on the consolidated obligations. Our ability to raise funds in the capital markets as well as our cost of borrowing can be affected by these credit ratings.
During 2008, the credit and liquidity crisis put a strain on available liquidity in the capital markets creating increased demand by our members for advances. As a result of our credit quality and standing in the capital markets, we had ready access to funding at relatively competitive interest rates. Additionally during 2008, several events increased longer-term funding costs relative to shorter-term funding costs. Therefore, in order to meet the demands of our members as well as support our liquidity requirements, we primarily issued discount notes to fund both our short- and long-term assets during 2008. This was evidenced by the receipt of $1,143.3 billion in proceeds from the issuance of discount notes and $21.1 billion in proceeds from the issuance of bonds during 2008.
As the credit and liquidity crisis continued in 2009, numerous government initiatives were created to provide liquidity and stimulate the economy, including the U.S. Treasury’s Financial Stability Plan, the FDIC’s TLGP, and the purchase of agency debt securities by the Federal Reserve. These government initiatives ultimately had a negative impact on the demand by our members for advances in 2009 thereby reducing our funding needs. In addition, spreads to LIBOR on our discount notes increased as a result of decreases in three-month LIBOR. Due to changes in market conditions and our debt spreads relative to LIBOR, discount notes became more expensive and bonds became less expensive, which resulted in lower amounts of discount note issuances and higher amounts of bond issuances during the last six months of 2009. As a result, we were able to better match fund our longer-term assets with longer-term debt. During 2009, proceeds on bonds were $32.4 billion and proceeds on discount notes were $719.3 billion.

 

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Other Sources of Liquidity
We utilize several other sources of liquidity to carry out our business activities. These include cash, interbank loans, payments collected on advances and mortgage loans, proceeds from the issuance of capital stock, member deposits, and current period earnings. During the year ended December 31, 2009, proceeds from the sale of mortgage loans and gains on the sale of U.S. Treasury obligations and related derivatives also served as additional sources of liquidity.
In the event of significant market disruptions or local disasters, the Bank President or his designee is authorized to establish interim borrowing relationships with other FHLBanks and the Federal Reserve. To provide further access to funding, the FHLBank Act authorizes the U.S. Treasury to purchase consolidated obligations issued by the GSEs, including FHLBanks, up to an aggregate principal amount of $4.0 billion. As a result of the Housing Act, this authorization was supplemented with a temporary authorization for the U.S. Treasury to purchase consolidated obligations issued by the FHLBanks in any amount deemed appropriate under certain conditions. This temporary authorization expired December 31, 2009 and no purchases were made under the temporary authority.
In addition, a Lending Agreement with the U.S. Treasury’s Government Sponsored Enterprise Credit Facility (GSECF) was established as a contingent source of liquidity for the GSEs if needed. We did not draw on this during 2009 and this credit facility expired as of December 31, 2009.
Uses of Liquidity
We use proceeds from the issuance of consolidated obligations primarily to fund advances as well as investment purchases. In addition, during the year ended December 31, 2009, we used proceeds from the sale of U.S. Treasury obligations and termination of the related derivatives and the sale of mortgage loans to purchase investments as well as early extinguish higher costing debt.
Advances
We use proceeds from the issuance of consolidated obligations to fund advances. During 2008, advance disbursements totaled $330.4 billion. As more funding options were available to our members and their deposit bases grew, their need for our advances declined significantly. Disbursements to members for the origination of advances declined to $38.0 billion in 2009.

 

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Investments
We use proceeds from the issuance of consolidated obligations and capital to fund the purchase of additional investments to both provide liquidity and increase our investment income. During 2009, we used a portion of the proceeds from the sale of mortgage loans to purchase additional investments that replaced the mortgage loans we sold. Short-term investment opportunities were limited in 2009 due to increased deposit levels and the availability of various government funding programs for financial institutions serving as our counterparties. The low growth market environment and the relative improvement in available funding sources resulted in decreased interest spreads on short-term investments. Although we continue to explore new investment opportunities that provide more favorable returns, the compressed spreads reduced our earnings potential on these investments. Excluding overnight investments, we purchased $27.1 billion of par value investments during the year ended December 31, 2009 compared to $24.2 billion during the same period in 2008.
Other Uses of Liquidity
During 2009, we also used proceeds from the sale of U.S. Treasury obligations and termination of the related derivatives and the sale of mortgage loans to extinguish approximately $0.9 billion par value debt and, as a result, recorded losses of approximately $89.9 million in other income (loss). Most of the extinguished debt was replaced with lower costing debt and we expect such losses will be offset in future periods through lower interest costs.
Other uses of liquidity include purchases of mortgage loans, repayment of member deposits, consolidated obligations, other borrowings, and interbank loans, redemption or repurchase of capital stock, and payment of dividends.

 

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Liquidity Requirements
Statutory Requirements
Finance Agency regulations mandate three liquidity requirements. First, contingent liquidity sufficient to meet our liquidity needs which shall, at a minimum, cover five calendar days of inability to access the consolidated obligation debt markets. The following table shows our sources of contingent liquidity to support operations for five calendar days compared to our liquidity needs at December 31, 2009 and 2008 (dollars in billions):
                 
    2009     2008  
 
               
Unencumbered marketable assets maturing within one year
  $ 4.0     $ 4.8  
Advances maturing in seven days or less
    0.5       1.3  
Unencumbered assets available for repurchase agreement borrowings
    15.5       10.5  
 
           
 
               
Total liquidity
  $ 20.0     $ 16.6  
 
           
 
               
Liquidity needs for five calendar days
  $ 1.9     $ 3.8  
 
           
 
               
Total liquidity as a percent of five day requirement
    1,053 %     437 %
 
           
Second, Finance Agency regulations require us to have available at all times an amount greater than or equal to members’ current deposits invested in advances with maturities not to exceed five years, deposits in banks or trust companies, and obligations of the U.S. Treasury. The following table shows our compliance with this regulation at December 31, 2009 and 2008 (dollars in billions):
                 
    2009     2008  
Advances with maturities not exceeding five years
  $ 24.6     $ 28.1  
Deposits in banks or trust companies
    0.5        
 
           
 
               
Total
  $ 25.1     $ 28.1  
 
           
 
               
Deposits1
  $ 1.2     $ 1.5  
 
           
     
1   Amount does not reflect the effect of derivative master netting arrangements with counterparties.

 

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Third, Finance Agency regulations require us to maintain, in the aggregate, unpledged qualifying assets in an amount at least equal to the amount of our participation in the total consolidated obligations outstanding. The following table shows our compliance with this regulation at December 31, 2009 and 2008 (dollars in billions):
                 
    2009     2008  
 
               
Total qualifying assets
  $ 64.6     $ 68.1  
Less: pledged assets
    0.1       0.3  
 
           
 
               
Total qualifying assets free of lien or pledge
  $ 64.5     $ 67.8  
 
           
 
               
Consolidated obligations outstanding
  $ 59.9     $ 62.8  
 
           
We were in compliance with all three of our liquidity requirements at December 31, 2009 and 2008.
In addition to the liquidity measures discussed above, the Finance Agency has provided us with guidance to maintain sufficient liquidity, through short-term investments, in an amount at least equal to our anticipated cash outflows under two different scenarios. One scenario (roll-off scenario) assumes that we cannot access the capital markets for the issuance of debt for a period of 10 to 20 days with initial guidance set at 15 days and that during that time members do not renew any maturing, prepaid, and called advances. The second scenario (renew scenario) assumes that we cannot access the capital markets for the issuance of debt for a period of three to seven days with initial guidance set at five days and that during that period we will automatically renew maturing and called advances for all members except very large, highly rated members. This guidance is designed to protect against temporary disruptions in the debt markets that could lead to a reduction in market liquidity and thus the inability for us to provide advances to our members.
The following table shows our number of days of liquidity under both liquidity scenarios previously described:
                 
    December 31,     Guidance  
    2009     Requirement  
 
               
Roll-off scenario
    36       15  
Renew scenario
    22       5  
At December 31, 2009, the actual days of liquidity under both scenarios exceeded the guidance requirements. We maintained a high level of liquidity at December 31, 2009 due to an expected slowdown of market funding opportunities and investment activity near year end.

 

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Operational and Contingent Liquidity-Bank policy requires that we maintain additional liquidity for day-to-day operational and contingency needs. Contingent liquidity should not be greater than available assets which include cash, money market, agency, and MBS securities. We maintain contingent liquidity to meet average overnight and one-week advances, meet the largest projected net cash outflow on any day over a projected 90-day period, and maintain repurchase agreement eligible assets of at least twice the largest projected net cash outflow on any day over a projected 90 day period.
The following table shows our contingent liquidity requirement at December 31, 2009 and 2008 (dollars in billions):
                 
    2009     2008  
 
               
Required liquidity
  $ (1.9 )   $ (3.9 )
Available assets
    15.8       11.1  
 
           
 
               
Excess contingent liquidity
  $ 13.9     $ 7.2  
 
           
We were in compliance with our contingent liquidity policy at December 31, 2009 and 2008.
Capital
Capital Requirements
The FHLBank Act requires that we maintain at all times permanent capital greater than or equal to the sum of our credit, market, and operations risk capital requirements, all calculated in accordance with the Finance Agency’s regulations. Only permanent capital, defined as Class B stock and retained earnings, can satisfy this risk based capital requirement. The FHLBank Act requires a minimum four percent capital-to-asset ratio, which is defined as total capital divided by total assets. The FHLBank Act also imposes a five percent minimum leverage ratio, which is defined as the sum of permanent capital weighted 1.5 times divided by total assets.
For purposes of compliance with the regulatory minimum capital-to-asset and leverage ratios, capital includes all capital stock, including mandatorily redeemable capital stock, plus retained earnings. If our capital falls below the above requirements, the Finance Agency has authority to take actions necessary to return us to safe and sound business operations within the regulatory minimum ratios. The Finance Agency promulgated a final rule on capital classifications and critical capital levels for the FHLBanks. Under this rule, it has been determined that we meet the “adequately capitalized” classification, which is the highest rating. For details on this rule, refer to “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operation — Legislative and Regulatory Developments.”

 

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The following table shows our compliance with the Finance Agency’s capital requirements at December 31, 2009 and 2008 (dollars in millions).
                                 
    2009     2008  
    Required     Actual     Required     Actual  
Regulatory capital requirements:
                               
Risk based capital
  $ 827     $ 2,953     $ 1,968     $ 3,174  
Total capital-to-asset ratio
    4.00 %     4.57 %     4.00 %     4.66 %
Total regulatory capital
  $ 2,586     $ 2,953     $ 2,725     $ 3,174  
Leverage ratio
    5.00 %     6.85 %     5.00 %     6.99 %
Leverage capital
  $ 3,233     $ 4,429     $ 3,406     $ 4,761  
The decrease in the regulatory capital-to-asset ratio from 4.66 percent at December 31, 2008 to 4.57 percent at December 31, 2009, was primarily due to the increase in our investments. Although the ratio declined, it exceeds the regulatory requirement and we do not expect it to decline below that requirement. Our regulatory capital-to-asset ratio at December 31, 2009 and 2008 would have been 4.47 percent and 4.58 percent if all excess capital stock had been repurchased.
We issue a single class of capital stock (Class B stock). Our Class B capital stock has a par value of $100 per share, and all shares are purchased, repurchased, redeemed, or transferred only at par value. We have two subclasses of Class B stock: membership stock and activity-based stock. We cannot redeem or repurchase any membership or activity-based stock if the repurchase or redemption would cause a member to be out of compliance with its required investment. The membership stock and activity-based stock percentages may be adjusted by our Board of Directors within ranges established in the Capital Plan. Our Board of Directors has a right and an obligation to call for additional capital stock purchases by our members if certain conditions exist.
Holders of Class B stock own a proportionate share of our retained earnings, paid-in surplus, undivided profits, and equity reserves. Holders of Class B stock have no right to receive any portion of these values except through the declaration of dividends or capital distributions upon our liquidation. Our Board of Directors may declare and pay a dividend only from current earnings or retained earnings. The Board of Directors may not declare or pay any dividends if we are not in compliance with our capital requirements or, if after paying the dividend, we would not be in compliance with our capital requirements.
Stock owned in excess of a member’s minimum investment requirement is known as excess stock. A member may request redemption of any or all of its excess stock by providing us with written notice five years in advance of the redemption. A stockholder may not have more than one redemption request pending at the same time for any share of stock.
Under our Capital Plan, we may repurchase excess membership stock at our discretion and upon 15 days’ written notice. If a member’s membership stock balance exceeds the $10.0 million cap as a result of a merger or consolidation, we may repurchase the amount of excess stock necessary to make the member’s membership stock balance equal to the $10.0 million cap.

 

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In accordance with our Capital Plan, we may repurchase excess activity-based capital stock that exceeds an operational threshold on a scheduled monthly basis, subject to certain limitations set forth in the Capital Plan. The current operational threshold is $50,000 and may be changed by the Board of Directors within a range specified in the Capital Plan with at least 15 days’ prior written notice. We may also change the scheduled date for repurchasing excess activity-based stock with at least 15 days’ prior written notice.
During the fourth quarter of 2008, we suspended our regular practice of voluntarily repurchasing excess activity-based capital stock. This action was taken after careful consideration of the unstable market conditions and stressed economic environment at that time. Our Board of Directors and management felt this action was necessary to preserve capital that supports our service to members. Due to improved market conditions during 2009, we resumed our normal practice of voluntarily repurchasing excess activity-based capital stock on December 18, 2009 and repurchased $569.6 million of activity-based capital stock.
Because membership is voluntary for all members, a member can provide a notice of withdrawal from membership at any time. If a member provides notice of withdrawal from membership, we will not repurchase or redeem any membership stock until five years from the date of receipt of a notice of withdrawal. If a member that withdraws from membership owns any activity-based capital stock, we will not redeem any required activity-based capital stock until the activity no longer remains outstanding.
A member may cancel any pending notice of redemption before the completion of the five-year redemption period by providing written notice of cancellation. We charge a cancellation fee, which is currently set at a range of one to five percent of the par value of the shares of capital stock subject to redemption. Our Board of Directors retains the right to change the cancellation fee at any time. We will provide at least 15 days advance written notice to each member of any adjustment or amendment to our cancellation fee.
In accordance with the FHLBank Act, each class of our stock is considered putable by the member. There are significant statutory and regulatory restrictions on the obligation or right to redeem outstanding capital stock.
In no case may we redeem any capital stock if, following such redemption, we would fail to satisfy our minimum capital requirements (i.e., a statutory capital-to-asset ratio requirement and leverage requirement established by the FHLBank Act and a regulatory risk based capital-to-asset ratio requirement established by the Finance Agency). By law, all member holdings of our stock immediately become nonredeemable if we become undercapitalized.
In no case may we redeem any capital stock without the prior approval of the Finance Agency if either our Board of Directors or the Finance Agency determines that we incurred or are likely to incur losses resulting or likely to result in a charge against capital.

