UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-K

 

[ü] 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
[  ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from                                    to                                   

 

Commission File Number: 000-51395

FEDERAL HOME LOAN BANK OF PITTSBURGH

 

(Exact name of registrant as specified in its charter)

 

 

(412) 288-3400

 

(Registrant’s telephone number, including area code)

 

 

 

 

 

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.
  oYes xNo

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  oYes xNo

 

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.  xYes oNo

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  o Yes o No

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  x

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  o Yes x 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 $4,007 million. There were 40,200,379 shares of common stock outstanding at February 28, 2010.

 

FEDERAL HOME LOAN BANK OF PITTSBURGH

 

TABLE OF CONTENTS

 

 

 

Business and Market Overview

 

The Federal Home Loan Bank of Pittsburgh’s (the Bank) mission is to provide a readily available, low-cost source of funds for housing and community lenders. The Bank strives to enhance the availability of credit for residential mortgages and targeted community development. The Bank manages its own liquidity so that funds are available to meet members’ demand. By providing needed liquidity and enhancing competition in the mortgage market, the Bank’s lending programs benefit homebuyers and communities.

 

Financial and housing markets have been in turmoil for the last two years, both here in the U.S. and worldwide. As a result of the extensive efforts of the U.S. government and other governments around the world to stimulate economic activity and provide liquidity to the capital markets, the economic environment seemed to have started to stabilize towards the end of 2009. Home sales showed signs of beginning to stabilize in the last half of 2009. However, unemployment and underemployment remained at higher levels. In addition, many government programs that support the financial and housing markets were still in place at year-end 2009 but will begin to wind down in 2010. There may be risks to the economy as these programs wind down and the government withdraws its support.

 

The housing market continues to be weak. Housing prices are low and still falling in some areas, although there are signs of increasing stability in others. Delinquency and foreclosure rates have continued to rise. While the agency mortgage-backed securities (MBS) market is active in funding new mortgage originations, the private label MBS market has not recovered. In addition, the commercial real estate market continues to trend downward.

 

These conditions, combined with ongoing concern about when the financial crisis and the recession may eventually level off, continued to affect the Bank’s business, results of operations and financial condition in 2009, as well as that of the Bank’s members, and may continue to exert a significant negative effect in the immediate future.

 

General

 

History.  The Bank is one of twelve Federal Home Loan Banks (FHLBanks). The FHLBanks operate as separate entities with their own managements, employees and boards of directors. The twelve FHLBanks, along with the Office of Finance (OF - the FHLBanks’ fiscal agent) and the Federal Housing Finance Agency (Finance Agency - the FHLBanks’ regulator) make up the Federal Home Loan Bank System (FHLBank System). The FHLBanks were organized under the authority of the Federal Home Loan Bank Act of 1932, as amended (Act). The FHLBanks are commonly referred to as government-sponsored enterprises (GSEs), which generally means they are a combination of private capital and public sponsorship. The public sponsorship attributes include: (1) being exempt from federal, state and local taxation, except real estate taxes; (2) being exempt from registration under the Securities Act of 1933 (1933 Act) (although the FHLBanks are required by Finance Agency regulation and the Housing and Economic Recovery Act of 2008 (the Housing Act) to register a class of their equity securities under the Securities Exchange Act of 1934 (1934 Act)) and (3) having a line of credit with the U.S. Treasury. This line represents the U.S. Treasury’s authority to purchase consolidated obligations in an amount up to $4 billion.

 

Cooperative.  The Bank is a cooperative institution, owned by financial institutions that are also its primary customers. Any building and loan association, savings and loan association, commercial bank, homestead association, insurance company, savings bank, credit union or insured depository institution that maintains its principal place of business in Delaware, Pennsylvania or West Virginia and that meets varying requirements can apply for membership in the Bank. The Housing Act expanded membership to include Community Development Financial Institutions (CDFIs). Pursuant to the Housing Act, the Finance Agency has amended its membership regulations to authorize non-federally insured CDFIs to become members of an FHLBank. The newly eligible CDFIs would include community development loan funds, venture capital funds and state-chartered credit unions without federal insurance. The regulation was effective February 4, 2010 and sets out the eligibility and procedural requirements for CDFIs that wish to become members of an FHLBank. All members are required to purchase capital stock in the Bank as a condition of membership. The capital stock of the Bank can be purchased only by members.

Mission.  The Bank’s primary mission is to intermediate between the capital markets and the housing market through member financial institutions. The Bank provides credit for housing and community development through two primary programs. First, it provides members with loans against the security of residential mortgages and other types of high-quality collateral. Second, the Bank purchases residential mortgage loans originated by or through member institutions. The Bank also offers other types of credit and noncredit products and services to member institutions. These include letters of credit, interest rate exchange agreements (interest rate swaps, caps, collars, floors, swaptions and similar transactions), affordable housing grants, securities safekeeping, and deposit products and services. The Bank issues debt to the public (consolidated obligation bonds and discount notes) in the capital markets through the OF and uses these funds to provide its member financial institutions with a reliable source of credit for these programs. The U.S. government does not guarantee the debt securities or other obligations of the Bank or the FHLBank System.

 

Overview.  The Bank is a GSE, chartered by Congress to assure the flow of liquidity through its member financial institutions into the American housing market. As a GSE, the Bank’s principal strategic position has historically been derived from its ability to raise funds in the capital markets at narrow spreads to the U.S. Treasury yield curve. Typically, this fundamental competitive advantage, coupled with the joint and several cross-guarantee on FHLBank System debt, has distinguished the Bank in the capital markets and has enabled it to provide attractively priced funding to members. However, as the financial crisis worsened in 2008, the spread between FHLBank System debt and U.S. Treasury debt widened, making it more difficult for the Bank to provide term funding to members at attractive rates in the beginning of 2009. However, during the last part of the second quarter of 2009 spreads narrowed, allowing the Bank to offer more attractive pricing through the end of the year.

 

Though chartered by Congress, the Bank is privately capitalized by its member institutions, which are voluntary participants in its cooperative structure. The characterization of the Bank as a voluntary cooperative with the status of a federal instrumentality differentiates the Bank from a traditional banking institution in three principal ways.

 

First, members voluntarily commit capital required for membership principally in order to gain access to the funding and other services provided by the Bank. The value in membership may be derived from the access to liquidity and the availability of favorably priced liquidity, as well as the potential for a dividend on the capital investment. Management recognizes that financial institutions choose membership in the Bank principally for access to attractively priced liquidity, dividends, and the value of the products offered within this cooperative.

 

Second, because the Bank’s customers and shareholders are predominantly the same group of 316, normally there is a need to balance the pricing expectations of customers with the dividend expectations of shareholders, although both are the same institutions. This is a challenge in the current economic environment. By charging wider spreads on loans to customers, the Bank could potentially generate higher earnings and potentially dividends for shareholders. Yet these same shareholders viewed as customers would generally prefer narrower loan spreads. In normal market conditions, the Bank strives to achieve a balance between the goals of providing liquidity and other services to members at advantageous prices and potentially generating a market-based dividend. The Bank typically does not strive to maximize the dividend yield on the stock, but to produce an earned dividend that compares favorably to short-term interest rates, compensating members for the cost of the capital they have invested in the Bank. As previously announced on December 23, 2008 the Bank has voluntarily suspended dividend payments until the Bank believes it is prudent to restore them, in an effort to build retained earnings.

 

Third, the Bank is different from a traditional banking institution because its GSE charter is based on a public policy purpose to assure liquidity for housing and to enhance the availability of affordable housing for lower-income households. In upholding its public policy mission, the Bank offers a number of programs that consume a portion of earnings that might otherwise become available to its shareholders. The cooperative GSE character of this voluntary membership organization leads management to strive to optimize the primary purpose of membership, access to funding, as well as the overall value of Bank membership.

 

In November 2008, the Bank experienced a significant increase in its risk-based capital (RBC) requirements due to deterioration in the market values of the Bank’s private label MBS. The Bank was narrowly in compliance with its RBC requirement. As a result, the Bank submitted a Capital Stabilization Plan (CSP) to the Finance Agency on February 27, 2009.

During 2009, many changes occurred in the environment affecting the Bank. The Financial Accounting Standards Board (FASB) changed the guidance for how to account for other-than-temporary impairment (OTTI). There have been multiple and significant downgrades of the Bank’s private label MBS securities, especially those private label MBS of 2007 or 2006 vintage, which have impacted the credit RBC requirement for the Bank. Macroeconomic conditions have not improved at the rate originally expected. The Bank has implemented significant elements of action plans, including completing its initial analysis on modifying the funding and hedging of the Bank’s balance sheet, simplifying the menu of advance products, and completing its analysis of the Bank’s capital structure. In addition, advances balances have decreased more than expected. Collectively, these developments merited an update of the CSP. On September 28, 2009, management submitted a revised CSP to the Bank’s regulator. The CSP submitted to the Finance Agency requests that the Bank not be required to increase member capital requirements unless it becomes significantly undercapitalized, which by definition would mean the Bank meets less than 75% of its risk-based, total or leverage capital requirements. As part of that effort, the Bank has reviewed its risk governance structure, risk management practices and expertise and has begun to make certain enhancements.

 

The Bank was in compliance with its risk-based, total and leverage capital requirements at December 31, 2009. On January 12, 2010, the Bank received final notification from the Finance Agency that it was considered adequately capitalized for the quarter ended September 30, 2009. In its determination, the Finance Agency expressed concerns regarding the Bank’s level of retained earnings, the quality of the Bank’s private label MBS portfolio and related accumulated other comprehensive income (AOCI), and the Bank’s ability to maintain permanent capital above RBC requirements. As of the date of this filing, the Bank has not received notice from the Finance Agency regarding its capital classification for the quarter ended December 31, 2009.

 

On August 4, 2009, the Finance Agency issued its final Prompt Corrective Action Regulation (PCA Regulation) incorporating the terms of the Interim Final Regulation issued on January 30, 2009. See also the “Legislative and Regulatory Developments” discussion in Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations (Management’s Discussion and Analysis) in this 2009 Annual Report filed on Form 10-K for additional information regarding the terms of the Interim Final Regulation.

 

Nonmember Borrowers.  In addition to member institutions, the Bank is permitted under the Act to make loans to nonmember housing associates that are approved mortgagees under Title II of the National Housing Act. These eligible housing associates must be chartered under law, be subject to inspection and supervision by a governmental agency, and lend their own funds as their principal activity in the mortgage field. The Bank must approve each applicant. Housing associates are not subject to certain provisions of the Act that are applicable to members, such as the capital stock purchase requirements. However, they are generally subject to more restrictive lending and collateral requirements than those applicable to members. Housing associates that are not state housing finance agencies are limited to pledging to the Bank as security for loans their Federal Housing Administration (FHA) mortgage loans and securities backed by FHA mortgage loans. Housing associates that are state housing finance agencies (that is, they are also instrumentalities of state or local governments) may, in addition to pledging FHA mortgages and securities backed by FHA mortgages, also pledge the following as collateral for Bank loans: (1) U.S. Treasury and agency securities; (2) single and multifamily mortgages; (3) AAA-rated securities backed by single and multifamily mortgages; and (4) deposits with the Bank. As of December 31, 2009, the Bank had approved three state housing finance agencies as housing associate borrowers. One of the housing associates has borrowed from the Bank from time to time, but had no balance as of December 31, 2009.

 

Supervision and Regulation.  The Bank is supervised and regulated by the Finance Agency, which is an independent agency in the executive branch of the United States government. The Finance Agency ensures that the Bank carries out its housing finance mission, remains adequately capitalized and able to raise funds in the capital markets, and operates in a safe and sound manner. The Finance Agency establishes regulations and otherwise supervises the operations of the Bank, primarily via periodic examinations. The Bank is also subject to regulation by the Securities and Exchange Commission (SEC).

Regulatory Oversight, Audits and Examinations

 

Regulation.  The Finance Agency supervises and regulates the FHLBanks and the OF. The Finance Agency establishes policies and regulations covering the operations of the FHLBanks. The Government Corporation Control Act provides that, before a government corporation issues and offers obligations to the public, the Secretary of the U.S. Treasury has the authority to prescribe the form, denomination, maturity, interest rate, and conditions of the obligations; the way and time issued; and the selling price. The U.S. Treasury receives the Finance Agency’s annual report to Congress, weekly reports reflecting consolidated obligations transactions of the FHLBanks, and other reports reflecting the operations of the FHLBanks. In addition, during 2009, the U.S. Treasury received weekly reports (through its agent, the Federal Reserve Bank of New York (FRBNY)) listing eligible collateral in support of the Government-Sponsored Enterprise Credit Facility (GSECF) Lending Agreement. This agreement, and the related reporting requirement, expired December 31, 2009. The Bank never drew on this line of credit.

 

Examination.  At a minimum, the Finance Agency conducts annual onsite examinations of the operations of the Bank. In addition, the Comptroller General has authority under the Act to audit or examine the Finance Agency and the Bank and to decide the extent to which they fairly and effectively fulfill the purposes of the Act. Furthermore, the Government Corporation Control Act provides that the Comptroller General may review any audit of the financial statements conducted by an independent registered public accounting firm. If the Comptroller General conducts such a review, then he or she must report the results and provide his or her recommendations to Congress, the Office of Management and Budget, and the FHLBank in question. The Comptroller General may also conduct his or her own audit of any financial statements of the Bank.