 

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Additionally, we cannot redeem shares of capital stock from any member if the principal or interest on any consolidated obligation of the FHLBank System is not paid in full when due, or under certain circumstances if (i) we project, at any time, that we will fail to comply with statutory or regulatory liquidity requirements, or will be unable to timely and fully meet all of our current obligations; (ii) we actually fail to comply with statutory or regulatory liquidity requirements or to timely and fully meet all of our current obligations, or enter or negotiate to enter into an agreement with one or more other FHLBanks to obtain financial assistance to meet our current obligations; or (iii) the Finance Agency determines that we will cease to be in compliance with statutory or regulatory liquidity requirements, or will lack the capacity to timely or fully meet all of our current obligations.
If we are liquidated, after payment in full to our creditors, our stockholders will be entitled to receive the par value of their capital stock as well as any retained earnings, paid-in surplus, undivided profits, and equity reserves, if any, in an amount proportional to the stockholder’s share of the total shares of capital stock. In the event of a merger or consolidation, our Board of Directors shall determine the rights and preferences of our stockholders, subject to any terms and conditions imposed by the Finance Agency.
Capital Stock
We had 24.6 million shares of capital stock outstanding at December 31, 2009 compared with 27.8 million shares outstanding at December 31, 2008. We issued 2.7 million shares to members and repurchased 5.7 million shares from members during 2009. We issued 55.8 million shares to members and repurchased 55.1 million shares from members during 2008. Approximately 78 percent and 83 percent of our capital stock outstanding at December 31, 2009 and 2008 was activity-based stock that fluctuates primarily with the outstanding balances of advances made to members and mortgage loans purchased from members.
Our capital stock balance categorized by type of financial services company, including mandatorily redeemable capital stock owned by former members, are noted in the following table at December 31, 2009 and 2008 (dollars in millions):
                 
Institutional Entity   2009     2008  
 
               
Commercial Banks
  $ 1,243     $ 1,314  
Insurance Companies
    982       1,203  
Savings and Loan Associations
    141       170  
Credit Unions
    95       94  
Former Members
    8       11  
 
           
 
               
Total regulatory capital stock
  $ 2,469     $ 2,792  
 
           

 

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Our members are required to maintain a certain minimum capital stock investment. Each member must maintain Class B membership stock in an amount equal to 0.12 percent of the member’s total assets as of the preceding December 31st subject to a cap of $10.0 million and a floor of $10,000. Each member must also maintain Class B activity-based stock in an amount equal to the total of:
  (1)   A specified percentage of its outstanding advances. As of December 31, 2009 the percentage was 4.45 percent.
  (2)   A specified percentage of its acquired member assets. As of December 31, 2009, the percentage was 4.45 percent.
  (3)   A specified percentage of its standby letters of credit. As of December 31, 2009, the percentage was 0.00 percent.
  (4)   A specified percentage of its advance commitments. As of December 31, 2009, the percentage was 0.00 percent.
  (5)   A specified percentage of its acquired member assets commitments. As of December 31, 2009, the percentage was 0.00 percent.
The minimum investment requirements are designed so that we remain adequately capitalized as member activity changes. To ensure we remain adequately capitalized within ranges established in the Capital Plan, these requirements may be adjusted upward or downward by our Board of Directors. At December 31, 2009 and 2008, approximately 85 percent and 92 percent of our total capital was capital stock.
Capital stock owned by members in excess of their minimum investment requirements is known as excess capital stock. Our excess capital stock including amounts classified as mandatorily redeemable capital stock was $61.8 million and $61.1 million at December 31, 2009 and 2008.
Mandatorily Redeemable Capital Stock
We reclassify stock subject to redemption from equity to a liability when a member engages in any of the following activities:
  (1)   Submits a written notice to redeem all or part of the member’s capital stock.
  (2)   Submits a written notice of the member’s intent to withdraw from membership, which automatically commences a five-year redemption period.
  (3)   Terminates its membership voluntarily as a result of a merger or consolidation into a nonmember or into a member of another FHLBank, or involuntarily as a result of action by our Board of Directors.

 

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When any of the above events occur, we will reclassify capital stock from equity to a liability at fair value. The fair value of capital stock subject to mandatory redemption is generally reported at par value as stock can only be acquired by members at par value and redeemed at par value. Fair value also includes estimated dividends earned at the time of the reclassification from equity to liabilities, until such amount is paid. Dividends related to capital stock classified as a liability are accrued at the expected dividend rate and reported as interest expense in the Statements of Income. The repayment of these mandatorily redeemable financial instruments is reflected as a cash outflow in the financing activities section of the Statements of Cash Flows.
If a member cancels its written notice of redemption or notice of withdrawal, we will reclassify mandatorily redeemable capital stock from a liability to equity. After the reclassification, dividends on the capital stock will no longer be classified as interest expense.
Although the mandatorily redeemable capital stock is not included in capital for financial reporting purposes, Finance Agency interpretation requires that such outstanding capital stock be considered capital for determining compliance with our regulatory capital requirements.
At December 31, 2009, we had $8.3 million in capital stock subject to mandatory redemption from 14 former members. At December 31, 2008, we had $10.9 million in capital stock subject to mandatory redemption from 10 former members. The decrease in mandatorily redeemable capital stock at December 31, 2009 was primarily due to the decrease in advance balances with former members whose stock was classified as mandatorily redeemable and therefore repurchased as activity paid down.
The following table shows the amount of capital stock subject to mandatory redemption by the time period in which we anticipate redeeming the capital stock based on our practices at December 31, 2009 and 2008 (dollars in millions):
                 
Year of Redemption   2009     2008  
 
               
2009
  $     $ 3  
2010
    7       6  
2011
    1       1  
2012
    *       1  
2013
    *       *  
2014
    *       *  
Thereafter
    *       *  
 
           
 
               
Total
  $ 8     $ 11  
 
           
     
*   Amount is less than one million.
A majority of the capital stock subject to mandatory redemption at December 31, 2009 and December 31, 2008 was due to voluntary termination of membership as a result of out of district mergers or consolidations.

 

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Dividends
Our Board of Directors may declare and pay dividends in either cash or capital stock or a combination thereof; however, historically, we have only paid cash dividends. Under Finance Agency regulations, we are prohibited from paying a dividend in the form of additional shares of capital stock if, after the issuance, the outstanding excess capital stock would be greater than one percent of our total assets. By regulation, we may pay dividends from current earnings or retained earnings, but we may not declare a dividend based on projected or anticipated earnings. Our Board of Directors may not declare or pay dividends if it would result in our non-compliance with capital requirements. Per regulation, we may not declare or pay a dividend if the par value of the stock is impaired or is projected to become impaired after paying such dividend.
Our ERMP requires a minimum retained earnings level. If actual retained earnings fall below the retained earnings requirement, we, as determined by our Board of Directors, are required to establish an action plan, which may include a dividend cap at less than the current earned dividend, to enable us to return to our required level of retained earnings within twelve months. At December 31, 2009 our actual retained earnings were above the retained earnings requirement, and therefore no action plan was necessary. Further discussion on our risk management metrics are discussed in “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operation — Risk Management.”
Our dividend philosophy is to pay out a sustainable dividend equal to or above the average three-month LIBOR rate for the covered period. While three-month LIBOR is the Bank’s dividend benchmark, the actual dividend payout is impacted by Board of Director polices, regulatory requirements, financial projections, and actual performance. Therefore, the actual dividend rate may be higher or lower than three-month LIBOR.
On February 18, 2010, the Board of Directors declared and approved a fourth quarter 2009 dividend at an annualized rate of 2.00 percent of average capital stock for the quarter. The dividend was paid on February 25, 2010. The dividend for the fourth quarter 2009 totaled $14.6 million, which was 36.1 percent of net income during the fourth quarter. Dividends declared that related to the calendar year 2009 were at an annual rate of 1.75 percent compared to average three-month LIBOR for the year of 0.69 percent. Dividends declared that related to calendar year 2008 were at an annual rate of 3.00 percent compared to average three-month LIBOR for the year of 2.93 percent.
Critical Accounting Policies and Estimates
Our accounting policies are fundamental to understanding “Management’s Discussion and Analysis of Financial Condition and Results of Operation.” We identified certain policies as critical because they require management to make particularly difficult, subjective, and/or complex judgments about matters that are inherently uncertain and because of the likelihood that materially different amounts would be reported under different conditions or using different assumptions.

 

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Several of these accounting policies involve the use of estimates that we consider critical because
    they are likely to change from period to period due to significant management judgments and assumptions about highly complex and uncertain matters.
    they use a different estimate or a change in estimate that could have a material impact on our reported results of operations or financial condition.
Estimates and assumptions that are significant to the results of operations and financial condition include those used in conjunction with
    fair value estimates.
 
    allowance for credit losses on advances and mortgage loans.
 
    derivative and hedge accounting.
 
    other-than-temporary impairment.
We evaluate our critical accounting policies and estimates on an ongoing basis. While management believes our estimates and assumptions are reasonable based on historical experience and other factors, actual results could differ from those estimates and differences could be material to the financial statements.
Fair Value Estimates
We carry certain assets and liabilities on the Statements of Condition at fair value, including investments classified as trading and available-for-sale, derivatives, and certain bonds for which the fair value option was elected. Fair value is a market-based measurement and is defined as the price received to sell an asset, or paid to transfer a liability, in an orderly transaction between market participants at the measurement date. The transaction to sell the asset or transfer the liability is a hypothetical transaction at the measurement date, considered from the perspective of a market participant holding the asset or owing the liability. In general, the transaction price will equal the exit price and, therefore, represent the fair value of the asset or liability at initial recognition. In determining whether a transaction price represents the fair value of the asset or liability at initial recognition, each reporting entity is required to consider factors specific to the asset or liability, the principal or most advantageous market for the assets or liability, and market participants with whom the entity would transact in that market.
Fair values play an important role in the valuation of certain of our assets, liabilities, and hedging transactions. Fair value is first determined based on quoted market prices or market-based prices, where available. If quoted market prices or market-based prices are not available, fair values are determined based on valuation models that use either:
    discounted cash flows, using market estimates of interest rates and volatility;
    dealer prices; or
    prices of similar instruments.

 

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Pricing models and their underlying assumptions are based on our best estimates with respect to:
    discount rates;
    prepayments;
    market volatility; and
    other factors.
These assumptions may have a significant effect on the reported fair values of assets and liabilities, including derivatives, and the income and expense related thereto. The use of different assumptions, as well as changes in market conditions, may result in materially different fair values.
The valuation of derivative assets and liabilities must reflect the value of the instrument including the values associated with counterparty risk and must also take into account the company’s own credit standing. We have collateral agreements with all our derivative counterparties and enforce collateral exchanges. Each derivative counterparty has bilateral collateral thresholds with us that take into account both our and the counterparty’s credit rating. As a result of these practices and agreements, we concluded that the impact of the credit differential between us and our derivative counterparties was sufficiently mitigated to an immaterial level and no further adjustments for credit were deemed necessary to the recorded fair values of derivative assets and liabilities in the Statements of Condition at December 31, 2009 and 2008.
We categorize our financial instruments carried at fair value into a three-level classification. The valuation hierarchy is based upon the transparency (observable or unobservable) of inputs to the valuation of an asset or liability as of the measurement date. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect our market assumptions. We utilize valuation techniques that maximize the use of observable inputs and minimize the use of unobservable inputs. We do not have any assets and liabilities carried at level 3 fair value on the Statements of Condition at December 31, 2009 and 2008.
For further discussion regarding how we measure financial assets and liabilities at fair value, see “Item 8. Financial Statements and Supplementary Data — Note 18 — Estimated Fair Values.”

 

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Allowance for Credit Losses
Advances
We are required by Finance Agency regulation to obtain sufficient collateral on advances to protect against losses and to accept only certain collateral on advances such as whole first mortgages on improved residential property or securities representing a whole interest in such mortgages; securities issued, insured, or guaranteed by the U.S. Government or any of the GSE’s, including without limitation MBS issued or guaranteed by Fannie Mae, Freddie Mac, or Ginnie Mae; cash deposited with us; guaranteed student loans; and other real estate-related collateral acceptable to us provided such collateral has a readily ascertainable value and we can perfect a security interest in such property. Additionally, CFIs may pledge secured small business loans, small farm loans, and agribusiness loans as collateral. At December 31, 2009 and 2008, we had rights to collateral (either loans or securities) on a member-by-member basis, with a discounted value in excess of outstanding advances. As additional security, the FHLBank Act provides that we have a lien on each borrower’s capital stock in the Bank; however, capital stock cannot be pledged as collateral to secure credit exposures. We have not incurred any credit losses on advances since our inception and, based on our credit extension and collateral policies, we do not anticipate any credit losses on our advances. Accordingly, we have not provided any allowance for credit losses on advances at December 31, 2009. For additional discussion regarding our advance collateral, see “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operation — Risk Management — Credit Risk — Advances.”
Mortgage Loans
We established an allowance for credit losses on our conventional mortgage loan portfolio. The allowance is an estimate of probable losses contained in the portfolio. We do not maintain an allowance for loan losses on our government-insured mortgage loan portfolio because of the (i) U.S. Government guarantee of the loans and (ii) contractual obligation of the loan servicer to repurchase the loan when certain criteria are met.
During the fourth quarter of 2009, we revised our allowance for credit losses methodology for conventional MPF loans. Under the prior methodology, we estimated our allowance for credit losses based primarily upon (i) the current level of nonperforming loans (i.e., those loans 90 days or more past due), (ii) historical losses experienced over several years, and (iii) credit enhancement fees available to recapture expected losses assuming a constant portfolio balance.
Under the revised methodology, we estimate our allowance for credit losses based primarily upon a rolling twelve-month average of (i) loan delinquencies, (ii) loans migrating to real estate owned, and (iii) actual historical losses, as well as credit enhancement fees available to recapture expected losses assuming a declining portfolio balance adjusted for prepayments.

 

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We implemented this revised methodology in order to better incorporate current market conditions. For the year ended December 31, 2009, we increased our allowance for credit losses through a provision of $1.5 million, of which $0.1 million related to the change in allowance methodology. The remaining provision of $1.4 million was due to increased delinquencies and loss severities throughout 2009. For additional discussion on our allowance for credit losses, see “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operation — Risk Management — Credit Risk — Mortgage Assets.”
Derivative and Hedge Accounting
All derivatives are recognized in the Statements of Condition at their fair values and are reported as either “derivative assets” or “derivative liabilities” net of cash collateral and accrued interest from counterparties.
By regulation, we are only allowed to use derivative instruments to mitigate identifiable risks. We formally document all relationships between derivative instruments and hedged items, as well as our risk management objectives and strategies for undertaking various hedge transactions and our method of assessing hedge effectiveness. Our current hedging strategies relate to hedges of existing assets and liabilities that qualify for fair value hedge accounting treatment and economic hedges that are used to reduce market risk at the balance sheet or portfolio level. As economic hedges do not qualify for hedge accounting treatment, only the derivative instrument is marked to market.
Each derivative is designated as one of the following:
  (1)   A hedge of the fair value of a recognized asset or liability or an unrecognized firm commitment (a fair value hedge).
  (2)   A nonqualifying hedge of an asset, liability, or firm commitment (an economic hedge) for asset-liability management purposes.
We recognize changes in the fair value of a derivative that is designated and qualifies as a fair value hedge and changes in the fair value of the hedged asset, liability, or unrecognized firm commitment that are attributable to the hedged risk in other income (loss) as “Net gain (loss) on derivatives and hedging activities.” Hedge ineffectiveness (the amount by which the change in the fair value of the derivative differs from the change in fair value of the hedged item) is recorded in other income (loss) as “Net gain (loss) on derivatives and hedging activities.”
Changes in the fair value of a derivative not qualifying for hedge accounting (an economic hedge) are recorded in current period earnings with no fair value adjustment to an asset or liability. The fair value adjustments are recorded in other income (loss) as “Net gain (loss) on derivatives and hedging activities.”

 

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The differences between accrued interest receivable and accrued interest payable on derivatives designated as fair value hedges are recognized as adjustments to the income or expense of the designated underlying financial instrument. The differences between accrued interest receivable and accrued interest payable on derivatives designated as economic hedges are recognized in other income (loss).
Certain derivatives might qualify for the “short cut” method of assessing effectiveness. The short cut method allows us to make the assumption of no ineffectiveness, which means that the change in fair value of the hedged item is assumed to equal the change in the fair value of the derivative. No further evaluation of effectiveness is performed for these hedging relationships unless a critical term changes.
For a hedging relationship that does not qualify for the short cut method, we measure our effectiveness using the “long haul” method, in which the change in fair value of the hedged item must be measured separately from the change in fair value of the derivative. We design effectiveness testing criteria based on our knowledge of the hedged item and hedging instrument that was employed to create the hedging relationship. We use regression analyses to assess hedge effectiveness prospectively and retrospectively.
We may issue debt, make advances, or purchase financial instruments in which a derivative instrument is “embedded.” Upon execution of these transactions, we assess whether the economic characteristics of the embedded derivative are clearly and closely related to the economic characteristics of the remaining component of the debt, advance, or purchased financial instrument (the host contract) and whether a separate, non-embedded instrument with the same terms as the embedded instrument would meet the definition of a derivative. If we determine that (i) the embedded derivative has economic characteristics not clearly and closely related to the economic characteristics of the host contract and (ii) a separate, stand-alone instrument with the same terms would qualify as a derivative instrument, the embedded derivative is separated from the host contract, carried at fair value, and designated as a stand-alone derivative instrument used as an economic hedge. However, if the entire contract (the host contract and the embedded derivative) is to be measured at fair value, with changes in fair value reported in current period earnings, or if we cannot reliably identify and measure the embedded derivative for purposes of separating that derivative from its host contract, the entire contract is carried at fair value and no portion of the contract is designated as a hedging instrument.

 

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Other-Than-Temporary Impairment
We evaluate our individual available-for-sale and held-to-maturity securities in an unrealized loss position for OTTI on a quarterly basis. As part of this process, we consider our intent to sell each debt security before its anticipated recovery and whether it is likely we will be required to sell the debt security before its anticipated recovery. If either of these conditions is met, we recognize an OTTI charge in earnings equal to the entire unrealized loss amount. For securities in unrealized loss position that do not meet these conditions, we perform an analysis to determine if any of these securities are other-than-temporarily impaired. For our private-label MBS, we perform a cash flow analysis to determine if we would recover the entire amortized cost basis of the debt security. The present value of the cash flows expected to be collected is compared to the amortized cost basis of the debt security to determine whether a credit loss exists. If there is a credit loss (the difference between the present value of the cash flows expected to be collected and the amortized cost basis of the debt security), the carrying value of the debt security is adjusted to its fair value. However, rather than recognizing the entire difference between the amortized cost basis and the fair value in earnings, only the amount of the impairment representing the credit loss (i.e., the credit component) is recognized in earnings, while the amount related to all other factors (i.e., the non-credit component) is recognized in accumulated other comprehensive loss. The total OTTI is presented in the Statements of Income with an offset for the amount of the total OTTI that is recognized in accumulated other comprehensive loss. To date, we have never experienced an OTTI loss.
Legislative and Regulatory Developments
Proposed Regulation on Community Development Loans by Community Financial Institutions and Secured Lending by FHLBanks to Members and Their Affiliates
On February 23, 2010, the Finance Agency issued a proposed regulation with a comment deadline of April 26, 2010 that would (i) implement the Housing Act provision allowing CFIs to secure advances from FHLBanks with community development loans, and (ii) deem all secured extensions of credit by an FHLBank to a member of any FHLBank to be an advance subject to applicable Finance Agency regulations on advances.
We are unable to predict what impact the proposed regulation may have on us if adopted. However, the proposed regulation’s provision concerning secured extensions of credit may have the potential to limit the parties with whom we enter into repurchase agreements, since such agreements would be subject to applicable Finance Agency regulations, including capitalization requirements, and non-members may not purchase our stock, thereby reducing our available lines of liquidity.

 

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Proposed Regulation on Temporary Increases in Minimum Capital Levels
On February 8, 2010, the Finance Agency issued a proposed regulation with a comment deadline of April 9, 2010 that, if adopted as proposed, would set forth certain standards and procedures that the Director of the Finance Agency would employ in determining whether to require or rescind a temporary increase in the minimum capital levels for any of the FHLBanks, Fannie Mae and Freddie Mac. To the extent that the final rule results in an increase in our capital requirements, our ability to pay dividends and repurchase or redeem capital stock may be adversely impacted.
Reporting of Fraudulent Financial Instruments
On January 27, 2010, the Finance Agency issued a final regulation, which became effective February 26, 2010, requiring Fannie Mae, Freddie Mac, and the FHLBanks to report to the Finance Agency any such entity’s purchase or sale of fraudulent financial instruments or loans, or financial instruments or loans such entity suspects is possibly fraudulent. The regulation imposes requirements on the timeframe, format, document retention, and nondisclosure obligations for reporting fraud or possible fraud to the Finance Agency. We are also required to establish and maintain adequate internal controls, policies and procedures, and an operational training program to discover and report fraud or possible fraud. The adopting release provides that the regulation will apply to all of our programs and products. The adopting release for the regulation provides that the Finance Agency will issue certain guidance specifying the investigatory and reporting obligations under the regulation. We will be in a better position to assess the significance of the reporting obligations once the Finance Agency has promulgated additional guidance with respect to specific requirements of the regulation.
Minority and Women Inclusion
The Housing Act requires the FHLBanks to establish or designate an Office of Minority and Women Inclusion that is responsible for carrying out all matters relating to diversity in management, employment, and business practices. On January 11, 2010, the Finance Agency issued a proposed rule to effect this provision of the Housing Act. Comments on the proposed rule are due by April 26, 2010.
Membership for Community Development Financial Institutions
On January 5, 2010, the Finance Agency issued a final rule establishing the eligibility requirements and procedural requirements for non-depository CDFIs that wish to become FHLBank members. The newly eligible non-depository CDFIs include community development loan funds, venture capital funds and state-chartered credit unions without federal insurance. At February 28, 2010, while eligible to become members, no non-depository CDFIs are included in our membership.

 

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FDIC Modifies & Extends Temporary Liquidity Guarantee Program for Bank Debt Liabilities
The FDIC has taken a number of actions with regard to the extension of the TLGP. The TLGP comprises two components: the Debt Guarantee Program (DGP), which provides FDIC guarantees of certain senior unsecured bank debt, and the Transaction Account Guarantee (TAG) program, which provides FDIC guarantees for all funds held at participating banks in qualifying non-interest bearing transaction accounts. On August 26, 2009, the FDIC adopted a final rule providing for a six-month extension of the TAG program, through June 30, 2010. On October 30, 2009, the FDIC adopted a final rule that allows for the DGP to terminate on October 31, 2009, for most DGP participants, but also establishes a limited emergency guarantee facility for those DGP participants that are unable to issue non-guaranteed debt to replace maturing senior unsecured debt because of market disruptions or other circumstances beyond their control. Under this limited emergency facility, the FDIC will guarantee senior unsecured debt issued on or before April 30, 2010. The TAG and DGP provide alternative sources of funds for many of our members that compete with our advance business.
Finance Agency Examination Guidance — Examination for Accounting Practices
On October 27, 2009, the Finance Agency issued examination guidance and standards, which were effective immediately, relating to the accounting practices of Fannie Mae, Freddie Mac and the FHLBanks, consistent with the safety and soundness responsibilities of the Finance Agency. The areas addressed by the examination guidance include: (i) accounting policies and procedures; (ii) Audit Committee responsibilities; (iii) independent internal audit function responsibilities; (iv) accounting staff; (v) financial statements; (vi) external auditor; and (vii) review of audit and accounting functions. This examination guidance is not intended to be in conflict with statutes, regulations, and/or GAAP. Additionally, this examination guidance is not intended to relieve or minimize the decision-making responsibilities, or regulated duties and responsibilities of the entity’s management, Board of Directors, or Committees thereof.
Principles for Executive Compensation at the FHLBanks and the Office of Finance
On October 27, 2009, the Finance Agency issued an advisory bulletin establishing certain principles for executive compensation at the FHLBanks and the Office of Finance. These principles include that: (i) such compensation must be reasonable and comparable to that offered to executives in similar positions at comparable financial institutions; (ii) such compensation should be consistent with sound risk management and preservation of the par value of FHLBank capital stock; (iii) executive incentive-based compensation should be tied to longer-term performance and outcome-indicators and be deferred and made contingent upon performance over several years; and (iv) the board of directors should promote accountability and transparency in the process of setting compensation.

 

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Directors’ Compensation and Expenses
On October 23, 2009, the Finance Agency issued a proposed rule on FHLBank directors’ compensation and expenses with a comment deadline of December 7, 2009. The proposed rule would allow each FHLBank to pay its directors reasonable compensation and expenses, subject to the authority of the Finance Agency Director (Director) to object to, and to prohibit prospectively, compensation and/or expenses that the Director determines are not reasonable. To assist the Director in reviewing the compensation and expenses of FHLBank directors, each FHLBank would be required to submit to the Director by specified deadlines: (i) the compensation anticipated to be paid to its directors for the following calendar year; (ii) the amount of compensation and expenses paid to each director for the immediately preceding calendar year; and (iii) a copy of the FHLBank’s written compensation policy, along with all studies or other supporting materials upon which the board of directors relied in determining the level of compensation and expenses to pay to its directors.
FHLBank Boards of Directors — Eligibility and Elections
On October 7, 2009, the Finance Agency published a final rule concerning the nomination and election of directors. The final rule provides for the following:
    Requires the board of directors of each FHLBank to determine annually how many of its independent directorships should be designated as public interest directorships, but mandates that at least two independent directors be public interest directors;
    Sets forth new provisions for filling a vacancy on the board of directors;
    Amends the election requirement for independent directors. The final rule provides that if an FHLBank’s board of directors nominates only one person for each directorship, receipt of 20 percent of the eligible votes by that nominee is required for that nominee to be elected. If, however, an FHLBank’s board of directors nominates more persons for the type of independent directorship to be filled than there are directorships of that type to be filled in the election, then the person with the highest number of votes will be declared elected; and
    Clarifies the requirements for subsequent elections in the event an independent director cannot be elected based on the failure to meet the 20 percent requirement of eligible votes.
The final rule became effective on November 6, 2009.