 

Audit.  The Bank has an internal audit department that conducts routine internal audits and reports directly to the Audit Committee of the Bank’s Board of Directors (Board). In addition, an independent Registered Public Accounting Firm (RPAF) audits the annual financial statements of the Bank. The independent RPAF conducts these audits following the Standards of the Public Company Accounting Oversight Board (PCAOB) of the United States of America and Government Auditing Standards issued by the Comptroller General. The Bank, the Finance Agency, and Congress all receive the RPAF audit reports.

 

Advances

 

Advance Products

 

The Bank makes advances (loans to members and eligible nonmember housing associates) on the security of pledged mortgage loans and other eligible types of collateral.

The following table presents a summary and brief description of the advance products offered by the Bank as of December 31, 2009. Information presented below relates to advances and excludes mortgage loans purchased by the Bank and held for portfolio and loans relating to the Banking on Business (BOB) program, which are discussed in detail below.

 

Advance Portfolio as of December 31, 2009

 

 

n/m — not meaningful

 

Notes:

 

RepoPlus.  The Bank serves as a major source of liquidity for its members. Access to the Bank for liquidity purposes can reduce the amount of low-yielding liquid assets a member would otherwise need to hold for liquidity purposes. The Bank’s RepoPlus advance products serve member short-term liquidity needs. These products are typically a short-term (1-89 day) fixed-rate product. As of December 31, 2009, the total par value of these products was $3.8 billion. These short-term balances tend to be extremely volatile as members borrow and repay frequently.

 

Mid-Term RepoPlus.  The Bank’s advance products also help members in asset/liability management by offering loans to minimize the risks associated with the maturity, amortization and prepayment characteristics of mortgage loans. Such advances from the Bank can reduce a member’s interest rate risk associated with holding long-term fixed-rate mortgage loans. The Mid-Term RepoPlus product assists members with managing intermediate-term interest rate risk. To assist members with managing the basis risk, or the risk of a change in the spread relationship between two indices, the Bank offers adjustable-rate Mid-Term RepoPlus advances with maturity terms between 3 months and 3 years. Adjustable-rate, Mid-Term RepoPlus advances can be priced based on 1-month London Interbank Offered Rate (LIBOR) or 3-month LIBOR indices. As of December 31, 2009, the par value of Mid-Term RepoPlus advances totaled $16.3 billion. These balances tend to be somewhat unpredictable as these advances are not always replaced as they mature; the Bank’s members’ liquidity needs drive these fluctuations.

 

Term Advances.  For managing longer-term interest rate risk and to assist with asset/liability management, the Bank primarily offers long-term fixed-rate advances for terms from 3 to 30 years. Amortizing long-term fixed-rate advances can be fully amortized on a monthly basis over the term of the loan or amortized balloon-style, based on an amortization term longer than the maturity of the loan. As of December 31, 2009, the par value of term advances totaled $12.7 billion.

 

Convertible Select, Hedge Select and Returnable.  Some of the Bank’s advances contain embedded options. The member can either sell an embedded option to the Bank or it can purchase an embedded option from the Bank. As of December 31, 2009, the par value of advances for which the Bank had the right to convert the advance, called Convertible Select, constituted $6.8 billion of the total advance portfolio. Advances in which the members purchased an option from the Bank are referred to as Hedge Select. In August 2009, the Bank eliminated the Hedge Select product; however, legacy balances with a total par balance of $50.0 million remained in the portfolio at December 31, 2009. Advances in which members have the right to prepay the advance without a fee, called Returnable, accounted for $12.0 million of the total par value of the advance portfolio at December 31, 2009.

 

Collateral

 

The Bank makes advances to members and eligible nonmember housing associates based upon the security of pledged mortgage loans and other eligible types of collateral. In addition, the Bank has established lending policies and procedures to limit risk of loss while balancing the members’ needs for funding; the Bank also protects against credit risk by fully collateralizing all member and nonmember housing associates’ advances. The Act requires the Bank to obtain and maintain a security interest in eligible collateral at the time it originates or renews an advance.

 

Collateral Agreements.  The Bank provides members with two options regarding collateral agreements; a blanket collateral pledge agreement and a specific collateral pledge agreement. Under a blanket agreement, the Bank obtains a lien against all of the member’s unencumbered eligible collateral assets and most ineligible collateral assets, to secure the member’s obligations with the Bank. Under a specific agreement, the Bank obtains a lien against the specific eligible collateral assets of a member, to secure the member’s obligations with the Bank. The member provides a detailed listing, as an addendum to the agreement, identifying those assets pledged as collateral. The specific agreement covers only those assets identified; the Bank is therefore relying on a specific subset of the member’s total eligible collateral as security for the member’s loans. In both cases (for members borrowing under either blanket or specific agreement), the Bank perfects its security interest under Article 9 of the Uniform Commercial Code (UCC) by filing a financing statement. The Bank requires housing finance agencies (HFAs) and insurance companies to sign specific agreements.

 

Collateral Status.  These agreements require one of three types of collateral status: undelivered, detailed listing or delivered status. A member is assigned a collateral status based on the Bank’s determination of the member’s current financial condition and credit product usage, as well as other information that may have been obtained.

The least restrictive collateral status, and the most widely used by the Bank’s members, is the undelivered collateral status. This status is generally assigned to lower risk institutions pledging collateral. Under undelivered collateral status, a member borrower is not required to deliver detailed reporting on pledged assets; rather, the Bank monitors the eligible collateral using regulatory financial reports, which are typically submitted quarterly, and/or periodic collateral certification reports, which are submitted to the Bank by the member. Origination of new advances or renewal of advances must only be supported by certain eligible collateral categories. Approximately 85.7% of the collateral pledged to the Bank was under a blanket lien agreement and in undelivered status at December 31, 2009. The remaining 14.3% of the collateral pledged to the Bank is in either listing or delivery status, which is discussed below. At December 31, 2009, nine of the Bank’s top ten borrowers were in undelivered collateral status and one was in specific-pledge, listing or delivery collateral status.

 

Under the Bank’s policy, the Bank may require members to provide a detailed listing of eligible advance collateral being pledged to the Bank due to their high usage of Bank credit products, the type of assets being pledged or the credit condition of the member. This is referred to as detail listing collateral status. In this case, the member typically retains physical possession of collateral pledged to the Bank but provides a listing of assets pledged. In some cases, the member may benefit by listing collateral, in lieu of undelivered status, since it may result in a higher collateral weighting being applied to the collateral (discussed below). The Bank benefits from listing collateral status because it provides more loan information to calculate a more precise valuation on the collateral. Typically, those members with large, frequent borrowings are covered under listing status with a blanket agreement.

 

The third collateral status used by the Bank’s members is delivered, or possession, collateral status. In this case, the Bank requires the member to deliver physical possession, or grant control of, eligible collateral to the Bank, including through a third party custodian for the Bank to sufficiently secure all outstanding obligations. Typically, the Bank would take physical possession/control of collateral if the financial condition of the member was deteriorating or if the member exceeded certain credit product usage triggers. Delivery of collateral may also be required if there is a regulatory action taken against the member by its regulator that would indicate inadequate controls or other conditions that would be of concern to the Bank. Delivery collateral status may apply to both blanket lien and specific agreements. The Bank requires delivery to a restricted account of all securities pledged as collateral. The Bank also requires delivery of collateral from de novo institution members at least during their first two years of operation.

 

With respect to specific collateral agreement borrowers (typically HFAs and insurance companies, as noted above), the Bank takes control of all collateral pledged at the time the loan is made through the delivery of securities or mortgage loans to the Bank or its custodian.

 

All eligible collateral securing advances is discounted to protect the Bank from default in adverse conditions. These discounts, also referred to as collateral weighting, vary by collateral type and whether the calculation is based on book value or fair value of the collateral and are presented in detail in the table entitled “Lending Value Assigned to the Collateral as a Percentage of Value” below. The discounts typically include margins for estimated costs to sell or liquidate and the risk of a decline in the collateral value due to market or credit volatility. The Bank reviews the collateral weightings periodically and may adjust them for individual borrowers on a case-by-case basis as well as the members’ reporting requirements to the Bank.

 

The Bank determines the type and amount of collateral each member has available to pledge as security for Bank advances by reviewing, on a quarterly basis, call reports the members file with their primary banking regulators. Depending on a member’s credit product usage and current financial condition, that member may also be required to file a Qualifying Collateral Report (QCR) on a quarterly or monthly basis. The resulting total value of collateral available to be pledged to the Bank after any collateral weighting is referred to as a member’s maximum borrowing capacity (MBC).

 

The Bank also performs periodic on-site collateral reviews of its borrowing members to confirm the amounts and quality of the eligible collateral pledged for the member’s loans. For certain pledged residential and commercial mortgage loan collateral, as well as delivered and third-party held securities, the Bank employs outside service providers to assist in determining values. In addition, the Bank has developed and maintains an Internal Credit Rating (ICR) system that assigns each member a numerical rating on a scale of one to ten. The combination of the member’s ICR, borrowing levels, assigned collateral values and on-site collateral review results determine

collateral weightings and collateral status. The Bank reserves the right, at its discretion, to refuse certain collateral or to adjust collateral weightings that are applied. In addition, the Bank can require additional or substitute collateral during the life of a loan to protect its security interest.

 

At December 31, 2009, the principal form of eligible collateral to secure loans made by the Bank was single-family residential mortgage loans, which included a very low amount of manufactured housing loans. High-quality securities, including U.S. Treasuries, Federal Deposit Insurance Corporation (FDIC)-guaranteed Temporary Liquidity Guarantee Program (TLGP) investments, U.S. agency securities, GSE MBS, and select private label MBS, were also accepted as collateral. FHLBank deposits and multi-family residential mortgages, as well as other real estate related collateral (ORERC), comprised the remaining portion of qualifying collateral. See the “Credit and Counterparty Risk” discussion in Risk Management in Item 7. Management’s Discussion and Analysis in this 2009 Annual Report filed on Form 10-K for further information on collateral policies and practices and details regarding eligible collateral, including amounts and percentages of eligible collateral securing loans as of December 31, 2009.

 

Priority.  As additional security for each member’s indebtedness, the Bank has a statutory lien on the member’s capital stock in the Bank. In the event of a deterioration in the financial condition of a member, the Bank will take control of sufficient eligible collateral to further perfect its security interest in collateral pledged to secure the members’ indebtedness to the Bank. Members with deteriorating creditworthiness or those exceeding certain product usage levels are required to deliver collateral to secure their obligations with the Bank. Furthermore, the Bank requires separate approval of such members’ new or additional advances.

 

The Act affords any security interest granted to the Bank by any member, or any affiliate of a member, priority over the claims and rights of any third party, including any receiver, conservator, trustee or similar party having rights of a lien creditor. The only two exceptions are: (1) claims and rights that would be entitled to priority under otherwise applicable law and are held by actual bona fide purchasers for value; and (2) parties that are secured by actual perfected security interests ahead of the Bank’s security interest. The Bank has detailed liquidation plans in place to expedite the sale of securities and advance collateral upon the failure of a member. At December 31, 2009 and 2008, respectively, on a borrower-by-borrower basis, the Bank had secured a perfected interest in eligible collateral with an eligible collateral value (after collateral weightings) in excess of the book value of all advances. Management believes that adequate policies and procedures are in place to effectively manage the Bank’s credit risk associated with lending to members and nonmember housing associates.

 

Nationally, during 2009, 140 FDIC – insured institutions have failed. None of the FHLBanks have incurred any losses on advances outstanding to these institutions. Although the majority of these institutions were members of the System, only one was a member of the Bank. The Bank had no advances or other credit products outstanding to this member at the time of the closure.

 

Types of Collateral.  At December 31, 2009, approximately 49.1% of the total member eligible collateral available to secure advances made by the Bank was single-family, residential mortgage loans. Generally, the Bank uses a discounted cash flow model to value its traditional listed or delivered mortgage loan collateral. Since 2006, the Bank has contracted with a leading provider of comprehensive mortgage analytical pricing to provide more precise valuations of some listed and delivered residential mortgage loan collateral. The Bank assigns book value to non-listed and non-delivered collateral.

 

Another category of collateral is high quality securities. This typically includes U.S. Treasuries, U.S. agency securities, TLGP investments, GSE MBS, and private label MBS with a credit rating of AAA. This category accounted for approximately 2.9% of the total amount of eligible collateral (after collateral weighting) held by members at December 31, 2009. In 2009, the Bank began requiring delivery of such securities to be counted within a member’s collateral base. The Bank also began accepting limited amounts of private label MBS rated AA for certain members. As of December 31, 2009, no such AA rated collateral was pledged or counted within member borrowing capacity.

 

The Bank will also accept FHLBank deposits and multi-family residential mortgage loans as eligible collateral. These comprised 7.0% of the collateral (after collateral weighting) used to secure loans at December 31, 2009.

 

The Bank also may accept other real estate related collateral (ORERC) as qualifying collateral as long as it has a readily ascertainable value and the Bank is able to secure a perfected interest in it. Types of acceptable ORERC

include commercial mortgage loans and second-mortgage installment loans. Previously, the overall amount of eligible ORERC was subject to a limit of 50% of a member’s maximum borrowing capacity; however, this limit was removed in 2009. Since 2007, the Bank has contracted with a leading provider of multi-family and commercial mortgage analytical pricing to provide more precise valuations of listed and delivered multi-family and commercial mortgage loan collateral.

 

ORERC accounts for approximately 41.0% of the total amount of eligible collateral (after collateral weighting) held by members as of December 31, 2009. The Bank does not have a member advance secured by a member’s pledge of any form of non-residential mortgage assets other than ORERC, eligible securities and/or Community Financial Institutions (CFI) collateral.

 

In addition, member CFIs may pledge a broader array of collateral to the Bank, including secured small business, small farm and small agri-business loans and securities representing a whole interest in such secured loans. During 2008, the Housing Act redefined member CFIs as FDIC-insured institutions with no more than $1.0 billion in average assets over the past three years. The Bank implemented this expanded authority during 2009. This limit may be adjusted by the Finance Agency based on changes in the Consumer Price Index; for 2010, to date the limit has not been adjusted. The determination to accept such collateral is at the discretion of the Bank and is made on a case-by-case basis. If delivery of collateral is required, the Bank will accept such ORERC and CFI collateral only after determining the member has exhausted all other available collateral of the types enumerated above. Advances to members holding CFI collateral within their total collateral base totaled approximately $5.6 billion as of December 31, 2009. However, these loans were collateralized by sufficient levels of non-CFI collateral.

 

The subprime segment of the mortgage market primarily serves borrowers with poorer credit payment histories; such loans typically have a mix of credit characteristics that indicate a higher likelihood of default and higher loss severities than prime loans. Nontraditional residential mortgage loans are defined as mortgage loans that allow borrowers to defer payment of principal or interest. These loans, which also may be referred to as “alternative” or “exotic” mortgage loans, may be interest-only loans, payment-option loans, negative-amortization loans or collateral-dependent loans. They may have other features, such as variable interest rates with below-market introductory rates, simultaneous second-lien loans and reduced documentation to support the repayment capacity of the borrower. Nontraditional residential mortgage loans exhibit characteristics that may result in increased risk relative to traditional residential mortgage loans. They may pose even greater risk when granted to borrowers with undocumented or undemonstrated repayment capacity, such as low or no documentation loans or those with credit characteristics that would be characterized as subprime. The potential for increased risk is particularly true if the nontraditional residential mortgage loans are not underwritten to determine a borrower’s capacity to repay the loan at the full payment amount once a temporarily reduced payment period expires.

 

Although subprime mortgages are no longer considered an eligible collateral asset class by the Bank, it is possible that the Bank may have subprime mortgages pledged as collateral through the blanket-lien pledge. The Bank requires members to identify the amount of subprime and nontraditional mortgage collateral in its compilation of mortgage data each quarter. This amount is deducted from the calculation of the member’s maximum borrowing capacity. Members may request that nontraditional mortgage loan collateral be added to the member’s eligible collateral pool with the understanding that they will be subject to a rigorous on-site review of such collateral, processes and procedures for originating and servicing the loans, an analysis of the quality of the loan level data and a review of the loan underwriting. These mortgage loans will receive weightings based on a case-by-case review by the Bank. Management believes that the Bank has limited exposure to subprime and nontraditional loans due to its business model, conservative policies pertaining to collateral and low credit risk due to the design of its mortgage loan programs.

The various types of eligible collateral and related lending values as of December 31, 2009 are summarized in the table and accompanying footnotes listed below:

 

 

n/a — not available

 

Notes:

 

During 2009, loan collateral weightings for certain types of collateral were changed to differentiate between members that file a QCR and those that do not. Details related to filing a QCR are included in the “Credit and Counterparty Risk — Total Credit Products and Collateral” discussion in Risk Management in Item 7. Management’s Discussion and Analysis in this 2009 Annual Report filed on Form 10-K.

 

 

n/a — not available

 

Notes:

 

Specialized Programs

 

The Bank helps members meet their Community Reinvestment Act responsibilities. Through community investment cash advance programs such as the Affordable Housing Program (AHP) and the Community Lending Program (CLP), members have access to subsidized and other low-cost funding. Members use the funds from these programs to create affordable rental and homeownership opportunities, and for commercial and economic development activities that benefit low- and moderate-income neighborhoods, thus contributing to the revitalization of their communities.

 

Banking on Business (BOB) Loans

 

The Bank’s BOB loan program for members is targeted to small businesses in the Bank’s district of Delaware, Pennsylvania and West Virginia. The program’s objective is to assist in the growth and development of small businesses, including both the start-up and expansion of these businesses. The Bank makes funds available to members to extend credit to an approved small business borrower, thereby enabling small businesses to qualify for credit that would otherwise not be available. The original intent of the BOB program was a grant program through members to help facilitate community economic development; however, repayment provisions within the program require that the BOB program be accounted for as an unsecured loan program. As the members collect directly from the borrowers, the members remit to the Bank repayment of the loans. If the business is unable to repay the loan, it may be forgiven at the member’s request, subject to the Bank’s approval. In 2009 and 2010, the Bank has made $3.5 million available each year to assist small businesses through the BOB loan program.

 

Investments

 

Overview.  The Bank maintains a portfolio of investments for three main purposes: liquidity, collateral for derivative counterparties and additional earnings. For liquidity purposes, the Bank invests in shorter-term instruments, including overnight Federal funds, to ensure the availability of funds to meet member requests. In addition, the Bank invests in other short-term instruments, including term Federal funds, interest-earning certificates of deposit and commercial paper. The Bank also maintains a secondary liquidity portfolio, which includes FDIC-guaranteed TLGP investments, U.S. Treasury and agency securities that can be financed under normal market conditions in securities repurchase agreement transactions to raise additional funds. U.S. Treasury securities are the primary source for derivative counterparty collateral.

 

The Bank further enhances interest income by maintaining a long-term investment portfolio, including securities issued by GSEs and state and local government agencies as well as agency and private label MBS. Securities currently in the portfolio were required to carry the top two ratings from Moody’s Investors Service, Inc. (Moody’s), Standard & Poor’s (S&P) or Fitch Ratings (Fitch) at the time of purchase. The long-term investment portfolio is intended to provide the Bank with higher returns than those available in the short-term money markets. Investment income also bolsters the Bank’s capacity to meet its commitment to affordable housing and community investment, to cover operating expenses, and to satisfy its statutory Resolution Funding Corporation (REFCORP) assessment. See the “Credit and Counterparty Risk – Investments” discussion in Risk Management in Item 7. Management’s Discussion and Analysis in this 2009 Annual Report filed on Form 10-K for discussion of the credit risk of the investment portfolio, including OTTI charges, and further information on these securities’ current ratings.

 

Prohibitions.  Under Finance Agency regulations, the Bank is prohibited from purchasing certain types of securities, including:

 

The provisions of the Finance Agency regulatory policy, the FHLBank System Financial Management Policy, further limit the Bank’s investment in MBS and ABS. These provisions require that the total book value of MBS owned by the Bank not exceed 300 percent of the Bank’s previous month-end regulatory capital on the day it purchases additional MBS. In addition, the Bank is prohibited from purchasing:

 

In March 2008, an increase in the investment level of MBS was authorized for the FHLBanks by the Finance Agency for two years. Subject to approval by the Board and filing of required documentation, the Bank may invest up to 600 percent of regulatory capital in MBS. The Bank has not sought approval to exceed the original 300 percent limit. The FHLBanks are also prohibited from purchasing a consolidated obligation as part of the consolidated obligation’s initial issuance. The Bank’s Investment Policy prohibits it from investing in another FHLBank consolidated obligation at any time. The Federal Reserve Board (Federal Reserve) requires Federal Reserve Banks (FRBs) to release interest and principal payments on the FHLBank System consolidated obligations only when there are sufficient funds in the FHLBanks’ account to cover these payments. The prohibitions on purchasing FHLBank consolidated obligations noted above will be temporarily waived if the Bank is obligated to accept the direct placement of consolidated obligation discount notes to assist in the management of any daily funding shortfall of another FHLBank.

 

The Bank does not consolidate any off-balance sheet special-purpose entities or other conduits.

 

Mortgage Partnership Finance^® (MPF^®) Program

 

In 1999, the Bank began participating in the Mortgage Partnership Finance (MPF) Program under which the Bank invests in qualifying 5- to 30-year conventional conforming and government-insured fixed-rate mortgage loans secured by one-to-four family residential properties. The MPF Program was developed by the FHLBank of Chicago in 1997 to provide participating members, including housing associates, a secondary market alternative that allows for increased balance sheet liquidity for members as well as removes assets that carry interest rate and prepayment risks from their balance sheets. In addition, the MPF Program provides a greater degree of competition among mortgage purchasers and allows small and mid-sized community-based financial institutions to participate more effectively in the secondary mortgage market.

 

The Bank currently offers three products under the MPF Program to Participating Financial Institutions (PFIs): Original MPF, MPF Government and MPF Xtra. Further details regarding the credit risk structure for each of the products, as well as additional information regarding the MPF Program and the products offered by the Bank is provided in the “Mortgage Partnership Finance Program” section in Item 7. Management’s Discussion and Analysis as well as the Risk Factor entitled “The MPF Program has different risks than those related to the Bank’s traditional loan business, which could adversely impact the Bank’s profitability.” in the Item 1A. Risk Factors, both in this 2009 Annual Report filed on Form 10-K.

 

Under the MPF Program, participating members generally market, originate and service qualifying residential mortgages for sale to the Bank. Member banks have direct knowledge of their mortgage markets and have developed expertise in underwriting and servicing residential mortgage loans. By allowing participating members to originate mortgage loans, whether through retail or wholesale operations, and to retain or sell servicing of

mortgage loans, the MPF Program gives control of the functions that relate to credit risk to participating members. Participating members may also receive a servicing fee if they choose to retain loan servicing rather than transfer servicing rights to a third-party servicer.

 

Participating members are paid a credit enhancement fee for retaining and managing a portion of the credit risk in the conventional mortgage loan portfolios sold to the Bank under the traditional MPF Program. The credit enhancement structure motivates participating members to minimize loan losses on mortgage loans sold to the Bank. The Bank is responsible for managing the interest rate risk, prepayment risk, liquidity risk and a portion of the credit risk associated with the mortgage loans.

 

In 2009, the Bank began offering MPF Xtra to members. MPF Xtra allows PFIs to sell residential, conforming fixed-rate mortgages to FHLBank of Chicago, which concurrently sells them to Fannie Mae on a nonrecourse basis. MPF Xtra does not have the credit enhancement structure of the traditional MPF Program and these loans are not reported on the Bank’s balance sheet. In the MPF Xtra product, there is no credit obligation assumed by the PFI or the Bank and no credit enhancement fees are paid. PFIs which have completed all required documentation and training are eligible to participate in the program. As of December 31, 2009, 34 PFIs were eligible to participate in the program. Of these, 14 have sold $25.0 million of mortgage loans through the MPF Xtra program.

 

Effective July 15, 2009, the Bank introduced a temporary loan payment modification plan (loan modification plan) for participating PFIs, which will be available until December 31, 2011 unless further extended by the MPF Program. Borrowers with conventional loans secured by their primary residence, which were closed prior to January 1, 2009 are eligible for the loan modification plan. This plan pertains to borrowers currently in default or in imminent danger of default. In addition, there are specific eligibility requirements that must be met and procedures that the PFIs must follow to participate in the loan modification plan. As of December 31, 2009, there has been no activity under this loan modification plan.

 

The FHLBank of Chicago, in its role as MPF Provider, provides the programmatic and operational support for the MPF Program and is responsible for the development and maintenance of the origination, underwriting and servicing guides.

 

The Bank held approximately $5.1 billion and $6.1 billion in mortgage loans at par under the MPF Program at December 31, 2009 and December 31, 2008 respectively. These balances represented approximately 7.8% and 6.7% of total assets at December 31, 2009 and 2008, respectively. Mortgage loans contributed approximately 19.4% and 9.4% of total interest income for full year 2009 and 2008, respectively. While interest income on mortgage loans dropped 11.1% in the year-over-year comparison, the Bank’s total interest income decreased 56.8%. This sharp decline in total interest income resulted in the increase in the ratio of mortgage loan interest income to total interest income.

 

The Finance Agency requires that all pools of MPF Program loans purchased by the Bank have the credit risk exposure equivalent of an AA rated mortgage instrument. The Bank maintains an allowance for credit losses on its mortgage loans that management believes is adequate to absorb any probable losses incurred beyond the credit enhancements provided by participating members. The Bank had approximately $2.7 million and $4.3 million in allowance for credit losses on this portfolio at December 31, 2009 and 2008, respectively.

 

“Mortgage Partnership Finance,” “MPF” and “MPF Xtra” are registered trademarks of the FHLBank of Chicago.

 

Deposits

 

The Act allows the Bank to accept deposits from its members, from any institution for which it is providing correspondent services, from other FHLBanks, or from other Federal instrumentalities. Deposit programs are low-cost funding resources for the Bank, which also give members a low-risk earning asset that satisfies their regulatory liquidity requirements. The Bank offers several types of deposit programs to its members including demand, overnight and term deposits.

Debt Financing — Consolidated Obligations

 

The primary source of funds for the Bank is the sale of debt securities, known as consolidated obligations. These consolidated obligations are issued as both bonds and discount notes, depending on maturity. Consolidated obligations are the joint and several obligations of the FHLBanks, backed by the financial resources of the twelve FHLBanks. Consolidated obligations are not obligations of the United States government, and the United States government does not guarantee them. Moody’s has rated consolidated obligations Aaa/P-1, and S&P has rated them AAA/A-1+. The following table presents the total par value of the consolidated obligations of the Bank and the FHLBank System at December 31, 2009 and 2008.