 

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Collateral for Advances and Interagency Guidance on Nontraditional Mortgage Products
On August 10, 2009, the Finance Agency published a notice for comment on a study to review the extent to which loans and securities used as collateral to support FHLBank advances are consistent with the Federal banking agencies’ guidance on nontraditional mortgage products. The Finance Agency requested comments on whether it should take any additional regulatory actions to ensure that FHLBanks are not supporting predatory practices. The Finance Agency also noted its intent to revise previously published guidelines for subprime and nontraditional loans pledged as collateral. This proposed revision would require members pledging private-label residential MBS and residential loans acquired after July 10, 2007 to comply with the Federal interagency guidance regardless of the origination date of the loans in the security or of the loans pledged. At this time, we are uncertain whether the Finance Agency will implement this revision or impose other restrictions on FHLBank collateral practices as a result of this notice for comment.
Board of Directors of FHLBank System Office of Finance
On August 4, 2009, the Finance Agency published a notice of proposed rulemaking, with comments due November 4, 2009, related to the reconstitution of the Office of Finance Board of Directors. The proposed rule would increase the size of the Office of Finance Board of Directors, create a fully independent audit committee, provide for the creation of other committees, and set a method for electing independent directors, along with setting qualification standards for these directors. Currently, the Office of Finance is governed by a board of directors, the composition and functions of which are determined by the Finance Agency’s regulations. Under existing Finance Agency regulation, the Office of Finance Board of Directors is made up of two FHLBank Presidents and one independent director. The Finance Agency has proposed that all twelve FHLBank Presidents be members of the Office of Finance Board of Directors, along with three to five independent directors. The independent directors would comprise the Audit Committee of the Office of Finance Board of Directors with oversight responsibility for the combined financial reports. Under the proposed rule, the Audit Committee of the Office of Finance would be responsible for ensuring that the FHLBanks adopt consistent accounting policies and procedures.
Golden Parachute and Indemnification Payments
On June 29, 2009, the Finance Agency published a proposed rule setting forth the standards that the Finance Agency would take into consideration when limiting or prohibiting golden parachute and indemnification payments. The proposed rule, if adopted, would better conform existing Finance Agency regulations on golden parachutes to FDIC rules and further detail what golden parachute and indemnification payments made by Fannie Mae, Freddie Mac, the FHLBanks, and the Office of Finance are limited under regulations. Comments on the proposed rule were due July 29, 2009.

 

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Executive Compensation
On June 5, 2009, the Finance Agency published a proposed rule to set forth requirements and processes with respect to executive compensation provided by the regulated entities (Fannie Mae, Freddie Mac, and the FHLBanks) and the Office of Finance. The Executive Compensation rule would address the statutory authority of the Director to approve, disapprove, modify, prohibit, or withhold compensation of executive officers of these regulated entities. The proposed rule would also address the Finance Agency Director’s authority to approve, in advance, agreements or contracts of executive officers that provide compensation in connection with termination of employment. The proposed rule would prohibit a regulated entity or the Office of Finance to pay compensation to an executive officer that is not reasonable and comparable with compensation paid by similar businesses involving similar duties and responsibilities. Failure by a regulated entity or the Office of Finance to comply with the requirements of this part may result in supervisory action by the Finance Agency, including an enforcement action to require an individual to make restitution to or reimbursement of excessive compensation or inappropriately paid termination benefits. Comments on the proposed rule were due August 4, 2009.
U.S. Treasury Department’s Financial Regulatory Reform
In June 2009, the U.S. Treasury Department announced a broad ranging plan for financial regulatory reform that would change how financial firms, markets, and products are regulated. Included in this reform plan are proposals to create a systemic risk regulator and a consumer financial protection agency and to provide more regulation of certain over-the-counter derivatives. Congress is currently considering legislation to implement these proposals. In addition, under the plan, the U.S. Treasury Department and the Housing and Urban Development Department are charged with developing recommendations regarding the future of the housing GSEs, including the FHLBanks. At this time, it is uncertain what parts, if any, of the reform plan will be enacted or implemented, whether any legislation enacted will result in more regulation of the FHLBanks and their use of derivatives, and what recommendations will be made with regard to the future of the GSEs.
Helping Families Save Their Homes Act of 2009
On May 20, 2009, the Helping Families Save Their Homes Act of 2009 was enacted to encourage loan modifications in order to prevent mortgage foreclosures and to buttress the federal deposit insurance system. One provision in this Act provides a safe harbor from liability for mortgage servicers who modify the terms of a mortgage consistent with certain qualified loan modification plans. Another provision extends the temporary increase in federal deposit insurance coverage to $250,000 for banks, thrifts, and credit unions through 2013. At this time it is uncertain what effect the provisions regarding loan modifications will have on the value of our mortgage asset portfolio. The extension of federal deposit insurance coverage could potentially decrease demand for our advances.

 

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Other-Than-Temporary Impairment Guidance
On April 28, 2009 and May 7, 2009, the Finance Agency provided the FHLBanks with guidance on the process for determining OTTI with respect to private-label MBS. The goal of the guidance is to promote consistency in the determination of OTTI for private-label MBS among all FHLBanks. We adopted the Finance Agency guidance as further described below, effective January 1, 2009.
Beginning with the second quarter of 2009, the FHLBanks formed an OTTI Governance Committee with the responsibility for reviewing and approving the key modeling assumptions, inputs, and methodologies used by the FHLBanks to generate cash flow projections used in analyzing credit losses and determining OTTI for private-label MBS. The OTTI Governance Committee charter was approved on June 11, 2009 and provides a formal process by which the other FHLBanks can provide input on and approve the assumptions.
An FHLBank may engage one of four designated FHLBanks to perform the cash flow analysis underlying its OTTI determination. Each FHLBank is responsible for making its own determination of OTTI and the reasonableness of assumptions, inputs, and methodologies used. Additionally, each FHLBank performs the required present value calculations using appropriate historical cost bases and yields. FHLBanks that hold commonly owned private-label MBS are required to consult with one another to ensure that any decision on a commonly held private-label MBS that is other-than-temporarily impaired, including the determination of fair value and the credit loss component of the unrealized loss, is consistent among those FHLBanks.
In order to promote consistency in the application of the assumptions and implementation of the OTTI methodology, the FHLBanks have established control procedures whereby the FHLBanks performing cash flow analysis select a sample group of private-label MBS and each perform cash flow analyses on all such test MBS, using the assumptions approved by the OTTI Governance Committee. These FHLBanks exchange and discuss the results and make any adjustments necessary to achieve consistency among their respective cash flow models.
FDIC Deposit Insurance Assessments
On February 27, 2009, the FDIC approved a final regulation that would increase the deposit insurance assessment for those FDIC-insured institutions that have outstanding FHLBank advances and other secured liabilities to the extent that the institution’s ratio of secured liabilities to domestic deposits exceeds 25 percent. On May 29, 2009, the FDIC published a final rule to impose a five basis point special assessment on an FDIC-insured institution’s assets minus Tier 1 capital as of June 30, 2009, subject to certain caps. Past FDIC assessments have been based on the amount of deposits held by an institution. In addition, Congress is considering legislation to require the FDIC to base future assessments on the amount of assets held by an institution instead of on the amount of deposits it holds. The FDIC’s risk-based assessment and an assessment framework based on assets may provide an incentive for some of our members to hold more deposits than they would if non-deposit liabilities were not a factor in determining an institution’s deposit insurance assessments.

 

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U.S. Treasury Department’s Financial Stability Plan
On February 10, 2009, the U.S. Treasury Department announced a Financial Stability Plan to address the global capital markets crisis and U.S. economic recession that continued into 2009. This Financial Stability Plan evolved to include a number of initiatives, including the encouragement of lower mortgage rates, foreclosure relief programs, a bank capital injection program, major lending programs with the Federal Reserve directed at the securitization markets for consumer and small business lending, and a purchase program for certain illiquid assets. As part of this stability plan, a new bond purchase program to support lending by Housing Finance Agencies and a temporary credit and liquidity program to improve their access to liquidity for outstanding Housing Finance Agency bonds were created. To pay for a portion of the assistance provided by the stability plan, the Obama Administration has proposed legislation that would assess a Financial Responsibility Fee on large financial institutions’ liabilities (excluding deposits and insurance policy reserves). If such a fee were to be imposed, advances to our large members may become more costly.
Off-balance Sheet Arrangements
Our primary source of funds is the sale of consolidated obligations. Although we are primarily liable for the portion of consolidated obligations issued on our behalf, we also are jointly and severally liable with the other FHLBanks for the payment of principal and interest on all consolidated obligations of each of the FHLBanks. If the principal or interest on any consolidated obligation issued on behalf of any FHLBank is not paid in full when due, the FHLBanks may not pay dividends or redeem or repurchase shares of stock from any member of that FHLBank. The Finance Agency, at its discretion, may require any FHLBank to make principal or interest payments due on any consolidated obligation whether or not the consolidated obligation represents a primary liability of such FHLBank. Because of the high credit quality of each FHLBank, management has concluded that the probability that an FHLBank would be unable to repay its participation is remote. Furthermore, the Finance Agency regulations require that all FHLBanks maintain at least an AA rating. Therefore, no liability is recorded for the joint and several obligation related to the other FHLBanks’ share of consolidated obligations.
The par amount of the outstanding consolidated obligations of all 12 FHLBanks was approximately $930.5 billion and $1,251.5 billion at December 31, 2009 and 2008. The par value of consolidated obligations for which we are the primary obligor was approximately $59.7 billion and $62.4 billion at December 31, 2009 and 2008.
During the third quarter of 2008, we entered into a Lending Agreement with the U.S. Treasury in connection with the U.S. Treasury’s establishment of the GSECF, as authorized by the Housing Act. The GSECF was designed to serve as a contingent source of liquidity for the GSEs, including the 12 FHLBanks. The GSECF expired on December 31, 2009. The Bank did not draw on this available source of liquidity during 2009.

 

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In the ordinary course of business, we issue letters of credit on behalf of our members and housing associates to facilitate business transactions with third parties. Letters of credit may be used to facilitate residential housing finance or other housing activities, facilitate community lending, assist with asset-liability management, and provide liquidity or other funding. Members and housing associates must fully collateralize letters of credit with eligible collateral. At December 31, 2009 and 2008 we had $3.5 billion and $3.4 billion in letters of credit outstanding. If we are required to make payment for a beneficiary’s draw, rather than obtaining repayment of these amounts from the member, these amounts may be converted into a collateralized advance to the member.
At December 31, 2009, we had approximately $26.7 million in outstanding commitments to purchase mortgage loans compared with $289.6 million at December 31, 2008. We did not have any outstanding commitments for additional advances at December 31, 2009 or 2008. We entered into $0.2 billion and $1.0 billion par value traded but not settled bonds at December 31, 2009 and 2008. We had $56.0 million and $267.9 million of cash pledged as collateral to broker-dealers at December 31, 2009 and 2008. We execute derivatives with large highly rated banks and broker-dealers and enter into bilateral collateral agreements.
In conjunction with our sale of certain mortgage loans to the FHLBank of Chicago, whereby the mortgage loans were immediately resold by the FHLBank of Chicago to Fannie Mae, we entered into an agreement with the FHLBank of Chicago on June 11, 2009 to indemnify the FHLBank of Chicago for potential losses on mortgage loans remaining in four master commitments from which the mortgage loans were sold. We and the FHLBank of Chicago each hold certain participation interests in the four master commitments and therefore share, on a proportionate basis, any losses incurred after considering PFI credit enhancement provisions. The sale of mortgage loans under these master commitments reduced the amount of future credit enhancement fees available for recapture by us and the FHLBank of Chicago. Therefore, under the agreement, we agreed to indemnify the FHLBank of Chicago for any losses not otherwise recovered through credit enhancement fees, subject to an indemnification cap of $2.1 million by December 31, 2010, $1.2 million by December 31, 2012, $0.8 million by December 31, 2015, and $0.3 million by December 31, 2020. At December 31, 2009, we were not aware of any losses incurred by the FHLBank of Chicago that would not otherwise be recovered through credit enhancement fees.

 

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At December 31, 2009 and 2008, we had executed 24 and 9 standby bond purchase agreements with state housing associates within our district whereby we would be required to purchase bonds under circumstances defined in each agreement. We would hold investments in the bonds until the designated remarketing agent could find a suitable investor or the housing associate repurchases the bonds according to a schedule established by the standby bond purchase agreement. The 24 outstanding standby bond purchase agreements at December 31, 2009 totaled $711.1 million and expire seven years after execution, with a final expiration in 2016. The 9 outstanding standby bond purchase agreements at December 31, 2008 totaled $259.7 million and expire seven years after execution, with a final expiration in 2015. We received fees for the guarantees that amounted to $1.1 million and $0.2 million for the years ended December 31, 2009 and 2008. At December 31, 2009, we were not required to purchase any bonds under the executed standby bond purchase agreements. Should we be required to purchase these bonds, we would fund those purchases through the use of our normal funding operations. For further details on our funding operations and strategies, see “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operation — Liquidity and Capital Resources.”
On March 31, 2009, we entered into an agreement with the Missouri Housing Development Commission to purchase up to $75 million of taxable single family mortgage revenue bonds. The agreement was set to expire November 6, 2009, however, it was extended 60 days through January 6, 2010. At December 31, 2009, we purchased $15 million in mortgage revenue bonds under this agreement. These bonds are recorded as held-to-maturity investments at December 31, 2009. As of January 6, 2010, the agreement expired and we made no subsequent bond purchases.
On September 25, 2009, we entered into an agreement with the Iowa Finance Authority to purchase up to $100 million of taxable single family mortgage revenue bonds. The agreement expires on September 24, 2010. At December 31, 2009, we had not purchased any mortgage revenue bonds under this agreement. If required, we will fund the purchase of these bonds through the use of our normal funding procedures. For further details on our funding strategies, see “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operation — Liquidity and Capital Resources.”
Our financial statements do not include a liability for future statutorily mandated payments from the FHLBanks to REFCORP. No liability is recorded because each FHLBank must pay 20 percent of net earnings (after its AHP obligation) to REFCORP to support the payment of part of the interest and principal on the bonds issued by REFCORP, and the FHLBanks are unable to estimate their future required payments because the payments are based on future earnings and are not estimable. Accordingly, the REFCORP payments are disclosed as a long-term statutory payment requirement and, for accounting purposes, are treated, accrued, and recognized like an income tax.