 

 

Office of Finance.  The OF has responsibility for issuing and servicing consolidated obligations on behalf of the FHLBanks. The OF also serves as a source of information for the Bank on capital market developments, markets the FHLBank System’s debt on behalf of the Bank, selects and evaluates underwriters, prepares combined financial statements, administers REFCORP and the Financing Corporation, and manages the Banks’ relationship with the rating agencies and the U.S. Treasury with respect to the consolidated obligations.

 

Consolidated Obligation Bonds.  On behalf of the Bank, the OF issues bonds that the Bank uses primarily to fund advances. The Bank also uses bonds to fund the MPF Program and its investment portfolio. Typically, the maturity of these bonds ranges from one year to ten years, but the maturity is not subject to any statutory or regulatory limit. Bonds can be issued and distributed through negotiated or competitively bid transactions with approved underwriters or selling group members. In some instances, particularly with complex structures, the Bank swaps its term debt issuance to floating rates through the use of interest rate swaps.

 

Bonds can be issued in several ways. The first way is through a daily auction for both bullet (non-callable and non-amortizing) and American-style (callable daily after lock out period expires) callable bonds. Bonds can also be issued through a selling group, which typically has multiple lead investment banks on each issue. The third way bonds can be issued is through a negotiated transaction with one or more dealers. The process for issuing bonds under the three general methods above can vary depending on whether the bonds are non-callable or callable.

 

For example, the Bank can request funding through the TAP auction program (quarterly debt issuances that reopen or “tap” into the same CUSIP number) for fixed-rate non-callable (bullet) bonds. This program uses specific maturities that may be reopened daily during a three-month period through competitive auctions. The goal of the TAP program is to aggregate frequent smaller issues into a larger bond issue that may have greater market liquidity.

 

Consolidated Obligation Discount Notes.  The OF also sells discount notes to provide short-term funds for advances for seasonal and cyclical fluctuations in deposit flows, mortgage financing, short-term investments and other funding needs. Discount notes are sold at a discount and mature at par. These securities have maturities of up to 365 days.

 

There are three methods for issuing discount notes. First, the OF auctions one-, two-, three- and six-month discount notes twice per week and any FHLBank can request an amount to be issued. The market sets the price for these securities. The second method of issuance is via the OF’s window program through which any FHLBank can offer a specified amount of discount notes at a maximum rate and a specified term up to 365 days. These securities are offered daily through a consolidated discount note selling group of broker-dealers. The third method is via reverse inquiry, wherein a dealer requests a specified amount of discount notes be issued for a specific date and price. The OF shows reverse inquiries to the FHLBanks, which may or may not choose to issue those particular discount notes.

See the “Current Financial and Mortgage Market Events and Trends” discussion in the Earnings Performance section and “Liquidity and Funding Risk” discussion in the Risk Management section, both in Item 7. Management’s Discussion and Analysis in this 2009 Annual Report filed on Form 10-K for further information regarding consolidated obligations and related liquidity risk.

 

Capital Resources

 

Capital Plan.  From its enactment in 1932, the Act provided for a subscription-based capital structure for the FHLBanks. The amount of capital stock that each FHLBank issued was determined by a statutory formula establishing how much FHLBank stock each member was required to purchase. With the enactment of the Gramm-Leach-Bliley Act (GLB Act), the statutory subscription-based member stock purchase formula was replaced with requirements for total capital, leverage capital, and RBC for the FHLBanks. The FHLBanks were also required to develop new capital plans to replace the previous statutory structure.

 

The Bank implemented its capital plan on December 16, 2002. In general, the capital plan requires each member to own stock in an amount equal to the aggregate of a membership stock requirement and an activity-based stock requirement. The Bank may adjust these requirements from time to time within limits established in the capital plan.

 

Bank capital stock may not be publicly traded; it may be issued, exchanged, redeemed and repurchased at its stated par value of $100 per share. Under the capital plan, capital stock may be redeemed upon five years’ notice, subject to certain conditions. In addition, the Bank has the discretion to repurchase excess stock from members. Ranges have been built into the capital plan to allow the Bank to adjust the stock purchase requirement to meet its regulatory capital requirements, if necessary. Please refer to the detailed description of the capital plan attached as Exhibit 4.1 to the Bank’s registration statement on Form 10, as amended, filed July 19, 2006. On December 23, 2008, the Bank announced its decision to voluntarily suspend excess capital stock repurchases until further notice. This action was taken after careful analysis and consideration of certain negative market trends and the impact on the Bank’s profitability and financial condition. The Bank has submitted a CSP to the Finance Agency. See further details in the General discussion in this Item 1: Business section.

 

The Bank has initiated the process of amending its capital plan. The goal of this capital plan amendment is to provide members with a stable membership capital stock calculation that would replace the Unused Borrowing Capacity calculation. Additionally, the proposed amendment would expand the AMA stock purchase requirement range and prospectively establish a capital stock purchase requirement for letters of credit. As required by Finance Agency regulation and the terms of the capital plan, any amendment must be approved by the Finance Agency prior to becoming effective.

 

Dividends and Retained Earnings.  The Bank may pay dividends from current net earnings or previously retained earnings, subject to certain limitations and conditions. The Bank’s Board may declare and pay dividends in either cash or capital stock. The Bank’s practice has been to pay only a cash dividend. Effective September 26, 2008, the Bank revised its previous retained earnings policy and established a new capital adequacy metric, referred to as the Projected Capital Stock Price (PCSP) The PCSP metric retains the overall risk components approach of the previous policy but expands and refines the risk components to calculate an estimate of capital-at-risk, or the projected variability of capital stock. As of December 31, 2009, the balance in retained earnings was $389.0 million. Under the policy, the amount of dividends the Board determines to pay out, if any, is affected by, among other factors, the level of retained earnings recommended under this new retained earnings policy. On December 23, 2008, the Bank announced its decision to voluntarily suspend payment of dividends until further notice. Bank management and the Board, as well as the Finance Agency, believe that the level of retained earnings with respect to the total balance of AOCI should be considered in assessing the Bank’s ability to resume paying a dividend.

 

Please see the Capital Resources section and the “Risk Governance” discussion in Risk Management, both in Item 7. Management’s Discussion and Analysis in this 2009 Annual Report filed on Form 10-K for additional discussion of the Bank’s capital-related metrics, retained earnings, dividend payments, capital levels and regulatory capital requirements.

Derivatives and Hedging Activities

 

The Bank enters into interest rate swaps, swaptions, interest rate cap and floor agreements and forward contracts (collectively, derivatives) to manage its exposure to changes in interest rates. The Bank uses these derivatives to adjust the effective maturity, repricing frequency, or option characteristics of financial instruments to achieve its risk management objectives. The Bank uses derivative financial instruments in several ways: (1) by designating them as a fair value or cash flow hedge of an underlying financial instrument, a firm commitment or a forecasted transaction; (2) by acting as an intermediary between members and the capital markets; or (3) in asset/liability management (i.e., an economic hedge). See Note 12 to the audited financial statements in Item 8. Financial Statements and Supplementary Financial Data for additional information.

 

For example, the Bank uses derivatives in its overall interest rate risk management to adjust the interest rate sensitivity of assets and liabilities. The Bank also uses derivatives to manage embedded options in assets and liabilities; to hedge the benchmark fair value of existing assets, liabilities and anticipated transactions; to hedge the duration risk of prepayable instruments; and to reduce funding costs. To reduce funding costs, the Bank may enter into derivatives concurrently with the issuance of consolidated obligations. This strategy of issuing bonds while simultaneously entering into derivatives provides the Bank the flexibility to offer a wider range of attractively priced loans to its members. The continued attractiveness of such debt depends on price relationships in both the bond market and derivative markets. If conditions in these markets change, the Bank may alter the types or terms of the bonds issued. In acting as an intermediary between members and the capital markets, the Bank enables its smaller members to access the capital markets in a cost-efficient manner.

 

The Finance Agency regulates the Bank’s use of derivatives. The regulations prohibit the trading in or speculative use of these instruments and limit credit risk arising from these instruments. The Bank typically uses derivatives to manage its interest rate risk positions and mortgage prepayment risk positions. All derivatives are recorded in the Statement of Condition at fair value.

The following tables summarize the derivative instruments, along with the specific hedge transaction utilized to manage various interest rate and other risks. The Bank periodically engages in derivative transactions classified as cash flow hedges primarily through a forward starting interest rate swap that hedges an anticipated issuance of a consolidated obligation. The Bank had no outstanding cash flow hedges as of December 31, 2009.

 

Derivative Transactions Classified as Fair Value Hedges

 

Derivative Transactions Classified as Economic Hedges

 

 

Competition

 

Advances.  The Bank competes with other suppliers of wholesale funding, both secured and unsecured, including the FRBs, commercial banks, investment banking divisions of commercial banks, and brokered deposits, largely on the basis of cost as well as types and weightings of collateral. Competition may be greater in regard to larger members, which have greater access to the capital markets. During 2008 and into 2009, the Federal Reserve took a series of unprecedented actions that made it more attractive for eligible financial institutions to borrow directly from the FRBs, creating increased competition for the Bank with a larger number of members, including smaller institutions. As a result of disruptions in the credit and mortgage markets in the second half of 2007, the Bank had experienced unprecedented loan growth. This growth has since reversed, with advances declining 33.8% from December 31, 2008 to December 31, 2009. This decline was due to the following: (1) members’ access to additional liquidity from government programs; (2) members’ reactions to the Bank’s pricing of the short-term advance products; (3) the impact of members raising core deposits; (4) members reducing the size of their balance sheets; (5) members reacting to the Bank’s temporary actions of not paying dividends and not repurchasing excess capital stock by limiting their use of the Bank’s advance products; and (6) the recent economic recession, which decreased the Bank’s members’ need for funding from the Bank.

 

Competition within the FHLBank System is somewhat limited; however, there may be some members of the Bank that have affiliates that are members of other FHLBanks. The Bank does not monitor in detail for these types of affiliate relationships, and therefore, does not know the extent to which there may be competition with the other FHLBanks for loans to affiliates under a common holding company structure. The Bank’s ability to compete successfully with other FHLBanks for business depends primarily on pricing, dividends, capital stock requirements, credit and collateral terms, and products offered.

 

Purchase of Mortgage Loans.  Members have several alternative outlets for their mortgage loan production including Fannie Mae, Freddie Mac, and other secondary market conduits. The MPF Program competes with these alternatives on the basis of price and product attributes. Additionally, a member may elect to hold all or a portion of its mortgage loan production in portfolio, potentially funded by a loan from the Bank. The Bank’s volume of conventional, conforming fixed-rate mortgages has declined as a result of a stagnant housing market and the weak employment and economic conditions. In addition, the lack of an off-balance sheet solution for the MPF program credit structure had previously affected program pricing and caused the Bank to strategically position the MPF Program for community and regional institutions thereby excluding larger PFIs from participation. As previously discussed, in 2009 the Bank began offering the MPF Xtra product to members. MPF Xtra does not have the credit enhancement structure of the traditional MPF Program. These loans are sold through the FHLBank of Chicago to

Fannie Mae and, therefore, not reported on the Bank’s balance sheet. Also in 2009, as mentioned previously, the Bank introduced a loan modification plan for participating PFIs, which will be available until December 31, 2011 unless further extended by the MPF Program.

 

Issuance of Consolidated Obligations.  The Bank competes with the U.S. Treasury, Fannie Mae, Freddie Mac and other government-sponsored enterprises as well as corporate, sovereign and supranational entities for funds raised through the issuance of unsecured debt in the national and global debt markets. Increases in the supply of competing debt products may, in the absence of increases in demand, result in higher debt cost. The Bank’s status as a GSE affords certain preferential treatment for its debt obligations under the current regulatory scheme for depository institutions operating in the United States as well as preferential tax treatment in a number of state and municipal jurisdictions. Any change in these regulatory conditions as they affect the holders of Bank debt obligations would likely alter the relative competitive position of such debt issuance resulting in potentially higher cost to the Bank. The Federal banking agencies have proposed a lower RBC requirement applicable to Fannie Mae and Freddie Mac debt. If this proposal becomes final and a similar change is not applied to FHLBank debt, the System’s competitive position will erode. In addition, the FDIC’s unsecured debt guarantee program and the extension of the program through October 31, 2009 created additional competition for the Bank’s debt issuances.

 

The issuance of callable debt and the simultaneous execution of callable interest rate derivatives that mirror the debt have been an important source of funding for the Bank. There is considerable competition among high-credit-quality issuers in the markets for callable debt and for derivative agreements, which can raise the cost of issuing this form of debt.

 

Major Customers

 

Sovereign Bank, Ally Bank and PNC Bank each had advance balances in excess of ten percent of the Bank’s total portfolio as of December 31, 2009. See details in the Item 1A. Risk Factor entitled “The loss of significant Bank members or borrowers may have a negative impact on the Bank’s loans and capital stock outstanding and could result in lower demand for its products and services, lower dividends paid to members and higher borrowing costs for remaining members, all which may affect the Bank’s profitability and financial condition.” and “Credit and Counterparty Risk” in the Risk Management section in Item 7. Management’s Discussion and Analysis, both in this 2009 Annual Report filed on Form 10-K.

 

Personnel

 

As of December 31, 2009, the Bank had 231 full-time employee positions and five part-time employee positions, for a total of 233.5 full-time equivalents, and an additional 26 contractors. The employees are not represented by a collective bargaining unit and the Bank considers its relationship with its employees to be good.

 

Taxation

 

The Bank is exempt from all Federal, state and local taxation with the exception of real estate property taxes.

 

Resolution Funding Corporation (REFCORP) and Affordable Housing Program (AHP) Assessments

 

The Bank is obligated to make payments to REFCORP in an amount of 20% of net earnings after operating expenses and AHP expenses. The Bank must make these payments to REFCORP until the total amount of payments actually made by all twelve FHLBanks is equivalent to a $300 million annual annuity whose final maturity date is April 15, 2030. The Finance Agency will shorten or lengthen the period during which the FHLBanks must make payments to REFCORP depending on actual payments relative to the referenced annuity. In addition, the Finance Agency, in consultation with the Secretary of the U.S. Treasury, selects the appropriate discounting factors used in this calculation. See Note 18 to the audited financial statements in Item 8. Financial Statements and Supplementary Financial Data for additional information.

In addition, the FHLBanks must set aside for the AHP annually on a combined basis, the greater of an aggregate of $100 million or 10 percent of current year’s net earnings (income before interest expense related to mandatorily redeemable capital stock but after the assessment for REFCORP). If the Bank experienced a net loss, as defined in Note 17 to the audited financial statements in Item 8. Financial Statements and Supplementary Financial Data in this 2009 Annual Report filed on Form 10-K, for a full year, the Bank would have no obligation to the AHP for the year except in the following circumstance: if the result of the aggregate ten percent calculation described above is less than $100 million for all twelve FHLBanks, then the Act requires that each FHLBank contribute such prorated sums as may be required to assure that the aggregate contributions of the FHLBanks equal $100 million. The proration would be made on the basis of an FHLBank’s net earnings in relation to the income of all FHLBanks for the previous year. Each FHLBank’s required annual AHP contribution is limited to its annual net earnings. If an FHLBank finds that its required contributions are contributing to the financial instability of that FHLBank, it may apply to the Finance Agency for a temporary suspension of its contributions. As allowed by AHP regulations, an FHLBank can elect to allot fundings based on future periods’ required AHP contributions to be awarded during a year (referred to as Accelerated AHP). The Accelerated AHP allows an FHLBank to commit and disburse AHP funds to meet the FHLBank’s mission when it would otherwise be unable to do so, based on its normal funding mechanism. See the Risk Factor entitled “The Bank’s Affordable Housing Program and other related community investment programs may be severely affected if the Bank’s annual net income is reduced or eliminated.” in Item 1A. Risk Factors and Note 17 to the audited financial statements in Item 8. Financial Statements and Supplementary Financial Data, both in this 2009 Annual Report filed on Form 10-K for additional information.

 

Currently, combined assessments for REFCORP and AHP are the equivalent of approximately a 26.5% effective rate for the Bank. Because the Bank was in a net loss position for the year ended December 31, 2009, it recorded no combined assessment expense. The combined REFCORP and AHP assessments for the Bank were $7.0 million and $85.6 million for the years ended December 31, 2008 and 2007, respectively. In 2008, the Bank overpaid its 2008 REFCORP assessment as a result of the loss recognized in fourth quarter 2008. The Bank will use its overpayment as a credit against future REFCORP assessments (to the extent the Bank has positive net income in the future) over an indefinite period of time. This overpayment was recorded as a prepaid asset by the Bank and reported as “prepaid REFCORP assessment” on the Statement of Condition at December 31, 2008 and 2009. Over time, as the Bank uses this credit against its future REFCORP assessments, this prepaid asset will be reduced until the prepaid asset has been exhausted. If any amount of the prepaid asset still remains at the time that the REFCORP obligation for the FHLBank System as a whole is fully satisfied, REFCORP, in consultation with the U.S. Treasury, will implement a procedure so that the Bank would be able to collect on its remaining prepaid asset.

 

SEC Reports and Corporate Governance Information

 

The Bank is subject to the informational requirements of the 1934 Act and, in accordance with the 1934 Act, files annual, quarterly and current reports, as well as other information with the SEC. The Bank’s SEC File Number is 000-51395. Any document filed with the SEC may be read and copied at the SEC’s Public Reference Room at 100 F Street NE, Washington, D.C. 20549. Information on the operation of the Public Reference Room can be obtained by calling the SEC at 1-800-SEC-0330. The SEC also maintains an internet site that contains reports, information statements and other information regarding registrants that file electronically with the SEC, including the Bank’s filings. The SEC’s website address is www.sec.gov. Copies of such materials can also be obtained at prescribed rates from the public reference section of the SEC at 100 F Street NE, Washington, D.C. 20549.

 

The Bank also makes the Annual Report filed on Form 10-K, quarterly reports filed on Form 10-Q, current reports filed on Form 8-K, and amendments to those reports filed or furnished to the SEC pursuant to Section 13(a) or 15(d) of the 1934 Act available free of charge on or through its internet website as soon as reasonably practicable after such material is filed with, or furnished to, the SEC. The Bank’s internet website address is www.fhlb-pgh.com. The Bank filed the certifications of the President and Chief Executive Officer and the Chief Financial Officer required pursuant to Sections 302 and 906 of the Sarbanes-Oxley Act of 2002 with respect to this 2009 Annual Report filed on Form 10-K as exhibits to this Report.

 

Information about the Bank’s Board and its committees and corporate governance, as well as the Bank’s Code of Conduct, is available in the governance section of the “Investor Relations” link on the Bank’s website at

www.fhlb-pgh.com. Printed copies of this information may be requested without charge upon written request to the Legal Department at the Bank.

 

 

There are many factors-several beyond the Bank’s control-that could cause results to differ significantly from the Bank’s expectations. The following discussion summarizes some of the more important factors that should be considered carefully in evaluating the Bank’s business. This discussion is not exhaustive and there may be other factors not described or factors, such as credit, market, operations, business, liquidity, interest rate and other risks, changes in regulations, and changes in accounting requirements, which are described elsewhere in this report (see the Risk Management discussion in Item 7. Management’s Discussion and Analysis in this 2009 Annual Report filed on Form 10-K), which could cause results to differ materially from the Bank’s expectations. However, management believes that these risks represent the material risks relevant to the Bank, its business and industry. Any factor described in this report could by itself, or together with one or more other factors, adversely affect the Bank’s business operations, future results of operations, financial condition or cash flows, and, among other outcomes, could result in the Bank continuing to not pay dividends on its common stock or repurchase excess capital stock.

 

Continued global financial market disruptions during 2009 and the long recession has sustained the uncertainty and unpredictability the Bank faces in managing its business. Geopolitical conditions or a natural disaster, especially one affecting the Bank’s district, customers or counterparties, could also adversely affect the Bank’s business, results of operations or financial condition.

 

The Bank’s business and earnings are affected by international, domestic and district-specific business and economic conditions. These economic forces, which may also affect counterparty and members’ business and results of operations, include real estate values, residential mortgage originations, short-term and long-term interest rates, inflation and inflation expectations, unemployment levels, money supply, fluctuations in both debt and equity markets, and the strength of the foreign, domestic and local economies in which the Bank operates. During the financial crisis which began in mid-2007, global financial markets suffered significant illiquidity, increased mortgage delinquencies and foreclosures, falling real estate values, the collapse of the secondary market for MBS, loss of investor confidence, a highly volatile stock market and interest rate fluctuations. These disruptions resulted in the bankruptcy or acquisition of numerous major financial institutions and diminished overall confidence in the financial markets, financial institutions in particular. During 2008 and into 2009, there were world-wide disruptions in the credit and mortgage markets and an overall downturn in the U.S. economy. The ongoing weakening of the U.S. housing market and the commercial real estate market, decline in home prices, and loss of jobs contributed to the recent national recession, resulted in increased delinquencies and defaults on mortgage assets and reduced the value of the collateral securing these assets. In combination, these circumstances could increase the possibility of under-collateralization of the advance portfolio and the risk of loss. Continued deterioration in the mortgage markets negatively impacted the value of the MBS, resulting in additional OTTI to the MBS portfolio and possible additional realized losses should the Bank be forced to liquidate MBS. See additional discussion in the Risk Factors entitled “The Bank invests in MBS, including significant legacy positions in private label MBS. The MBS portfolio shares risks similar to MPF as well as risks unique to MBS investments. The increased risks inherent with these investments have adversely impacted the Bank’s profitability and capital position and are likely to continue to do so during 2010.”

 

All of the factors described above have contributed to a material increase in the risks faced by the Bank. Some of these increased risks are reflected in the various internal risk measurements currently used by the Bank. For example, the Bank’s capital adequacy and market risk metrics of Projected Capital Stock Price (PCSP) and actual duration of equity have exceeded Board-approved limits due in large part to significantly higher credit spreads on the Bank’s private label MBS portfolio. In order to more effectively manage the risk positions which are affected by these spreads, management developed and the Board approved the usage of an Alternative Risk Profile. Please refer to the Risk Management section for further information regarding market risk metrics and the Alternative Risk Profile. For additional information regarding the Alternative Risk Profile assumptions and approach, see the “Risk Governance” discussion in Risk Management in Item 7. Management’s Discussion and Analysis in this 2009 Annual Report filed on Form 10-K.

The Bank is affected by the global economy through member ownership and investor appetite. Changes in perception regarding the stability of the U.S. economy, the degree of government support of financial institutions or the depletion of funds available for investment by overseas investors could lead to changes in foreign interest in investing in, or supporting, U.S. financial institutions or holding FHLBank debt.

 

Geopolitical conditions can also affect earnings. Acts or threats of terrorism, actions taken by the U.S. or other governments in response to acts or threats of terrorism and/or military conflicts, could affect business and economic conditions in the U.S., including both debt and equity markets.

 

Damage caused by acts of terrorism or natural disasters could adversely impact the Bank or its members, leading to impairment of assets and/or potential loss exposure. Real property that could be damaged in these events may serve as collateral for loans, or security for the mortgage loans the Bank purchases from its members and the MBS held as investments. If this real property is not sufficiently insured to cover the damages that may occur, there may be insufficient collateral to secure the Bank’s loans or investment securities and the Bank may be severely impaired with respect to the value of these assets.

 

The Bank is also exposed to risk related to a changing interest rate environment, especially in difficult economic times such as the recent recession. If this risk is not properly monitored and managed, it could affect the Bank’s results of operations and financial condition. For additional details, please see the Risk Factor entitled “Fluctuating interest rates or the Bank’s inability to successfully manage its interest rate risk may adversely affect the Bank’s net interest income, overall profitability and the market value of its equity.”

 

The Bank may fail to meet its minimum regulatory capital requirements, or be otherwise designated by the Finance Agency as undercapitalized, which would impact the Bank’s ability to conduct business “as usual,” result in prohibitions on dividends, excess capital stock repurchases and capital stock redemptions and potentially impact the value of Bank membership.

 

The Bank is required to maintain sufficient permanent capital, defined as capital stock plus retained earnings, to meet its combined risk-based capital (RBC) requirements. These requirements include components for credit risk, market risk and operational risk. Only permanent capital, defined as retained earnings plus Class B stock, can satisfy the RBC requirement. Each of the Bank’s investments carries a credit RBC requirement that is based on the rating of the investment. As a result, ratings downgrades on individual investments cause an increase in the total credit RBC requirement. Additionally, the market values on private label MBS have a significant impact on the market RBC requirement. In addition, the Bank is required to maintain certain regulatory capital and leverage ratios, which it has done. Any violation of these requirements will result in prohibitions on stock redemptions and repurchases and dividend payments.

 

On August 4, 2009, the Finance Agency issued its final Prompt Correct Action Regulation (PCA Regulation) incorporating the terms of the Interim Final Regulation. If the Bank becomes undercapitalized either by failing to meet its regulatory capital requirements or by the Finance Agency exercising its discretion to categorize an FHLBank as undercapitalized, then, in addition to the capital stock redemption, excess capital stock repurchase and dividend prohibitions noted above, it will also be subject to asset growth limits. If it becomes significantly undercapitalized, it could be subject to additional actions such as replacement of its Board and management, required capital stock purchase increases and required asset divestiture. The regulatory actions applicable to an FHLBank in a significantly undercapitalized status may also be imposed on an FHLBank by the Finance Agency at its discretion on an undercapitalized FHLBank. Violations could also result in changes in the Bank’s member lending, investment or MPF Program purchase activities, a change in permissible business activities, as well as the restrictions on dividend payments and restrictions on capital stock redemptions and repurchases. See the Capital Resources discussion in Item 7. Management’s Discussion and Analysis in this 2009 Annual Report filed on Form 10-K for further information.

 

Continued declines in market conditions could also result in a possible violation of regulatory and/or statutory capital requirements and may impact the Bank’s ability to redeem capital stock at par value. This could occur if: (1) a member were to withdraw from membership (or seek to have its excess capital stock redeemed) at a time when the Bank is not in compliance with its minimum capital requirements or is deemed to be undercapitalized despite being in compliance with its minimum capital requirements; or (2) it is determined the Bank’s capital stock is or is

likely to be impaired as a result of losses in, or the depreciation of, assets which may not be recoverable in future periods. The Bank’s primary business is making loans to its members, which in turn creates capital for the Bank. As members increase borrowings, the Bank’s capital grows. As loan demand declines, so does the amount of capital required to support those balances. Ultimately, this capital would be returned to the member. Without new borrowing activity to offset the run-off of existing borrowings, capital levels could eventually decline. The Bank has the ability to increase the capital requirements on existing borrowings to boost capital levels; however, this may deter new borrowings and reduce the value of membership as the return on that investment may not be as profitable to the member as other investment opportunities.