 

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Contractual Obligations
The following table shows payments due by period under specified contractual obligations at December 31, 2009 and 2008 (dollars in millions):
                                         
    2009  
    Payments Due by Period  
                    Over one     Over three        
            One year     through     through     Over  
Contractual Obligations   Total     or less     three years     five years     five years  
 
                                       
Long-term debt1
  $ 50,323     $ 23,040     $ 15,501     $ 3,945     $ 7,837  
Operating lease obligations
    16       1       2       2       11  
Purchase obligations2
    4,587       374       3,386       107       720  
Mandatorily redeemable capital stock3
    8       7       1       *       *  
 
                             
 
                                       
Total
  $ 54,934     $ 23,422     $ 18,890     $ 4,054     $ 8,568  
 
                             
                                         
    2008  
    Payments Due by Period  
                    Over one     Over three        
            One year     through     through     Over  
Contractual Obligations   Total     or less     three years     five years     five years  
 
                                       
Long-term debt1
  $ 42,269     $ 15,963     $ 10,829     $ 6,029     $ 9,448  
Operating lease obligations
    17       1       2       2       12  
Purchase obligations2
    4,955       2,826       1,832       30       267  
Mandatorily redeemable capital stock3
    11       3       6       1       1  
 
                             
 
                                       
Total
  $ 47,252     $ 18,793     $ 12,669     $ 6,062     $ 9,728  
 
                             
     
1   Long-term debt includes bonds (at par value). Long-term debt does not include discount notes and is based on contractual maturities. Actual distributions could be impacted by factors affecting early redemptions. Index amortizing notes are included in the table based on contractual maturities. The amortizing feature of these notes based on underlying indices could cause redemption at different times than contractual maturities.
 
2   Purchase obligations include the notional amount of standby letters of credit, commitments to fund mortgage loans, standby bond purchase agreements, commitments to purchase housing bonds, and advances and bonds traded but not settled (see additional discussion of these items in “Item 8. Financial Statements and Supplementary Data — Note 19 — Commitments and Contingencies”).
 
3   Mandatorily redeemable capital stock payment periods are based on how we anticipate redeeming the capital stock based on our practices.
 
*   Represents an amount less than one million.

 

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Risk Management
We have risk management policies, established by our Board of Directors, that monitor and control our exposure to market, liquidity, credit, operational, and business risk. Our primary objective is to manage assets, liabilities, and derivative exposures in ways that protect the par redemption value of capital stock from risks, including fluctuations in market interest rates and spreads. Our risk management strategies and limits protect us from significant earnings volatility. We periodically evaluate these strategies and limits in order to respond to changes in our financial position and general market conditions. This periodic evaluation may result in changes to our risk management policies and/or risk measures.
Our ERMP provides the ability to conduct a robust risk management practice allowing for flexibility to make rational decisions in stressed interest rate environments.
Our Board of Directors determined we should operate under a risk management philosophy of maintaining an AAA rating. An AAA rating provides us with ready access to funds in the capital markets. In line with this objective, the ERMP establishes risk measures, with policy limits or management action triggers (MATs), consistent with the maintenance of an AAA rating, to monitor our market risk, liquidity risk, and capital adequacy. Our MATs require close monitoring and measuring of the risks inherent in our Statements of Condition but provide more flexibility to react prudently when those trigger levels occur. The following is a list of the risk measures in place at December 31, 2009 and whether they are monitored by a policy limit and/or MAT:
     
Market Risk:
  Mortgage Portfolio Market Value Sensitivity (policy limit and MAT)
Market Value of Capital Stock Sensitivity (policy limit and MAT)
Projected 12-month GAAP Earnings Per Share Sensitivity (MAT)
Liquidity Risk:
  Contingent Liquidity (policy limit and MAT)
Capital Adequacy:
  Economic Capital Ratio (MAT)
 
  Economic Value of Capital Stock (MAT)
Management identified Economic Value of Capital Stock (EVCS) and Market Value of Capital Stock (MVCS) sensitivity as our key risk measures.
Market Risk/Capital Adequacy
We define market risk as the risk that net interest income or MVCS will change as a result of changes in market conditions such as interest rates, spreads, and volatilities. Interest rate risk was the predominant type of market risk exposure throughout 2009 and 2008. Our ERMP is designed to provide an asset and liability management framework to respond to changes in market conditions while minimizing balance sheet stress and income volatility. Management and the Board of Directors routinely review both the policy thresholds and the actual exposures to verify the interest rate risk in our balance sheet remains at prudent and reasonable levels.

 

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The goal of our interest rate risk management strategy is to manage interest rate risk by setting and operating within an appropriate framework and limits. Our general approach toward managing interest rate risk is to acquire and maintain a portfolio of assets, liabilities, and hedges, which, taken together, limit our expected exposure to market/interest rate risk. Management regularly monitors our sensitivity to interest rate changes by monitoring our market risk measures in parallel and non-parallel interest rate shifts. Our key market risk and capital adequacy measures are quantified in the “Economic Value of Capital Stock” and “Market Value of Capital Stock” sections that follow.
Valuation Models
We use sophisticated risk management systems to evaluate our financial position. These systems employ various mathematical models and valuation techniques to measure interest rate risk. For example, we use valuation techniques designed to model embedded options and other cash flow uncertainties across a number of hypothetical interest rate environments. The techniques used to model embedded options rely on
    understanding the contractual and behavioral features of each instrument.
 
    using appropriate market data, such as yield curves and implied volatilities.
    using appropriate option valuation models and prepayment functions to describe the evolution of interest rates over time and the expected cash flows of financial instruments in response.
The method for calculating fair value is dependent on the instrument type. We rely on these approaches:
    Option-free instruments, such as plain vanilla interest rate swaps, bonds, and advances require an assessment of the future course of interest rates. Once the course of interest rates has been specified and the expected cash flows determined, the appropriate forward rates are used to discount the future cash flows to a fair value.
    Option-embedded instruments, such as cancelable interest rate swaps, swaptions, caps, and floors, callable bonds, and mortgage-related instruments, are typically evaluated using interest rate tree (lattice) or Monte Carlo simulations that generate a large number of possible interest rate scenarios.

 

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Models are inherently imperfect predictors of actual results because they are based on assumptions about future performance. Changes in any models or in any of the assumptions, judgments, or estimates used in the models may cause the results generated by the model to be materially different. Our risk computations require the use of instantaneous shifts in assumptions such as interest rates, spreads, interest rate volatilities, and prepayment speeds. These assumptions are based on management’s best estimates at the time the model is run. Ultimately these computations may differ from our interest rate risk exposure because they do not take into account any portfolio rebalancing and hedging actions that are required to maintain risk exposures within our policies and guidelines. Management has adopted controls, procedures, and policies to monitor and manage assumptions used in these models.
Economic Value of Capital Stock
We define EVCS as the net present value of expected future cash flows of our assets, liabilities, and derivatives, discounted at our cost of funds, divided by the total shares of capital stock outstanding. This method reduces the impact of day-to-day price changes (e.g. mortgage option-adjusted spread) which cannot be attributed to any of the standard market factors, such as movements in interest rates or volatilities. Thus, EVCS approximates the long-term value of one share of our capital stock.
Our ERMP sets the MAT for EVCS at $100 per share. Under the policy, if EVCS drops below $100 per share, the ERMP requires that we increase our required retained earnings to account for the shortfall. If actual retained earnings fall below the retained earnings requirement we, as determined by the Board of Directors, are required to establish an action plan to enable us to return to our required retained earnings within twelve months. At December 31, 2009, our actual retained earnings were above the retained earnings minimum, and therefore no action plan was necessary.
The following table shows EVCS in dollars per share based on outstanding shares including shares classified as mandatorily redeemable, at each quarter-end during 2009 and 2008.
         
Economic Value of Capital Stock (Dollars Per Share)  
2009
       
December
  $ 108.7  
September
  $ 106.9  
June
  $ 102.1  
March
  $ 86.3  
2008
       
December
  $ 80.0  
September
  $ 96.1  
June
  $ 105.1  
March
  $ 105.3  

 

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Our EVCS has recovered significantly since December 31, 2008 increasing to $108.7 at December 31, 2009. The improvement was primarily attributable to the following:
    Improvement in our funding costs relative to LIBOR. Because the EVCS methodology focuses on the long-term value of one share of capital stock, we discount future cash flows of our assets, liabilities, and derivatives using our cost of funds. During 2009, our cost of funds relative to LIBOR improved, and therefore EVCS was positively impacted as the long-term net earnings potential of our balance sheet increased.
    Decreased interest rate volatility. Decreased interest rate volatility during 2009 had a positive impact on all value measurements (including EVCS) through its impact on the value of mortgage-related assets. As interest rate volatility decreased, the value of the prepayment option to homeowners embedded in the mortgage-related assets decreased, thereby increasing the value of the assets.
    Adjustments to our prepayment model. During the second quarter of 2009 we adjusted our prepayment model to more accurately reflect the recent prepayment experiences of our MPF portfolio. This adjustment decreased the projected prepayment speeds on those assets, resulting in higher future cash flows and thus higher EVCS.
    Increased retained earnings. Retained earnings increased during 2009 due primarily to the Bank’s increased net income. As we retain net income, our equity position increases thereby increasing EVCS.
    Elimination of the negative spread carried on our liquidity portfolio. During the fourth quarter of 2008, we funded a portion of our liquidity portfolio with fixed rate longer-dated discount notes. Subsequent to the issuance of these discount notes, interest rates fell significantly resulting in a negative spread as the cost of the discount notes was greater than the earnings on the liquidity portfolio. This negative spread significantly decreased EVCS at December 31, 2008. As the discount notes matured throughout 2009, the impact of the negative spread was eliminated thereby increasing EVCS.

 

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Market Value of Capital Stock
We define MVCS as the present value of assets minus the present value of liabilities adjusted for the net present value of derivatives divided by the total shares of capital stock outstanding. It represents the “liquidation value” of one share of our stock if all assets and liabilities were liquidated at current market prices. MVCS does not represent our long-term value, as it takes into account only the short-term market price fluctuations. These fluctuations are generally unrelated to the long-term value of the cash flows from our assets and liabilities.
The MVCS calculation uses market prices, as well as implied forward rates, and assumes a static balance sheet. The timing and variability of balance sheet cash flows are calculated by an internal model. To ensure the accuracy of the market value calculation, we reconcile the computed market prices of complex instruments, such as financial derivatives and mortgage assets, to market observed prices or dealers’ quotes.
Interest rate risk stress tests of MVCS involve instantaneous parallel shifts in interest rates. The resulting percentage change in MVCS from the base case value is an indication of longer-term repricing risk and option risk embedded in the balance sheet.
To protect the MVCS from large interest rate swings, we use hedging transactions, such as entering into or canceling interest rate swaps on existing debt, altering the funding structure supporting MBS and MPF purchases, and purchasing interest rate swaptions and caps.
The policy limits for MVCS are five percent and ten percent declines from base case in the up and down 100 and 200 basis point parallel interest rate shift scenarios, respectively. Any breach of policy limits requires an immediate action to bring the exposure back within policy limits, as well as a report to the Board of Directors.

 

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The following tables show our base case and change from base case MVCS in dollars per share and percent change respectively, based on outstanding shares including shares classified as mandatorily redeemable, assuming instantaneous shifts in interest rates at each quarter-end during 2009 and 2008:
                                         
    Market Value of Capital Stock (Dollars per Share)  
    Down 200     Down 100     Base Case     Up 100     Up 200  
2009
                                       
December
  $ 85.1     $ 100.2     $ 100.2     $ 97.2     $ 92.0  
September
  $ 78.4     $ 91.7     $ 95.5     $ 93.5     $ 89.0  
June
  $ 72.1     $ 86.9     $ 91.2     $ 90.4     $ 87.4  
March
  $ 42.7     $ 59.2     $ 76.3     $ 86.9     $ 85.7  
2008
                                       
December
  $ 20.6     $ 41.0     $ 58.4     $ 66.2     $ 64.3  
September
  $ 84.3     $ 89.3     $ 91.8     $ 89.6     $ 87.0  
June
  $ 81.7     $ 93.5     $ 97.0     $ 94.0     $ 89.1  
March
  $ 77.8     $ 85.7     $ 90.0     $ 87.6     $ 84.1  
                                         
    Percent Change from Base Case  
    Down 200     Down 100     Base Case     Up 100     Up 200  
2009
                                       
December
    (15.1 )%     0.0 %     0.0 %     (3.0 )%     (8.2 )%
September
    (17.9 )%     (4.0 )%     0.0 %     (2.1 )%     (6.8 )%
June
    (20.9 )%     (4.7 )%     0.0 %     (0.9 )%     (4.2 )%
March
    (44.0 )%     (22.3 )%     0.0 %     14.0 %     12.3 %
2008
                                       
December
    (64.8 )%     (29.7 )%     0.0 %     13.5 %     10.1 %
September
    (8.2 )%     (2.7 )%     0.0 %     (2.5 )%     (5.3 )%
June
    (15.7 )%     (3.6 )%     0.0 %     (3.1 )%     (8.1 )%
March
    (13.5 )%     (4.7 )%     0.0 %     (2.7 )%     (6.6 )%

 

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The increase in base case MVCS at December 31, 2009 compared with December 31, 2008 was primarily attributable to the following:
    Decreased option-adjusted spread on our mortgage assets. During 2009, the spread between mortgage interest rates and LIBOR decreased which increased the value of our mortgage assets.
    Increased longer-term interest rates. As longer-term interest rates increased during 2009, the prepayments on fixed-rate mortgage assets were reinvested at higher interest rates, while the cost of the associated debt remained constant/fixed. As a result, the value of the mortgage assets decreased less than the value of the corresponding debt, thereby increasing MVCS.
    Decreased interest rate volatility. Decreased interest rate volatility during 2009 had a positive impact on all value measurements (including MVCS) through its impact on the value of mortgage-related assets. As interest rate volatility decreased, the value of the prepayment option to homeowners embedded in the mortgage-related assets decreased, thereby increasing the value of the assets.
    Increased retained earnings. Retained earnings increased during 2009 due primarily to the Bank’s increased net income. As we retain net income, our equity position increases thereby increasing MVCS.
    Elimination of the negative spread carried on our liquidity portfolio. During the fourth quarter of 2008, we funded a portion of our liquidity portfolio with fixed rate longer-dated discount notes. Subsequent to the issuance of these discount notes, interest rates fell significantly resulting in a negative spread as the cost of the discount notes was greater than the earnings on the liquidity portfolio. This negative spread significantly decreased MVCS at December 31, 2008. As the discount notes matured throughout 2009, the impact of the negative spread was eliminated thereby increasing MVCS.
During 2009 and a majority of 2008, our projected MVCS in the down 200 basis point rate shift scenario fell below the ten percent policy threshold loss. However, in February 2008, our Board of Directors suspended all policy limits pertaining to the down 200 basis point rate shift scenario due to the already low interest rate environment. In addition, our projected MVCS in the down 100 basis point rate shift scenario was below the five percent threshold during the last quarter of 2008 and the first quarter of 2009. While this was a policy breach, management determined that the cost of employing hedging strategies to rebalance the profile and eliminate the breach outweighed the protection it would provide.