 

Under Finance Agency regulation, the Bank may pay dividends on its capital stock only out of previously retained earnings or current net income. The payment of dividends is subject to certain statutory and regulatory restrictions (including that the Bank is in compliance with all minimum capital requirements and has not been designated undercapitalized by the Finance Agency) and is highly dependent on the Bank’s ability to continue to generate future net income and maintain adequate retained earnings and capital levels. In December 2008, the Bank announced the voluntary suspensions of dividend payments and repurchases of excess capital stock, until further notice. In this unprecedented environment, the Board and Bank management are confident this was the necessary course of action as they work to maintain sufficient levels of retained earnings. Dividend payments are expected to be restored when the Bank determines it is prudent to do so. Even at that point, the Bank may decide to pay dividends significantly lower than historical rates as the Bank builds retained earnings. Separately, payment of dividends could also be suspended if the principal and interest due on any consolidated obligation has not been paid in full or if the Bank becomes unable to comply with regulatory capital or liquidity requirements or satisfy its current obligations. See additional discussion regarding the Bank’s initiative to build retained earnings in Item 7. Management’s Discussion and Analysis in this 2009 Annual Report filed on Form 10-K.

 

As a result of the significant decline in excess permanent capital over required RBC capital in 2008, as well as the decline in retained earnings due to OTTI charges recorded in fourth quarter 2008, the Bank submitted a capital stabilization plan (CSP) to the Finance Agency for review and approval; the Finance Agency’s review is pending. As a result of the suspension of excess capital stock repurchases, the amount of excess permanent capital increased during 2009. The Bank was in compliance with all of its capital requirements at December 31, 2009.

 

The Bank may be limited in its ability to access the capital markets, which could adversely affect the Bank’s liquidity. In addition, if the Bank’s ability to access the long-term debt markets would be limited, this may have a material adverse effect on its liquidity, results of operations and financial condition, as well as its ability to fund operations, including advances.

 

The Bank’s ability to operate its business, meet its obligations and generate net interest income depends primarily on the ability to issue large amounts of debt frequently, with a variety of maturities and call features and at attractive rates. The Bank actively manages its liquidity position to maintain stable, reliable, and cost-effective sources of funds, while taking into account market conditions, member credit demand for short-and long-term loans, investment opportunities and the maturity profile of the Bank’s assets and liabilities. The Bank recognizes that managing liquidity is critical to achieving its statutory mission of providing low-cost funding to its members. In managing liquidity risk, the Bank is required to maintain a level of liquidity in accordance with policies established by management and the Board and Finance Agency guidance to target as many as 15 days of liquidity, depending on the scenario. See the “Liquidity and Funding Risk” discussion in Risk Management in Item 7. Management’s Discussion and Analysis in this 2009 Annual Report filed on Form 10-K for additional information on the Finance Agency guidance.

 

In early July 2008, market concerns about the outlook for the net supply of GSE debt over the short-term, as well as concerns regarding any investments linked to the U.S. housing market, adversely affected the Bank’s access to the unsecured debt markets, particularly for long-term or callable debt. These concerns abated somewhat during 2009, resulting in an increase in availability of term FHLBank debt during the year. The ability to obtain funds through the sale of consolidated obligations depends in part on prevailing conditions in the capital markets at that time, which are beyond the Bank’s control. Accordingly, the Bank cannot make any assurance that it will be able to obtain funding on acceptable terms, if at all. If the Bank cannot access funding when needed, its ability to support

and continue its operations, including providing term funding to members, would be adversely affected, which would negatively affect its financial condition and results of operations.

 

The U.S. Treasury has the authority to prescribe the form, denomination, maturity, interest rate and conditions of consolidated obligations issued by the FHLBanks. The U.S. Treasury can, at any time, impose either limits or changes in the manner in which the FHLBanks may access the capital markets. Certain of these changes could require the Bank to hold additional liquidity, which could adversely impact the type, amount and profitability of various loan products the Bank could make available to its members.

 

During 2008 and into 2009, there were several actions taken by the U.S. Treasury, the Federal Reserve and the FDIC that were intended to stimulate the economy and reverse the illiquidity in the credit and housing markets. These included establishment of the Government-Sponsored Enterprise Credit Facility (GSECF), the Troubled Asset Relief Program (TARP), the Temporary Liquidity Guarantee Program (TLGP), and the Term Asset-Backed Securities Loan Facility (TALF). The TLGP had initially been set to expire on June 30, 2009; however, the guarantee under the program was extended until October 31, 2009 in exchange for an additional premium for the guarantee. The Bank did not borrow under the lending agreement established under the GSECF. TARP funds were not available to the Bank. In addition, the Bank, as well as the other FHLBanks, Fannie Mae and Freddie Mac, have all experienced a deterioration in debt pricing as investor capital and dealer focus has been redirected towards those securities offered under the TLGP, which carry an explicit guarantee of the U.S. government.

 

As a result of these government actions, the Bank initially experienced an increase in funding costs relative to long-term debt, reflecting both investor reluctance to purchase longer-term obligations and investor demand for high-quality, shorter-term assets. The Bank’s composition of its consolidated obligations portfolio was heavily concentrated in discount notes and shorter-term bonds, which meant a large portion of the Bank’s debt matured within one year. As investor reluctance regarding purchasing longer-term obligations of GSEs, as well as concerns regarding any mortgage market-related investments, continued, the debt issuance and related pricing of the Bank debt was adversely affected. Beginning in August 2009, conditions improved and the Bank began to regain some access to the term debt markets. However, the Bank’s consolidated obligations portfolio is still primarily comprised of discount notes and shorter-term bonds. This short-funding strategy could expose the Bank to interest rate risk as the Bank may need to replace the shorter-maturity debt at a potentially higher price.

 

An inability to issue both short- and long-term debt at attractive rates and in amounts sufficient to operate its business and meet its obligations would have a material adverse effect on the Bank’s liquidity, results of operations and financial condition.

 

The Bank invests in MBS. The MBS portfolio shares risks similar to the MPF Program as well as risks unique to MBS investments. The increased risks inherent with these investments have adversely impacted the Bank’s profitability and capital position and are likely to continue to do so during 2010.

 

The Bank invests in MBS, including Agency and private label MBS. The private label category of these investments carries a significant amount of risk, relative to other investments within the Bank’s portfolio. The MBS portfolio accounted for 13.8% of the Bank’s total assets and 27.9% of the Bank’s total interest income at December 31, 2009.

 

MBS are backed by residential mortgage loans, the properties of which are geographically diverse, but may include exposure in some areas that have experienced rapidly declining property values. The MBS portfolio is also subject to interest rate risk, prepayment risk, operational risk, servicer risk and originator risk, all of which can have a negative impact on the underlying collateral of the MBS investments. The rate and timing of unscheduled payments and collections of principal on mortgage loans serving as collateral for these securities are difficult to predict and can be affected by a variety of factors, including the level of prevailing interest rates, restrictions on voluntary prepayments contained in the mortgage loans, the availability of lender credit, loan modifications and other economic, demographic, geographic, tax and legal factors.

 

The Bank holds investments in private label MBS which, at the time of purchase, were in senior tranches with the highest long-term debt rating. However, many of those securities have subsequently been downgraded, in some cases below investment grade. See details of this activity in the “Credit and Counterparty Risk-Investments” section of Risk Management in Item 7. Management’s Discussion and Analysis in this 2009 Annual Report filed on

Form 10-K. Throughout 2008 and into 2009, all types of private label MBS experienced increased delinquencies and loss severities. This trend accelerated during the third quarter of 2009; however, loss severities stabilized somewhat in the fourth quarter. If delinquencies and/or default rates on mortgages increase, and/or there is an additional decline in residential real estate values, the Bank could experience reduced yields or additional OTTI credit and noncredit losses on its private label MBS portfolio. During 2009, the U.S. housing market continued to experience significant adverse trends, including accelerating price depreciation in some markets and rising delinquency and default rates. If delinquency and/or loss rates on mortgages and/or home equity loans continue to increase in 2010, and/or a rapid decline or a continuing decline in residential real estate values continues, the Bank could experience additional material credit-related OTTI losses on its investment securities, which would negatively affect the Bank’s financial condition, results of operations and its capital position.

 

Through December 31, 2009, the Bank recognized $228.5 million in full year credit-related OTTI charges in earnings related to private label MBS, after the Bank determined that it was likely that it would not recover the entire amortized cost of each of these securities. The credit loss realized on the Bank’s private label MBS is equal to the difference between the amortized cost basis (pre-OTTI charge) and the present value of the estimated cash flows the Bank expects to realize on the private label MBS over their life. As of December 31, 2009, the Bank did not intend to sell and it is not more likely than not that the Bank will be required to sell any OTTI securities before anticipated recovery of their amortized cost basis. The Bank has not recorded significant OTTI on any other type of security (i.e., U.S. agency MBS or non-MBS securities). See the “Credit and Counterparty Risk — Other-Than-Temporary Impairment” discussion in Risk Management in Item 7. Management’s Discussion and Analysis and Note 8 to the audited financial statements in Item 8. Financial Statements and Supplementary Financial Data in this 2009 Annual Report filed on Form 10-K for discussion regarding OTTI analysis and conclusions.

 

The Bank has insurance on its home equity lines of credit (HELOC) investments. However, the current weakened financial condition of these insurers increases the risk that these counterparties will fail. Therefore, they may be unable to reimburse the Bank for claims under insurance policies on certain securities within the Bank’s private label MBS portfolio. As of year-end 2009, a trustee had to make claims on one of the insured HELOC bonds and the payments were made by the insurer. As delinquencies increase and credit enhancement provided by a security’s subordination structure is eroded, the likelihood that claims on these insurance policies will be made increases. The Bank has estimated that not all insurance providers on the HELOCs will make their contractual payments, so the Bank has recorded OTTI on these securities.

 

As discussed below, legislation allowing for bankruptcy modifications (referred to as cramdown legislation) on mortgages of owner-occupied homes had been passed by the House but was defeated in the Senate; however, similar legislation may be re-introduced during 2010. With this potential change in the law, the risk of losses on mortgages due to borrower bankruptcy filings could become material. The previously proposed legislation permitted a bankruptcy judge, in specified circumstances, to reduce the mortgage amount to today’s market value of the property, reduce the interest paid by the debtor, and/or extend the repayment period. In the event this legislation would again be proposed, passed and applied to existing mortgage debt (including residential MBS), the Bank could face increased risk of credit losses on its private label MBS that include bankruptcy carve-out provisions and allocation of bankruptcy losses over a specified dollar amount on a pro-rata basis across all classes of a security. The effect on the Bank will depend on the actual version of the legislation that is passed, related rating agency actions, and whether mortgages held by the Bank, either within the MPF Program or as collateral for MBS held by the Bank, are subject to bankruptcy proceedings under the new legislation. As of December 31, 2009, the Bank had 69 private label MBS with a par value of $3.8 billion that include bankruptcy carve-out language which could be affected by cramdown legislation.

 

On May 20, 2009, Congress enacted loan modification legislation. The legislation provides that if a servicer of residential mortgages agrees to enter into a residential loan modification, workout, or other loss mitigation plan with respect to a residential mortgage originated before the date of enactment of the legislation, including mortgages held in a securitization or other investment vehicle, to the extent that the servicer owes a duty to investors or other parties to maximize the net present value of such mortgages, the servicer is deemed to have satisfied that duty, and will not be liable to those investors or other parties, if certain criteria are met. Those criteria include the following: (1) default on the mortgage has occurred, is imminent, or is reasonably foreseeable; (2) the mortgagor occupies the property securing the mortgage as his or her principal residence; and (3) the servicer reasonably

determined that the application of the loss mitigation plan to the mortgage will likely provide an anticipated recovery on the outstanding principal mortgage debt that will exceed the anticipated recovery through foreclosure. There are other ongoing discussions of legislative and regulatory changes to increase mortgage loan modifications to help borrowers avoid foreclosure and some of these proposals include principal writedowns. At this time, the Bank is unable to predict what impact this legislation may have on the ultimate recoverability of the private label MBS investment portfolio; however, modifications may result in reductions in the value of the Bank’s private label MBS portfolio and increases in credit and noncredit losses the Bank incurs on such securities.

 

In February 2010, Fannie Mae and Freddie Mac announced that they intend to purchase seriously delinquent loans, defined as loans 120 days or more delinquent, out of collateral pools backing the MBS they have issued. While details of the purchase programs are not fully known, loans purchased by Fannie Mae and Freddie Mac at par value from the collateral pools supporting the MBS that were purchased by the Bank at a premium would result in an acceleration of premium amortization on the MBS. Accordingly, the principal of these securities would be paid down more quickly than anticipated, and the Bank’s net interest income from these investments would be reduced.

 

In addition, the purchase of seriously delinquent loans by Fannie Mae and Freddie Mac would result in significant levels of principal received by investors in a short period of time, resulting in an increase in market liquidity. This may, in turn, serve to limit the Bank’s opportunities to reinvest these prepayments profitably as other investors would be seeking to re-deploy these prepayments simultaneously. This could elevate purchase prices and reduce effective yields on the new investments.

 

Additionally, if Fannie Mae and Freddie Mac access the capital markets to fund these prepayments, the Bank’s own funding costs may be adversely impacted. The funding costs for Fannie Mae, Freddie Mac and the FHLBanks traditionally track each other closely. Therefore, any material increase in access to the capital markets could result in higher funding costs realized by Fannie Mae, Freddie Mac and the FHLBanks as well.

 

The Bank’s financial condition or results of operations may be adversely affected if MBS servicers fail to perform their obligations to service mortgage loans as collateral for MBS.

 

MBS servicers have a significant role in servicing the mortgage loans that serve as collateral for the Bank’s MBS portfolio, including playing an active role in loss mitigation efforts and making servicer advances. The Bank’s credit risk exposure to the servicer counterparties includes the risk that they will not perform their obligation to service these mortgage loans, which could adversely affect the Bank’s financial condition or results of operations. The risk of such a failure has increased as deteriorating market conditions have affected the liquidity and financial condition of some of the larger servicers. These risks could result in losses significantly higher than currently anticipated. In addition, the Bank is also exposed to the risk that a bank used by the servicer could be seized by the FDIC, which may result in additional complications with respect to the Bank collecting payments on its securities. The Bank is the owner of an MBS bond issued and serviced by Taylor Bean & Whitaker (TBW), which had a par balance of $52.3 million as of December 31, 2009. TBW filed for bankruptcy on August 24, 2009. TBW utilized Colonial Bank as its primary bank. Colonial Bank went into FDIC receivership on August 13, 2009. See further discussion regarding these bonds in the “Investment Securities” discussion in the Financial Condition section in Item 7. Management’s Discussion and Analysis in this 2009 Annual Report filed on Form 10-K.

 

The Bank is subject to credit risk due to default, including failure or ongoing instability of any of the Bank’s member, derivative, money market or other counterparties, which could adversely affect its profitability or financial condition.

 

Due to recent market events, some of the Bank’s members (or their affiliates), as well as derivative, money market and other counterparties, have experienced various degrees of financial distress, including liquidity constraints, credit downgrades or bankruptcy. The instability of the financial markets during 2009 resulted in many financial institutions becoming significantly less creditworthy, exposing the Bank to increased member and counterparty risk and risk of default. Changes in market perception of the financial strength of various financial institutions can occur very rapidly and can be difficult to predict. Over the past year, in a departure from historical experience, the pace at which financial institutions (including FDIC-insured institutions) have moved from having some financial difficulties to failure has increased dramatically. Consequently, the Bank faces an increased risk that a counterparty or member failure will result in a financial loss to the Bank.

The Bank faces credit risk on advances, mortgage loans, investment securities, derivatives, certificates of deposit, commercial paper and other financial instruments. The Bank protects against credit risk on advances through credit underwriting standards and collateralization. In addition, under certain circumstances the Bank has the right to obtain additional or substitute collateral during the life of a loan to protect its security interest. The Act defines eligible collateral as certain investment securities, residential mortgage loans, deposits with the Bank, and other real estate related assets. All capital stock of the Bank owned by the borrower is also available as supplemental collateral. Effective February 2010, the Bank was also authorized to approve CDFIs for membership and lend to CDFI members. In addition, members that qualify as CFIs may pledge secured small-business, small-farm, and small-agribusiness loans as collateral for loans. The Bank is also allowed to make loans to nonmember housing associates and requires them to deliver adequate collateral.

 

The types of collateral pledged by members are evaluated and assigned a borrowing capacity, generally based on a percentage of its value. This value can either be based on book value or market value, depending on the nature and form of the collateral being pledged. The volatility of market prices and interest rates could affect the value of the collateral held by the Bank as security for the obligations of Bank members as well as the ability of the Bank to liquidate the collateral in the event of a default by the obligor. Volatility within collateral indices may affect the method used in determining collateral weightings, which would ultimately affect the eventual collateral value. On advances, the Bank’s policies require the Bank to be over-collateralized. In addition, all advances are current and no loss has ever been incurred in the portfolio. Based on these factors, no allowance for credit losses on advances is required. The Bank has policies and procedures in place to manage the collateral positions; these are subject to ongoing review, evaluation and enhancements as necessary.

 

In 2009, 140 FDIC-insured institutions have failed across the country. The financial services industry has experienced an increase in both the number of financial institution failures and the number of mergers and consolidations. If member institution failures and mergers or consolidations occur affecting the Bank’s district, particularly out-of-district acquirers, this activity may reduce the number of current and potential members in the Bank’s district. The resulting loss of business could negatively impact the Bank’s financial condition and results of operations, as well as the Bank’s operations in general. Additionally, if Bank members fail and the FDIC or the member (or another applicable entity) does not either (1) promptly repay all of the failed institution’s obligations to the Bank or (2) assume the outstanding advances, the Bank may be required to liquidate the collateral pledged by the failed institution in order to satisfy its obligations to the Bank. If that were the case, the proceeds realized from the liquidation of pledged collateral may not be sufficient to fully satisfy the amount of the failed institution’s obligations and the operational cost of liquidating the collateral.

 

The Bank follows guidelines established by its Board on unsecured extensions of credit which limit the amounts and terms of unsecured credit exposure to highly rated counterparties, the U.S. Government and other FHLBanks. The Bank’s primary unsecured credit exposure includes Federal funds and money market exposure as well as the unsecured portion of any derivative transaction. Unsecured credit exposure to any counterparty is limited by the credit quality and capital level of the counterparty and by the capital level of the Bank. Nevertheless, the insolvency or other inability of a significant counterparty to perform its obligations under such transactions or other agreement could cause the Bank to incur losses and have an adverse effect on the Bank’s financial condition and results of operations.

 

In addition, the Bank’s ability to engage in routine derivatives, funding and other transactions could be adversely affected by the actions and commercial soundness of other financial institutions. Financial institutions are interrelated as a result of trading, clearing, counterparty or other relationships. As a result, defaults by, or even rumors or questions about, one or more financial services institutions, or the financial services industry generally, could lead to market-wide disruptions in which it may be difficult for the Bank to find counterparties for such transactions.

 

Due to the ongoing financial market stress, to the extent the number of high quality counterparties available for hedging transactions decreases, the Bank may face reduced, or limited, ability to enter into hedging transactions. As a result, the Bank may not be able to effectively manage interest rate risk, which could negatively affect its results of operations and financial condition. In addition, the Bank may be limited in the number of counterparties available

with which it can conduct business with respect to money market investments, liquidity positions and other business transactions. It may also affect the Bank’s credit risk position and the loan products the Bank can offer to members.

 

For additional discussion regarding the Bank’s credit and counterparty risk, see the “Credit and Counterparty Risk” discussion in Risk Management in Item 7. Management’s Discussion and Analysis in this 2009 Annual Report filed on Form 10-K. See discussion in “Current Financial and Mortgage Market Events and Trends” in the Earnings Performance section of Item 7. Management’s Discussion and Analysis regarding the impact of the Lehman Brothers Holding, Inc. (Lehman) bankruptcy filing.

 

The Bank is subject to legislative and regulatory actions, including a complex body of regulations, including Finance Agency regulations, which may be amended in a manner that may affect the Bank’s business, operations and/or financial condition and members’ investment in the Bank.

 

On December 11, 2009, the House 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: (1) create a consumer financial protection agency; (2) create an inter-agency oversight council that will identify and regulate systemically important financial institutions; (3) regulate the over-the-counter derivatives market; (4) reform the credit rating agencies; (5) provide shareholders with an advisory vote on the compensation practices of the entity in which they invest including for executive compensation and golden parachutes; and (6) 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, the Bank’s business, operations, funding costs, rights, obligations, and/or the manner in which the Bank carries out its housing-finance mission may be impacted. For example, regulations on the over-the-counter derivatives market that may be issued under the Reform Act could adversely impact the Bank’s ability to hedge its interest-rate risk exposure from advances, achieve the Bank’s risk management objectives, and act as an intermediary between its members and counterparties. However, the Bank cannot predict whether any such legislation will be enacted and what the content of any such legislation or regulations issued under any such legislation would be and so cannot predict what impact the Reform Act or similar legislation may have on the Bank.

 

Since enactment in 1932, the Act has been amended many times in ways that have significantly affected the rights and obligations of the FHLBanks and the manner in which they fulfill their housing finance mission. Future legislative changes to the Act may significantly affect the Bank’s business, results of operations and financial condition.

 

In July 2008, the Housing Act was enacted. One significant provision of the Housing Act was to create a newly established Federal agency regulator, the Finance Agency, to become the regulator of the FHLBanks, Fannie Mae and Freddie Mac. The Housing Act was intended to, among other things, address the housing finance crisis, expand the Federal Housing Administration’s financing authority and address GSE reform issues.

 

In addition to legislation described above, the FHLBanks are also governed by Federal laws and regulations as adopted by Congress and applied by the Finance Agency, an independent agency in the executive branch of the Federal government. The Finance Agency’s extensive statutory and regulatory authority over the FHLBanks includes, without limitation, the authority to liquidate, merge or consolidate FHLBanks, redistrict and/or adjust equities among the FHLBanks. The Bank cannot predict if or how the Finance Agency could exercise such authority in regard to any FHLBank or the potential impact of such action on members’ investment in the Bank. The Finance Agency also has authority over the scope of permissible FHLBank products and activities, including the authority to impose limits on those products and activities. The Finance Agency supervises the Bank and establishes the regulations governing the Bank. On February 8, 2010, the Finance Agency issued a proposed regulation to establish the terms under which it could impose additional temporary minimum capital requirements on an FHLBank. See Legislative and Regulatory Developments in Item 7. Management’s Discussion and Analysis for additional information. In August 2009, the Finance Agency issued the PCA Regulation, which incorporated the Interim Final Regulation regarding Capital Levels for FHLBanks previously issued in January 2009. For additional discussion, see the Risk Factor entitled “The Bank may fail to meet its minimum regulatory capital requirements, or be otherwise designated by the Finance Agency as undercapitalized, which would impact the Bank’s ability to conduct business “as usual,” result in prohibitions on dividends, excess capital stock repurchases and capital stock redemptions and potentially impact the value of Bank membership.”

In September 2008, the Federal Reserve announced it would begin purchasing short-term debt obligations issued by Fannie Mae, Freddie Mac and the FHLBanks. In November 2008, the Federal Reserve announced it would begin purchasing term debt obligations of FHLBanks, Fannie Mae and Freddie Mac as well as MBS guaranteed by Fannie Mae, Freddie Mac and Ginnie Mae. This total program, initiated to drive mortgage rates lower, make housing more affordable, and help stabilize home prices, may lead to continued artificially low agency-mortgage pricing. Comparative MPF Program price execution, which is a function of the FHLBank debt issuance costs, may not be competitive as a result. This trend could continue and member demand for MPF Program products could diminish.

 

The TARP was established in October 2008, providing the U.S. Treasury the authority to purchase up to $700 billion of assets, including mortgage-related assets, from financial institutions. The U.S. Treasury, through its TARP capital purchase program, has made and continues to make capital stock investments in U.S. financial institutions.

 

On February 27, 2009, the FDIC approved a final regulation imposing an increased deposit insurance premium assessment on FDIC-insured institutions that have outstanding advances and other secured liabilities greater than 25 percent of their domestic deposits. At that time, the FDIC also approved revisions to the TLGP program to provide an FDIC guarantee for convertible term debt. The Bank continues to monitor the FDIC’s actions and the impact on investor demand for Bank funding, as well as the impact on the Bank’s members.

 

The Bankruptcy Reform Act of 1994 substantially eliminated the risk of bankruptcy mortgage modifications, also known as cramdowns, on mortgages secured solely by the debtor’s principal residence. While this legislation is still in effect, there has been new legislation allowing for bankruptcy modifications (referred to as cramdown legislation) on mortgages of owner-occupied homes.

 

On May 20, 2009, the Helping Families Save Their Home Act of 2009 was enacted to encourage loan modifications in order to prevent mortgage foreclosures and to support the Federal deposit insurance system.

 

The Bank cannot predict whether new regulations will be promulgated or the effect of any new regulations on the Bank’s operations. Changes in Finance Agency regulations and Finance Agency regulatory actions could result in, among other things, changes in the Bank’s capital requirements, an increase in the Banks’ cost of funding, a change in permissible business activities, a decrease in the size, scope, or nature of the Banks’ lending, investment or mortgage purchase program activities, or a decrease in demand for the Bank’s products and services, which could negatively affect its financial condition and results of operations and members’ investment in the Bank.

 

See additional discussion regarding cramdown legislation and loan modifications in the Risk Factor entitled “The Bank invests in MBS, including significant legacy positions in private label MBS. The MBS portfolio shares risks similar to the MPF Program as well as risks unique to MBS investments. The increased risks inherent with these investments have adversely impacted the Bank’s profitability and capital position and are likely to continue to do so during 2010.”

 

The Bank is jointly and severally liable for the consolidated obligations of other FHLBanks. Additionally, the Bank may receive from or provide financial assistance to 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 of the FHLBanks, backed only by the financial resources of the FHLBanks. Accordingly, the Bank is jointly and severally liable with the other FHLBanks for all consolidated obligations issued, regardless of whether the Bank receives all or any portion of the proceeds from any particular issuance of consolidated obligations. As of December 31, 2009, out of a total of $930.6 billion in par value of consolidated obligations outstanding, the Bank was the primary obligor on $59.0 billion, or approximately 6.3% of the total.