 

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Mortgage Finance Market Risk
Our Mortgage Finance business segment is exposed to market risk as a result of the interest rate risk associated with fixed rate mortgage assets. Mortgage assets include mortgage loans, MBS, HFA, and SBA investments. Interest rate risk exists on our mortgage assets due to the embedded prepayment option available to homeowners creating a potential cash flow mismatch between our mortgage assets and the liabilities funding them. Generally, as interest rates decrease, homeowners are more likely to refinance fixed rate mortgages, resulting in increased prepayments that are received earlier than if interest rates remain stable. Replacing higher rate loans that prepay with lower rate loans has the potential of reducing our net interest income. Conversely, an increase in interest rates may result in slower than expected prepayments and an extension in the weighted-average life of the mortgage assets. In this case, we have the risk that our liabilities may mature faster than our mortgage assets requiring us to issue additional funding at a higher cost, which would also reduce net interest income.
We generally attempt to match the duration of our mortgage assets with the duration of our liabilities within a reasonable range. We issue a mix of debt securities across a broad spectrum of final maturities to achieve the desired liability durations. Because the cash flows of mortgage assets fluctuate as interest rates change, we frequently issue callable and noncallable debt to alter the cash flows of our liabilities to match partially the expected change in cash flows of our mortgage assets. The duration of callable debt, like that of a mortgage, shortens when interest rates decrease and lengthens when interest rates increase. If interest rates decrease, we are likely to call debt that carries an interest rate higher than the current market.
We fund certain mortgage loans with a combination of callable, noncallable, and APLS debt securities. APLS principal balances pay down consistent with a specified reference pool of mortgages determined at issuance and have a final stated maturity of four to 15 years. These consolidated obligations pay a fixed coupon with the redemption schedule dependent on the amortization of the underlying reference pool of mortgages identified earlier. These consolidated obligations are redeemed at the final maturity date, regardless of the then-outstanding amount of the reference pool.
The noncallable and callable consolidated obligations have varying costs with the shorter-term noncallable bonds generally having a lower cost than the longer-term callable bonds. As a result of these differing bond costs, the cost of funds supporting our mortgage assets will change over time and under varying interest rate scenarios. The related mortgage assets maintain a relatively constant yield, resulting in changes in the portfolio’s interest spread relationship over time. In a stable to rising interest rate environment, the lower-rate short-term bonds mature while the higher-rate callable bonds remain outstanding, resulting in an increasing cost of funds and a lower income spread as time passes. Conversely, in a falling interest rate environment, many of the higher-rate callable bonds are called away reducing the cost of funds and improving spreads.

 

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We improved our overall risk profile during 2009 due to a combination of the mortgage loan sale transaction and associated debt extinguishments and the replacement of the mortgage loans sold. We sold $2.1 billion of our mortgage loan portfolio during the second quarter of 2009 in an effort to improve our market value sensitivity to changes in interest rates. We are exposed to interest rate risk on our mortgage assets due to the embedded prepayment option available to homeowners creating a potential cash flow mismatch between our mortgage investments and the liabilities funding them. Therefore, selling a portion of our mortgage loans reduced this cash flow mismatch and improved our market value risk profile. Additionally, as a result of the mortgage loan sale transaction, we used a portion of the proceeds to purchase investments to replace the mortgage loans. The investments purchased do not expose us to the same prepayment risk associated with mortgage assets and therefore, also improved our market value risk profile.
Derivatives
We enter into derivative agreements to manage our exposure to changes in interest rates. We use derivatives to adjust the effective maturity, repricing frequency, or option characteristics of financial instruments to achieve risk management objectives. We do not use derivatives for speculative purposes.
Our current hedging strategies encompass hedges of specific assets and liabilities that qualify for fair value hedge accounting treatment and economic hedges that are used to reduce overall market risk of the balance sheet. All hedging strategies are approved by our Asset-Liability Committee.
The following table describes our approved derivative hedging strategies at December 31, 2009:
             
    Hedging   Derivative Hedging   Purpose of Hedge
Hedged Item   Classification   Instrument   Transaction
Advances
           
 
           
Fixed rate advances
  Fair value   Payment of fixed, receipt of variable interest rate swap   To protect against changes in interest rates by converting the asset’s fixed rate to the same variable rate index as the funding source.
 
           
Putable fixed rate advances
  Fair value   Payment of fixed, receipt of variable interest rate swap with put option   To protect against changes in interest rates including option risk by converting the asset’s fixed rate to the same variable rate index as the funding source.
 
           
Callable fixed rate advances
  Fair Value   Payment of fixed, receipt of variable interest rate swap with call option   To protect against changes in interest rates including option risk by converting the asset’s fixed rate to the same variable rate index as the funding source.

 

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    Hedging   Derivative Hedging   Purpose of Hedge
Hedged Item   Classification   Instrument   Transaction
Variable rate advances
  Economic   Payment of variable (i.e. six-month LIBOR), receipt of variable (i.e. three-month LIBOR) interest rate swap   To protect against repricing risk by converting the asset’s variable rate to the same index variable rate as the funding source.
 
           
Mortgage Assets
           
 
           
Mortgage delivery commitments
  Economic   Forward settlement
agreements
  To protect against changes in market value resulting from changes in interest rates.
 
           
Investments
           
 
           
Fixed rate investments
  Fair value or
economic
  Payment of fixed, receipt of variable interest rate swap   To protect against changes in interest rates by converting the asset’s fixed rate to the same variable rate index as the funding source.
 
           
Consolidated Obligations
           
 
           
Fixed rate consolidated obligations
  Fair value or
Economic
  Payment of variable, receipt of fixed interest rate swap   To protect against changes in interest rates by converting the debt’s fixed rate to the same variable rate index as the asset being funded.
 
           
Callable fixed rate consolidated obligations
  Fair value or
Economic2
  Payment of variable, receipt of fixed interest rate swap with call option   To protect against changes in interest rates including option risk by converting the debt’s fixed rate to the same variable rate index as the asset being funded.
 
           
Callable variable rate consolidated obligations1
  Fair value or
Economic2
  Payment of variable, receipt of variable interest rate swap with call option   To protect against changes in interest rates including option risk by converting the debt’s variable rate to the same variable rate index as the asset being funded.
 
           
Variable rate consolidated obligations
  Economic   Payment of variable (i.e. one-month LIBOR or another index), receipt of variable (i.e. three-month LIBOR) interest rate swap   To protect against repricing risk by converting the variable rate funding source to the same variable rate index as the asset being funded.
 
           
Balance Sheet
           
 
           
Interest rate caps
  Economic   N/A   To protect against changes in income of mortgage assets due to changes in interest rates.

 

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    Hedging   Derivative Hedging   Purpose of Hedge
Hedged Item   Classification   Instrument   Transaction
Interest rate floors1
  Economic   N/A   To protect against changes in income of mortgage assets due to changes in interest rates.
 
           
Interest rate swaps and swaptions1
  Economic   N/A   To protect against changes in income and market value of capital stock due to changes in interest rates.
     
1   This derivative hedging strategy was not outstanding as of December 31, 2009.
 
 
2   When the hedged item is a hybrid instrument with an embedded derivative we may (i) bifurcate the derivative or (ii) elect the fair value option on the entire hedged item; in both cases the resulting instrument is classified as an economic hedge.
Advances
We make advances to our members and eligible housing associates on the security of eligible collateral. We issue fixed and variable rate advances, callable advances, and putable advances.
The optionality embedded in certain financial instruments can create additional interest rate risk. When a borrower prepays an advance, we could suffer lower future income if the principal portion of the prepaid advance were reinvested in lower yielding assets that continue to be funded by higher cost debt. To protect against this risk, we may charge a prepayment fee that makes us financially indifferent to a borrower’s decision to prepay an advance. When we offer advances (other than overnight advances) that a borrower may prepay without a prepayment fee, we generally finance such advances with callable debt or otherwise hedge the embedded option.
Mortgage Assets
We manage the interest rate and prepayment risk associated with mortgage loans, securities, and certificates using a combination of debt issuance and derivatives. We may use derivative agreements to transform the characteristics of MBS to more closely match the characteristics of the supporting funding.
The prepayment options embedded in mortgage assets can result in extensions or contractions in the expected maturities of these investments, depending on levels of interest rates. The Finance Agency limits this source of interest rate risk by restricting the types of MBS we may own to those with limited average life changes under certain interest rate shock scenarios.
We enter into commitments to purchase mortgages from our participating members. We may establish an economic hedge of these commitments by selling MBS “to-be-announced” (TBA) for forward settlement. A TBA represents a forward contract for the sale of MBS at a future agreed upon date. Upon expiration of the mortgage purchase commitment, the Bank purchases the TBA to close the hedged position.

 

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Non-Mortgage Investments
We manage the risk arising from changing market prices and volatility of certain fixed rate non-mortgage assets by using derivative agreements to transform the fixed rate characteristics to more closely match the characteristics of the supporting funding.
Consolidated Obligations
We manage the risk arising from changing market prices and volatility of a consolidated obligation by matching the cash inflow on the derivative agreement with the cash outflow on the consolidated obligation. While consolidated obligations are the joint and several obligations of the FHLBanks, each FHLBank serves as sole counterparty to derivative agreements associated with specific debt issues for which it is the primary obligor.
In a typical transaction, fixed rate consolidated obligations are issued for us by the Office of Finance and we simultaneously enter into a matching derivative agreement in which the counterparty pays us fixed cash flows designed to mirror in timing, optionality, and amount the cash outflows paid by us on the consolidated obligation. In this typical transaction, we pay a variable cash flow that closely matches the interest payments we receive on short-term or variable rate assets. This intermediation between the capital and derivative markets permits us to raise funds at lower costs than would otherwise be available through the issuance of variable rate consolidated obligations in the capital markets.
We also enter into derivative agreements on variable rate consolidated obligations. For example, we enter into a derivative agreement where the counterparty pays us variable rate cash flows and we pay a different variable rate linked to LIBOR. This type of hedge allows us to manage our repricing risk between assets and liabilities.
We may also enter into interest rate swaps with an upfront payment in a comparable amount to the discount on the hedged consolidated obligation. This cash payment equates to the initial fair value of the interest rate swap and is amortized over the estimated life of the interest rate swap to net interest income as the discount on the bond is expensed. The interest rate swap is marked to market through “Net gain (loss) on derivatives and hedging activities” in the Statements of Income.
Balance Sheet
We enter into certain economic derivatives as macro balance sheet hedges to protect against changes in interest rates. These economic derivatives include interest rate caps, floors, swaps, and swaptions.
See additional discussion regarding our derivative contracts in “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operation — Statements of Condition — Derivatives.”

 

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Liquidity Risk
Liquidity risk is the risk that we will be unable to meet our obligations as they come due or meet the credit needs of our members and housing associates in a timely and cost efficient manner. Day-to-day and contingency liquidity objectives are designed to protect our financial strength and to allow us to withstand market disruption. To achieve this objective, we establish liquidity management requirements and maintain liquidity in accordance with Finance Agency regulations and our own liquidity policy. Our Board of Directors approves the liquidity policy. Our liquidity risk management process is based on ongoing calculations of net funding requirements, which are determined by analyzing future cash flows based on assumptions of the expected behavior of members and our assets, liabilities, capital stock, and derivatives. See “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operation — Liquidity and Capital Resources” for additional details on our liquidity management.
Credit Risk
We define credit risk as the potential that our borrowers or counterparties will fail to meet their obligations in accordance with agreed upon terms. Our primary credit risks arise from our ongoing lending, investing, and hedging activities. Our overall objective in managing credit risk is to operate a sound credit granting process and to maintain appropriate credit administration, measurement, and monitoring practices.
Advances
We are required by regulation to obtain and maintain a security interest in eligible collateral at the time we originate or renew an advance and throughout the life of the advance. Eligible collateral includes whole first mortgages on improved residential property or securities representing a whole interest in such mortgages; securities issued, insured, or guaranteed by the U.S. government or any of the GSEs, including without limitation MBS issued or guaranteed by Fannie Mae, Freddie Mac, or Ginnie Mae; cash deposited with us; guaranteed student loans; and other real estate-related collateral acceptable to the Bank provided such collateral has a readily ascertainable value and we can perfect a security interest in such property. Additionally, CFIs may pledge collateral consisting of secured small business, small farm, or small agribusiness loans, including secured business and agri-business lines of credit.
Credit risk arises from the possibility that a borrower is unable to repay their obligation and the collateral pledged to us is insufficient to cover the amount of exposure in default. We manage credit risk by securing borrowings with sufficient collateral acceptable to us, monitoring borrower creditworthiness through internal and independent third-party analysis, and performing collateral review and valuation procedures to verify the sufficiency of pledged collateral. We are required by law to make advances solely on a secured basis and have never experienced a credit loss on an advance since our inception. We maintain policies and practices to monitor our exposure and take action where appropriate. In addition, we have the ability to call for additional or substitute collateral, or require delivery of collateral, during the life of a loan to protect its security interest.

 

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Although management has policies and procedures in place to manage credit risk, we may be exposed because the outstanding advance value may exceed the liquidation value of our collateral. We mitigate this risk through applying collateral discounts, requiring most borrowers to execute a blanket lien, taking delivery of collateral, and limiting extensions of credit.
Collateral discounts, or haircuts, are applied to the unpaid principal balance or market value, if available, of the collateral to determine the advance equivalent value of the collateral securing each borrower’s obligations. The amount of these discounts will vary based on the type of collateral and security agreement. We determine these discounts or haircuts using data based upon historical price changes, discounted cash flow analysis, and loan level modeling.
At December 31, 2009 and 2008, borrowers pledged $86 billion and $87 billion of collateral (net of applicable discounts) to support $39 billion and $44 billion of advances and other activities. Borrowers pledge collateral in excess of their collateral requirement to demonstrate liquidity availability and to borrow additional amounts in the future.
The following table shows our composition of collateral pledged to the Bank (dollars in billions):
                                                 
    December 31, 2009     December 31, 2008  
            Discounted                     Discounted        
            Value of     Percent of             Value of     Percent of  
    Discount     Collateral     Total Pledged     Discount     Collateral     Total Pledged  
Collateral Type   Range     Pledged     Collateral     Range     Pledged     Collateral  
 
                                               
Residential loans
                                               
1-4 family
    13-62 %   $ 38.7       45 %     9-46 %   $ 36.0       41 %
Multi-family
    50-62       1.3       2       33-50       1.1       1  
Other real estate
    20-65       22.4       26       11-60       23.8       28  
Securities/insured loans
                                               
Cash, agency and RMBS
    0-45       16.8       19       0-46       19.0       22  
CMBS
    11-36       4.3       5       5-29       4.6       5  
Government insured loans
    9-38       1.0       1       17-23       0.9       1  
Secured small business loans and agribusiness loans
    50-76       1.8       2       50-75       1.8       2  
 
                                   
 
                                               
Total
          $ 86.3       100 %           $ 87.2       100 %
 
                                       

 

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Mortgage Assets
We are exposed to mortgage asset credit risk through our participation in the MPF program and MBS activities. Mortgage asset credit risk is the risk that we will not receive timely payments of principal and interest due from mortgage borrowers because of borrower defaults. Credit risk on mortgage assets is affected by numerous characteristics, including loan type, borrower’s credit history, and other factors such as home price fluctuations, unemployment levels, and other economic factors in the local market or nationwide.
MPF Loans
Through our participation in the MPF program, we invest in conventional and government-insured residential mortgage loans that are acquired through or purchased from a PFI. We currently offer six MPF loan products to our PFIs: Original MPF, MPF 100, MPF 125, MPF Plus, Original MPF Government, and MPF Xtra. For a description of these MPF products, refer to “Item 1. Business — Products and Services — Mortgage Finance — MPF Loan Types.”
The following table presents our MPF portfolio by product type at December 31, 2009 and 2008 at par value (dollars in billions):
                                 
    2009     2008  
Product Type   Dollars     Percent     Dollars     Percent  
 
                               
Original MPF
  $ 0.5       6.5 %   $ 0       .3 2.8 %
MPF 100
    0.1       1.3       0       .2 1.9  
MPF 125
    2.4       31.2       2       .0 18.7  
MPF Plus1
    4.3       55.8       7.8       72.9  
 
                       
Total conventional loans
    7.3       94.8       10       .3 96.3  
 
                               
Government-insured loans
    0.4       5.2       0.4       3.7  
 
                       
 
                               
Total mortgage loans
  $ 7.7       100.0 %   $ 10.7       100.0 %
 
                       
     
1   During the second quarter of 2009, we sold $2.1 billion of MPF Plus mortgage loans to the FHLBank of Chicago, who immediately resold these loans to Fannie Mae.
We manage the credit risk on mortgage loans acquired in the MPF program by (i) using agreements to establish credit risk sharing responsibilities with our PFIs, (ii) monitoring the performance of the mortgage loan portfolio and creditworthiness of PFIs, and (iii) establishing prudent credit loss reserves to reflect management’s estimate of probable credit losses inherent in the portfolio. Our management of credit risk in the MPF program involves several layers of legal loss protection that are defined in agreements among us and our PFIs.

 

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For our government-insured MPF loans, our loss protection consists of the loan guarantee and contractual obligation of the loan servicer to repurchase the loan when certain criteria are met.
For our conventional MPF loans, PFIs retain a portion of the credit risk on the MPF loans they sell to us by providing credit enhancement. The required PFI credit enhancement may vary depending on the MPF product alternatives selected.
PFIs are paid a credit enhancement fee for managing the credit risk, and in some instances all or a portion of the credit enhancement fee may be performance based. Credit enhancement fees are paid monthly and are determined based on the remaining unpaid principal balance of the MPF loans in the master commitment. To the extent we experience losses in a master commitment, we may be able to recapture credit enhancement fees paid to the PFI to offset these losses. For the years ended December 31, 2009, 2008, and 2007, credit enhancement fees paid to PFIs amounted to $15.6 million, $18.8 million, and $20.8 million.
For our conventional MPF loans, the availability of loss protection may differ slightly among MPF products. Our loss protection consists of the following loss layers, in order of priority:
    Homeowner Equity.
    Primary Mortgage Insurance. PMI is on all loans with homeowner equity of less than 20 percent of the original purchase price or appraised value.
    First Loss Account. The first loss account specifies our loss exposure under each master commitment prior to the PFI’s credit enhancement obligation. If we experience losses in a master commitment, these losses will either be (i) recovered through the recapture of performance based credit enhancement fees from the PFI or (ii) absorbed by us. The first loss account balance for all master commitments is a memorandum account and was $116.4 million and $105.9 million at December 31, 2009 and 2008.
    Credit Enhancement Obligation of PFI. PFIs have a credit enhancement obligation to absorb losses in excess of the first loss account in order to limit our loss exposure to that of an investor in an MBS that is rated the equivalent of AA by an NRSRO. PFIs are required to either collateralize their credit enhancement obligation with us or to purchase SMI from a highly rated mortgage insurer. All of our SMI providers have had their external ratings for claims-paying ability or insurer financial strength downgraded below AA. Ratings downgrades imply an increased risk that these SMI providers will be unable to fulfill their obligations to reimburse us for claims under insurance policies. On August 7, 2009, the Finance Agency granted a waiver for one year on the AA rating requirement of SMI providers for existing loans and commitments in the MPF program. Currently, we are evaluating the claims-paying ability of our SMI providers.

 

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We utilize an allowance for credit losses to reserve for estimated losses after considering the recapture of performance based credit enhancement fees from the PFI. The allowance for credit losses on mortgage loans was as follows for the years ended December 31, 2009, 2008, and 2007 (dollars in thousands):
                         
    2009     2008     2007  
 
                       
Balance, beginning of year
  $ 500     $ 300     $ 250  
 
                       
Charge-offs
    (88 )     (95 )     (19 )
Provision for credit losses
    1,475       295       69  
 
                 
 
                       
Balance, end of year
  $ 1,887     $ 500     $ 300  
 
                 
In accordance with our allowance for credit losses methodology, the allowance estimate is based on both quantitative and qualitative factors. Quantitative factors include but are not limited to portfolio composition and characteristics, delinquency levels, historical loss experience, changes in members’ credit enhancements, including the recovery of performance based credit enhancement fees, and other relevant factors using a pooled loan approach. Qualitative factors include but are not limited to changes in national and local economic trends. During the fourth quarter of 2009, we revised our allowance for credit loss methodology in order to better incorporate current market conditions. Refer to “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operation — Critical Accounting Policies and Estimates — Allowance for Credit Losses — Mortgage Loans” for details on the allowance revision.
We monitor and report our loan portfolio performance monthly. Adjustments to the allowance for credit losses are considered at least quarterly based upon the factors discussed above. For the year ended December 31, 2009, we increased our allowance for credit losses through a provision of $1.5 million. This was primarily due to increased delinquency and loss severity rates throughout 2009. In addition, credit enhancement fees available to recapture losses decreased in 2009 as a result of the mortgage loan sale and increased principal repayments. For the years ended December 31, 2008 and 2007, we increased our allowance for credit losses through a provision of $0.3 million and $0.1 million.

 

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The following table summarizes our loan delinquencies at December 31, 2009 (dollars in millions):
                         
    Unpaid Principal Balance  
            Government-        
    Conventional     Insured     Total  
 
                       
30 days
  $ 89     $ 17     $ 106  
60 days
    34       6       40  
90 days
    21       3       24  
Greater than 90 days
    22       2       24  
Foreclosures and bankruptcies
    64       1       65  
 
                 
 
                       
Total delinquencies
  $ 230     $ 29     $ 259  
 
                 
 
                       
Total mortgage loans outstanding
  $ 7,333     $ 380     $ 7,713  
 
                 
 
                       
Delinquencies as a percent of total mortgage loans
    3.1 %     7.6 %     3.4 %
 
                 
 
                       
Delinquencies 90 days and greater plus foreclosures and bankruptcies as a percent of total mortgage loans
    1.5 %     1.6 %     1.5 %
 
                 
The following table summarizes our loan delinquencies at December 31, 2008 (dollars in millions):
                         
    Unpaid Principal Balance  
            Government-        
    Conventional     Insured     Total  
 
                       
30 days
  $ 101     $ 23     $ 124  
60 days
    27       7       34  
90 days
    11       3       14  
Greater than 90 days
    12       3       15  
Foreclosures and bankruptcies
    47       5       52  
 
                 
 
                       
Total delinquencies
  $ 198     $ 41     $ 239  
 
                 
 
                       
Total mortgage loans outstanding
  $ 10,253     $ 423     $ 10,676  
 
                 
 
                       
Delinquencies as a percent of total mortgage loans
    1.9 %     9.7 %     2.2 %
 
                 
 
                       
Delinquencies 90 days and greater plus foreclosures and bankruptcies as a percent of total mortgage loans
    0.7 %     2.6 %     0.8 %
 
                 

 

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We place any conventional mortgage loan that is 90 days or more past due on nonaccrual status, meaning interest income on the loan is not accrued and any cash payments received are applied as a reduction of principal. A government-insured loan that is 90 days or more past due is not placed on nonaccrual status because of the (i) U.S. government guarantee of the loan and (ii) contractual obligation of the loan servicer to repurchase the loan when certain criteria are met.
As shown in the tables above, delinquencies and nonaccrual loans for our conventional portfolio increased in 2009 when compared to 2008, which is consistent with the overall trend of increased delinquencies in the mortgage market. Delinquencies for our government-insured portfolio decreased in 2009 when compared to 2008 primarily due to fewer delinquent loans and the contractual obligation of the loan servicer to repurchase the loans when certain criteria are met.
The following table shows the state concentrations of our MPF portfolio at December 31, 2009. State concentrations are calculated based on unpaid principal balances.
         
State Concentrations        
 
       
Minnesota
    18.5 %
Iowa
    16.8 %
Missouri
    9.4 %
California
    6.8 %
Illinois
    4.7 %
All others1
    43.8 %
 
     
 
       
Total
    100.0 %
 
     
     
1   There are no individual states with a concentration greater than 2.9 percent.
Effective August 1, 2009, we introduced a temporary loan payment modification plan for participating PFIs, which will be available until December 31, 2011. Homeowners with conventional loans secured by their primary residence originated prior to January 1, 2009 are eligible for the modification plan. This modification plan is available to homeowners currently in default or imminent danger of default. The modification plan states specific eligibility requirements that must be met and procedures the PFIs must follow to participate in the modification plan.
Mortgage-Backed Securities
Finance Agency regulations allow us to invest in MBS guaranteed by the U.S. Government, GSEs, and other MBS that are rated AAA by S&P, Aaa by Moody’s, or AAA by Fitch on the purchase date. We are exposed to credit risk to the extent these MBS fail to perform adequately. We do ongoing analysis to evaluate the investments and creditworthiness of the issuers, trustees, and servicers for potential credit issues.

 

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At December 31, 2009, we owned $11.3 billion of MBS, of which $11.2 billion or 99 percent were guaranteed by the U.S. Government or issued by GSEs and $0.1 billion or one percent were MPF shared funding certificates or private-label MBS. At December 31, 2008, we owned $9.3 billion of MBS, of which $9.2 billion or 99 percent were guaranteed by the U.S. Government or issued by GSEs and $0.1 billion or one percent were MPF shared funding certificates or private-label MBS.
Our MPF shared funding certificates are mortgage-backed certificates created from conventional conforming mortgages using a senior/subordinated tranche structure. We record these investments as held-to-maturity. We do not consolidate our investment in MPF shared funding certificates since we are not the sponsor or primary beneficiary of these variable interest entities. The following table shows our MPF shared funding certificates and credit ratings at December 31, 2009 and 2008 (dollars in millions):
                 
Credit Rating   2009     2008  
 
               
AAA
  $ 31     $ 45  
AA
    2       2  
 
           
 
               
Total
  $ 33     $ 47  
 
           
Our private-label MBS were all variable rate securities rated AA or higher by an NRSRO at December 31, 2009 and 2008 with the exception of one private-label MBS that was downgraded to an A rating on May 29, 2009. As of February 28, 2010, there have been no subsequent rating agency actions on our private-label MBS. All of these private-label MBS are backed by prime loans. For more information on our evaluation of OTTI, see “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operation — Critical Accounting Policies and Estimates — Other-Than-Temporary Impairment” and “Item 8. Financial Statements and Supplementary Date — Note 7 — Other-Than-Temporary Impairment.”
The following table summarizes the characteristics of our private-label MBS by year of securitization at December 31, 2009 (dollars in millions):
                                         
    Unpaid     Gross                      
    Principal     Unrealized             Investment        
Year of Securitization   Balance     Losses     Fair Value     Grade %1     Watchlist %2  
2003 and earlier
  $ 35     $ 7     $ 28       100 %     0 %
 
                             
     
1   Investment grade includes securities that are rated BBB or higher by any NRSRO.
 
2   Includes any securities placed on negative watch by any NRSRO.

 

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The following table summarizes the fair value of our private-label MBS as a percentage of unpaid principal balance by quarter:
                                         
    December 31,     September 30,     June 30,     March 31,     December 31,  
Year of Securitization   2009     2009     2009     2009     2008  
2003 and earlier
    80 %     81 %     80 %     77 %     74 %
 
                             
The following table shows portfolio characteristics of the underlying collateral of our private-label MBS at December 31, 2009:
         
Portfolio Characteristics   2009  
 
       
Weighted average FICO score at origination1
    725  
Weighted average loan-to-value at origination
    65 %
Weighted average original credit enhancement
    4 %
Weighted average credit enhancement
    9 %
Weighted average delinquency rate2
    5 %
     
1   FICO is a widely used credit industry model developed by Fair, Isaac, and Company, Inc. to assess borrower credit quality with scores ranging from a low of 300 to a high of 850.
 
2   Represents the delinquency rate on underlying loans that are 60 days or more past due.
The following table shows the state concentrations of our private-label MBS at December 31, 2009. State concentrations are calculated based on unpaid principal balances.
         
State Concentrations        
 
       
Florida
    14.1 %
California
    13.1 %
Georgia
    11.9 %
New York
    9.4 %
New Jersey
    5.1 %
All other1
    46.4 %
 
     
 
       
Total
    100.0 %
 
     
     
1   There are no individual states with a concentration greater than 4.4 percent.
Investments
We maintain an investment portfolio to provide investment income, provide liquidity, support the business needs of our members, and support the housing market through the purchase of mortgage-related assets. Finance Agency regulations and policies adopted by our Board of Directors limit the type of investments we may purchase.

 

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We invest in both short- and long-term investments. Our short-term portfolio includes, but is not limited to, interest-bearing deposits, Federal funds sold, commercial paper, and securities purchased under agreements to resell. Our long-term portfolio includes, but is not limited to, GSE obligations, MBS, municipal bonds, state and local HFA obligations, and TLGP debt. The primary credit risk of these investments is the counterparties’ ability to meet repayment terms.
We mitigate credit risk on investment securities by investing in highly-rated investment securities as well as establishing unsecured credit limits to counterparties based on the credit quality and capital levels of the counterparty as well as our capital level. Because the investments are transacted with highly rated counterparties, the credit risk is low; accordingly, we have not set aside specific reserves for our investment portfolio. We do, however, maintain a level of retained earnings to absorb any unexpected losses from our investments that may arise from stress conditions.
The following table shows our total investment securities by investment rating (excluding accrued interest receivable) (dollars in millions):
                                 
    December 31, 2009     December 31, 2008  
            Percent             Percent  
            of Total             of Total  
Credit Rating1   Amount     Investments     Amount     Investments  
 
                               
Long-term
                               
AAA2
  $ 16,687       80.3 %   $ 11,477       74.7 %
AA
    503       2.4       75       0.5  
A
    5       *              
BBB
    3       *       3       *  
 
                       
Total long-term
    17,198       82.7       11,555       75.2  
 
                               
Short-term
                               
A-1 or higher/P-1
    3,310       15.9       3,480       22.6  
A-2/P-2
    278       1.4       330       2.2  
 
                       
Total short-term
    3,588       17.3       3,810       24.8  
 
                               
Unrated3
    4       *       4       *  
 
                               
Total
  $ 20,790       100.0 %   $ 15,369       100.0 %
 
                       
     
1   Credit rating is the lowest of S&P, Moody’s, and Fitch ratings stated in terms of the S&P equivalent.
 
2   AAA rated investments include TLGP investments. We categorize these investments as AAA because of the U.S. Government guarantee.
 
3   Unrated securities represent an equity investment in Small Business Investment Company.
 
*   Amount is less than 0.1 percent.

 

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The increase in AAA and AA investments from 2008 to 2009 was due to increased investment purchases in an effort to improve investment income and replace mortgage assets sold in 2009. The increase was primarily due to purchases of TLGP investments and AA rated taxable municipal investments. For more details relating to our investment purchases, see “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operation — Results of Operations - Net Interest Income by Segment.”
Derivatives
Most of our hedging strategies use over-the-counter derivative instruments that expose us to counterparty credit risk because the transactions are executed and settled between two parties. When an over-the-counter derivative has a market value above zero, the counterparty owes us that value over the remaining life of the derivative. Credit risk arises from the possibility the counterparty will not be able to fulfill its commitment to pay the amount owed to us.
We manage this credit risk by spreading our transactions among many highly rated counterparties, by entering into collateral exchange agreements with counterparties that include minimum collateral thresholds, and by monitoring our exposure to each counterparty on a daily basis. In addition, all of our collateral exchange agreements include master netting arrangements whereby the fair values of all interest rate derivatives (including accrued interest receivable and payables) with each counterparty are offset for purposes of measuring credit exposure. The collateral exchange agreements require the delivery of collateral consisting of cash or very liquid highly rated securities if credit risk exposures rise above the minimum thresholds.

 

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The following tables show our derivative counterparty credit exposure at December 31, 2009 and 2008 excluding mortgage delivery commitments and after applying netting agreements and collateral (dollars in millions). We were in a net liability position at December 31, 2009 and 2008.
                                         
    2009  
                    Total     Value     Exposure  
    Active     Notional     Exposure at     of Collateral     Net of  
Credit Rating1   Counterparties     Amount2     Fair Value3     Pledged     Collateral4  
 
                                       
AAA
    1     $ 276     $     $     $  
AA
    7       17,419       5             5  
A
    14       29,176       9       3       6  
 
                             
 
                                       
Total
    22     $ 46,871     $ 14     $ 3     $ 11  
 
                             
                                         
    2008  
                    Total     Value     Exposure  
    Active     Notional     Exposure at     of Collateral     Net of  
Credit Rating1   Counterparties     Amount2     Fair Value3     Pledged     Collateral4  
 
                                       
AAA
    1     $ 309     $     $     $  
AA
    10       17,338       *             *  
A
    12       12,093                    
 
                             
 
                                       
Total
    23     $ 29,740     $ *     $     $ *  
 
                             
     
1   Credit rating is the lower of the S&P, Moody’s, and Fitch ratings stated in terms of the S&P equivalent.
 
2   Notional amounts serve as a factor in determining periodic interest amounts to be received and paid and generally do not represent actual amounts to be exchanged or directly reflect our exposure to counterparty credit risk.
 
3   For each counterparty, this amount includes derivatives with a net positive market value including the related accrued interest receivable/payable (net).
 
4   Amount equals total exposure at fair value less value of collateral pledged as determined at the counterparty level.
 
*   Amount is less than one million.
Operational Risk
We define Operational risk as the risk of loss resulting from inadequate or failed internal processes, people, systems, or external events. Operational risk is inherent in all of our business activities and processes. Management has established policies and procedures to reduce the likelihood of operational risk and designed our annual risk assessment process to provide ongoing identification, measurement, and monitoring of operational risk. Our Enterprise Risk Committee reviews risk assessment results and business unit recommendations regarding operational risk.

 

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Management reduces the risk of process and system failures by implementing internal controls designed to provide reasonable assurance that transactions are recorded in accordance with source documentation and by maintaining certain back-up facilities. In addition, management has developed and tested a comprehensive business continuity plan to restore mission critical processes and systems in a timely manner. Our Internal Audit Department also conducts independent operational and information system audits on a regular basis to ensure that adequate internal controls exist.
We use various financial models and model output to quantify financial risks and analyze potential strategies. Management mitigates the risk of incorrect model output leading to inappropriate business decisions by benchmarking model results to independent sources and having third parties periodically validate critical models.
We are prepared to deliver services to customers in normal operating environments as well as in the presence of significant internal or external stresses.
Despite the above policies and oversight, some operational risks are beyond our control, and the failure of other parties to adequately address their operational risk could adversely affect us.
Business Risk
We define business risk as the risk of an adverse impact on our profitability resulting from external factors that may occur in both the short- and long-term. Business risk includes political, strategic, reputation, regulatory, and/or environmental factors, many of which are beyond our control. From time to time, proposals are made, or legislative and regulatory changes are considered, which could affect our cost of doing business. Our risk management committees regularly discuss business risk issues. We control business risk through strategic and annual business planning and monitoring of our external environment.

 

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ITEM 7A — QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
See “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operation — Risk Management — Market Risk/Capital Adequacy” and the sections referenced therein for Quantitative and Qualitative Disclosures about Market Risk.
ITEM 8 — FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The following financial statements and accompanying notes, including the report of independent registered public accounting firm, are set forth beginning at page S-1.
         
Audited Financial Statements
       
Report of Independent Auditors dated March 18, 2010 — PricewaterhouseCoopers LLP
       
Statements of Condition at December 31, 2009 and 2008
       
Statements of Income for the Years Ended December 31, 2009, 2008, and 2007
       
Statements of Changes in Capital for the Years Ended December 31, 2009, 2008, and 2007
       
Statements of Cash Flows for the Years Ended December 31, 2009, 2008, and 2007
       
Notes to Financial Statements
       

 

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Supplementary Data
Selected Quarterly Financial Information
The following tables present selected financial data from the Statements of Condition at the end of each quarter of 2009 and 2008. They also present selected quarterly operating results for the same periods.
                                 
    2009  
    December 31,     September 30,     June 30,     March 31,  
Statements of Condition
(Dollars in millions)
                               
Investments1
  $ 20,790     $ 21,134     $ 21,576     $ 27,199  
Advances
    35,720       36,303       37,165       37,783  
Mortgage loans2
    7,719       7,839       8,120       10,588  
Total assets
    64,657       65,426       67,032       75,931  
Consolidated obligations
                               
Discount notes
    9,417       12,874       19,967       29,095  
Bonds
    50,495       46,918       41,599       41,633  
Total consolidated obligations3
    59,912       59,792       61,566       70,728  
Mandatorily redeemable capital stock
    8       18       12       11  
Capital stock — Class B putable
    2,461       2,952       2,923       2,871  
Retained earnings
    484       458       437       368  
Accumulated other comprehensive loss
    (34 )     (24 )     (22 )     (78 )
Total capital
    2,911       3,386       3,338       3,161  
                                 
    Three Months Ended  
    2009  
    December 31,     September 30,     June 30,     March 31,  
Statements of Income
(Dollars in millions)
                               
Net interest income4
  $ 66.9     $ 58.1     $ 63.1     $ 9.3  
Provision for credit losses on mortgage loans
    1.2       *       0.3        
Other income (loss)5
    6.6       1.5       51.2       (3.5 )
Other expense
    17.3       11.3       12.8       11.7  
Net income
    40.4       35.5       75.9       (5.9 )
     
1   Investments include: interest-bearing deposits, securities purchased under agreements to resell, Federal funds sold, trading securities, available-for-sale securities, and held-to-maturity securities.
 
2   Represents the gross amount of mortgage loans prior to the allowance for credit losses. The allowance for credit losses was $1.9 million, $0.8 million, $0.7 million, and $0.5 million at December 31, 2009, September 30, 2009, June 30, 2009, and March 31, 2009.
 
3   The par amount of the outstanding consolidated obligations for all 12 FHLBanks was $930.5 billion, $973.6 billion, $1,055.8 billion, and $1,135.4 billion at December 31, 2009, September 30, 2009, June 30, 2009, and March 31, 2009, respectively.
 
4   Net interest income is before provision for credit losses on mortgage loans.
 
5   Other income (loss) includes, among other things, net gain (loss) on derivatives and hedging activities, net (loss) gain on extinguishment of debt, net gain on trading securities, and net loss on bonds held at fair value.
 
*   Represents an amount less than $0.1 million.

 

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    2008  
    December 31,     September 30,     June 30,     March 31,  
Statements of Condition
(Dollars in millions)
                               
Investments1
  $ 15,369     $ 11,868     $ 14,047     $ 12,077  
Advances
    41,897       63,897       46,022       47,092  
Mortgage loans2
    10,685       10,576       10,583       10,707  
Total assets
    68,129       87,069       70,838       70,082  
Consolidated obligations
                               
Discount notes
    20,061       41,753       27,714       32,365  
Bonds
    42,723       39,217       37,588       32,166  
Total consolidated obligations3
    62,784       80,970       65,302       64,531  
Mandatorily redeemable capital stock
    11       11       43       43  
Capital stock — Class B putable
    2,781       3,807       3,016       3,012  
Retained earnings
    382       404       388       367  
Accumulated other comprehensive loss
    (146 )     (106 )     (58 )     (122 )
Total capital
    3,017       4,105       3,346       3,257  
                                 
    Three Months Ended  
    2008  
    December 31,     September 30,     June 30,     March 31,  
Statements of Income
(Dollars in millions)
                               
Net interest income4
  $ 28.2     $ 79.7     $ 73.0     $ 64.7  
Provision for credit losses on mortgage loans
    0.3                    
Other (loss) income5
    (13.5 )     (6.6 )     3.9       (11.6 )
Other expense
    11.3       10.8       11.6       10.4  
Net income
    2.3       45.8       47.9       31.4  
     
   
 
1   Investments include: interest-bearing deposits, Federal funds sold, trading securities, available-for-sale securities, and held-to-maturity securities.
 
2   Represents the gross amount of mortgage loans prior to the allowance for credit losses. The allowance for credit losses was $0.5 million at December 31, 2008 and $0.2 million at September 30, 2008, June 30, 2008, and March 31, 2008.
 
3   The par amount of the outstanding consolidated obligations for all 12 FHLBanks was $1,251.5 billion, $1,327.9 billion, $1,255.5 billion, and $1,220.4 billion at December 31, 2008, September 30, 2008, June 30, 2008, and March 31, 2008, respectively.
 
4   Net interest income is before provision for credit losses on mortgage loans.
 
5   Other (loss) income includes net (loss) gain on derivatives and hedging activities.

 

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Investment Portfolio Analysis
Supplementary financial data on our investment securities for the years ended December 31, 2009, 2008, and 2007 are included in the tables below.
At December 31, 2009, we had investments with a book value greater than 10 percent of our total capital with the following issuers (excluding GSEs and U.S. government agencies) (dollars in millions):
                 
            Total  
    Total     Market  
    Book Value     Value  
Bank of America Corporation
  $ 758     $ 758  
Bank of the West
    304       304  
Bank of Nova Scotia
    545       545  
BBVA
    461       461  
BNP Paribas
    395       395  
Citibank, N.A.
    340       340  
Credit Industriel
    300       300  
GE Capital Corporation
    1,105       1,105  
JP Morgan
    656       656  
Morgan Stanley