 

In addition to its extensive and broad authority in regard to the FHLBanks as noted above, the Finance Agency in its discretion may also require any FHLBank to make principal or interest payments due on any consolidated obligation, whether or not the primary obligor FHLBank has defaulted on the payment of that obligation. Accordingly, the Bank could incur significant liability beyond its primary obligation under consolidated obligations which could negatively affect the Bank’s financial condition and results of operations. The Bank

records a liability for consolidated obligations on its Statement of Condition equal to the proceeds it receives from the issuance of those consolidated obligations. The Bank does not recognize a liability for its joint and several obligations related to consolidated obligations issued by other FHLBanks because the Bank considers the obligation a related party guarantee. See Risk Management in Item 7. Management’s Discussion and Note 16 to the audited financial statements in Item 8. Financial Statements and Supplementary Financial Data in this 2009 Annual Report filed on Form 10-K for further information. See the Risk Factor entitled “Changes in the Bank’s, other FHLBanks’ or other GSEs’ credit ratings may adversely affect the Bank’s ability to issue consolidated obligations and enter into derivative transactions on acceptable terms.” for details regarding the most recent Moody’s and S&P ratings for the FHLBank System and each of the FHLBanks within the System.

 

The Bank or any other FHLBank may be required to, or may voluntarily decide to, provide financial assistance to one or more other FHLBanks. The Bank could be in the position of either receiving or providing such financial assistance, which could have a material effect on the Bank’s financial condition and the members’ investment in the Bank.

 

Changes in the Bank’s, other FHLBanks’ or other GSEs’ credit ratings may adversely affect the Bank’s ability to issue consolidated obligations and enter into derivative transactions on acceptable terms.

 

FHLBank System consolidated obligations have been assigned Aaa/P-1 and AAA/A-1+ ratings by Moody’s and S&P. These are the highest ratings available for such debt from an NRSRO. These ratings indicate that the FHLBanks have an extremely strong capacity to meet their commitments to pay principal of and interest on consolidated obligations and that the consolidated obligations are judged to be of the highest quality with minimal credit risk. The ratings also reflect the FHLBanks’ status as GSEs. The Bank’s latest stand-alone ratings by Moody’s and S&P are Aaa/P-1/Stable and AAA/Stable /A-1+ respectively. Items such as future OTTI charges or reserves on advances the Bank may be required to record could result in a lowering of the Bank’s stand-alone ratings. This could adversely affect the Bank’s ability to issue debt, enter into derivative contracts on acceptable terms and issue standby letters of credit. This could have a negative impact on the Bank’s financial condition and results of operations.

 

It is possible that the credit rating of an FHLBank or another GSE could be lowered at some point in the future, which might adversely affect the Bank’s costs of doing business, including the cost of issuing debt and entering into derivative transactions. The Bank’s costs of doing business and ability to attract and retain members could also be adversely affected if the credit ratings of one or more other FHLBanks are lowered, or if other FHLBanks incur significant losses.

 

Although the credit ratings of the consolidated obligations of the FHLBanks have not been affected by actions taken in prior years, similar ratings actions or negative guidance may adversely affect the Bank’s cost of funds and ability to issue consolidated obligations and enter into derivative transactions on acceptable terms, which could negatively affect financial condition and results of operations. The Bank’s costs of doing business and ability to attract and retain members could also be adversely affected if the credit ratings assigned to the consolidated obligations were lowered from AAA.

The following table presents the Moody’s and S&P ratings for the FHLBank System and each of the FHLBanks within the System as of March 15, 2010.

 

 

 

Fluctuating interest rates or the Bank’s inability to successfully manage its interest rate risk may adversely affect the Bank’s net interest income, overall profitability and the market value of its equity.

 

Like many financial institutions, the Bank realizes income primarily from the spread between interest earned on loans and investment securities and interest paid on debt and other liabilities, as measured by net interest income. The Bank’s financial performance is affected by fiscal and monetary policies of the Federal government and its agencies and in particular by the policies of the Federal Reserve. The Federal Reserve’s policies, which are difficult to predict, directly and indirectly influence the yield on the Bank’s interest-earning assets and the cost of interest-bearing liabilities. Although the Bank uses various methods and procedures to monitor and manage exposures due to changes in interest rates, the Bank may experience instances when its interest-bearing liabilities will be more sensitive to changes in interest rates than its interest-earning assets, when the timing of the re-pricing of interest-bearing liabilities does not coincide with the timing of re-pricing of interest-earning assets, or when the timing of the maturity or paydown of interest-bearing liabilities does not coincide with the timing of the maturity or paydown of the interest-earning assets.

 

Fluctuations in interest rates affect profitability in several ways, including but not limited to the following:

 

The Bank’s ability to anticipate changes regarding the direction and speed of interest rate changes, or to hedge the related exposures, significantly affect the success of the asset and liability management activities and the level of net interest income.

 

The Bank uses derivative instruments to attempt to reduce interest rate risk. In prior years, some of the Bank’s derivatives and hedging strategies were deemed ineligible for hedge accounting treatment under derivative accounting guidance and resulted in significant one-sided fair value adjustments which were reflected in the Statement of Operations in those periods. More recently, the Bank has implemented strategies which have reduced the amount of one-sided fair value adjustments and the resulting impact to the Statement of Operations. However, market movements and volatility affecting the valuation of instruments in hedging relationships can cause income volatility in the form of hedge ineffectiveness. Should the use of derivatives be further limited, with that activity being replaced with a higher volume of debt funding, the Bank may still experience income volatility driven by the market and interest rate sensitivities.

 

In addition, the Bank’s profitability and the market value of its equity, as well as its liquidity and financial condition, are significantly affected by its ability to manage interest rate risks. The Bank uses a number of measures and analyses to monitor and manage interest rate risk. Given the unpredictability of the financial markets, capturing all potential outcomes in these analyses is not practical. Key assumptions include, but are not limited to, loan volumes and pricing, market conditions for the Bank’s consolidated obligations, interest rate spreads and prepayment speeds and cash flows on mortgage-related assets. These assumptions are inherently uncertain and, as a result, the measures cannot precisely estimate net interest income or the market value of equity nor can they precisely predict the impact of higher or lower interest rates on net interest income or the market value of equity. Actual results will differ from simulated results due to the timing, magnitude, and frequency of interest rate changes and changes in market conditions and management strategies, among other factors. See additional discussion in Risk Management in Item 7. Management’s Discussion and Analysis in this 2009 Annual Report filed on Form 10-K. In December 2008, the Bank implemented changes to its dividend and retained earnings practices, including suspension of excess capital stock repurchases and dividend payments until further notice. These voluntary actions are discussed in more detail in Capital Resources in Item 7. Management’s Discussion and Analysis in this 2009 Annual Report filed on Form 10-K as well as in the Bank’s report on Form 8-K filed with the SEC on December 23, 2008. The Bank continues to monitor its position and evaluate its policies.

 

The loss of significant Bank members or borrowers may have a negative impact on the Bank’s loans and capital stock outstanding and could result in lower demand for its products and services, lower dividends paid to members and higher borrowing costs for remaining members, all which may affect the Bank’s profitability and financial condition.

 

One or more significant Bank members or borrowers could be merged into nonmembers, withdraw their membership or decrease their business levels with the Bank, which could lead to a significant decrease in the Bank’s total assets. Membership withdrawal may be due to a move to another FHLBank district or concern regarding a credit loss on the investment in the Bank. Additionally, there are instances when acquired banks are merged into banks chartered outside the Bank’s district or when a member is consolidated with an institution within the Bank’s district that is not one of the Bank’s members. Under the Act and the Finance Agency’s current rules, the Bank can generally do business only with member institutions that have charters in its district. If member institutions are acquired by institutions outside the Bank’s district and the acquiring institution decides not to maintain membership by dissolving charters, the Bank may be adversely affected, resulting in lower demand for products and services and ultimately requiring the redemption of related capital stock. At December 31, 2009, the Bank’s five largest customers, Sovereign Bank, Ally Bank, PNC Bank, ING Bank and Citizens Bank of Pennsylvania accounted for 63.9% of its total advances outstanding and owned 54.7% of its outstanding capital stock. Of these members, Sovereign Bank, Ally Bank and PNC Bank each had outstanding loan balances in excess of ten percent of the total portfolio. If any of these members paid off their outstanding loans or withdrew from membership, the Bank could

experience a material adverse effect on its outstanding loan levels and a decrease in demand for its products and services, all of which would impact the Bank’s financial condition and results of operations.

 

In the event the Bank would lose one or more large borrowers that represent a significant proportion of its business, the Bank could, depending on the magnitude of the impact, compensate for the loss by continuing to suspend, or otherwise restrict, dividend payments and repurchases of excess capital stock, raising loan rates, attempting to reduce operating expenses (which could cause a reduction in service levels or products offered) or by undertaking some combination of these actions. The magnitude of the impact would depend, in part, on the Bank’s size and profitability at the time the financial institution ceases to be a borrower.

 

See further discussion in the “Credit and Counterparty Risk — Loan Concentration Risk” section of Risk Management in Item 7. Management’s Discussion and Analysis and Note 9 to the audited financial statements in Item 8. Financial Statements and Supplementary Financial Data in this 2009 Annual Report filed on Form 10-K.

 

The Bank faces competition for loans, mortgage loan purchases and access to funding, which could negatively impact earnings.

 

The Bank’s primary business is making loans to its members. The Bank competes with other suppliers of wholesale funding, both secured and unsecured, including commercial banks and their investment banking divisions, the FRBs, the FDIC, and, in some circumstances, other FHLBanks. Members have access to alternative funding sources, which may offer more favorable terms than the Bank offers on its loans, including more flexible credit or collateral standards. In addition, many of the Bank’s competitors are not subject to the same body of regulations applicable to the Bank, which enables those competitors to offer products and terms that the Bank is not able to offer. In 2009, the Bank experienced a decline in its advances portfolio. This decline was driven by: (1) the impact of members’ access to additional liquidity from government programs; (2) an increase in members’ core deposits and reduction in the size of their balance sheets; (3) members’ reactions to the Bank’s pricing of short-term advances products; (4) members limiting use of Bank products in reaction to the Bank’s temporary actions of not paying dividends and not repurchasing excess capital stock; and (5) a decrease in members’ need for funding from the Bank due to the recession.

 

The availability of alternative funding sources that are more attractive than those funding products offered by the Bank may significantly decrease the demand for loans. Any changes made by the Bank in the pricing of its loans in an effort to compete effectively with these competitive funding sources may decrease loan profitability. A decrease in loan demand or a decrease in the Bank’s profitability on loans could negatively affect its financial condition and results of operations.

 

In connection with the MPF Program, the Bank is subject to competition regarding the purchase of conventional, conforming fixed-rate mortgage loans. In this regard, the Bank faces competition in the areas of customer service, purchase prices for the MPF loans and ancillary services such as automated underwriting. The Bank’s strongest competitors are large mortgage companies and the other housing GSEs, Fannie Mae and Freddie Mac. The Bank may also compete with other FHLBanks with which members have a relationship through affiliates. Most of the FHLBanks participate in the MPF Program or a similar program known as the Mortgage Purchase Program. Competition among FHLBanks for MPF business may be affected by the requirement that a member and its affiliates can sell loans into the MPF Program through only one FHLBank relationship at a time, as well as each FHLBank’s capital stock requirement for MPF exposure. Some of these mortgage loan competitors have greater resources, larger volumes of business, longer operating histories and more product offerings. In addition, because the volume of conventional, conforming fixed-rate mortgages fluctuates depending on the level of interest rates, the demand for MPF Program products could diminish. Increased competition can result in a reduction in the amount of mortgage loans the Bank is able to purchase and consequently lower net income.

 

The Finance Agency does not currently permit multidistrict membership; however, a decision by the Finance Agency to permit such membership could significantly affect the Bank’s ability to make loans and purchase mortgage loans.

 

The FHLBanks also compete with the U.S. Treasury, Fannie Mae, Freddie Mac, 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. Increases in the supply of competing debt products may, in the absence of

increases in demand, result in higher debt costs or lower amounts of debt issued at the same cost than otherwise would be the case. Increased competition could adversely affect the Bank’s ability to have access to funding, reduce the amount of funding available or increase the cost of funding. Any of these effects could adversely affect the Bank’s financial condition, results of operations and ability to pay dividends to members. During 2009, the FHLBanks continued to experience a decline in the demand for longer-term debt issuance due in part to legislative and regulatory actions taken by the U.S. Treasury and Federal Reserve to stimulate the housing and credit markets. These actions are discussed in more detail in the Risk Factors entitled “The Bank is subject to legislative and regulatory actions, including a complex body of regulations, including Finance Agency regulations, which may be amended in a manner that may affect the Bank’s business, operations and/or financial condition and members’ investment in the Bank.” and “The Bank may be limited in its ability to access the capital markets, which could adversely affect the Bank’s liquidity. In addition, if the Bank’s ability to access the long-term debt markets would be limited, this may have a material adverse effect on its liquidity, results of operations and financial condition, as well as its ability to fund operations, including advances.”

 

The MPF Program has different risks than those related to the Bank’s traditional loan business, which could adversely impact the Bank’s profitability.

 

The Bank participates in the MPF Program with the FHLBank of Chicago as MPF provider. Net mortgage loans held for portfolio accounted for 7.9% of the Bank’s total assets as of December 31, 2009 and approximately 19.4% of the Bank’s total interest income for the full year 2009. In contrast to the Bank’s traditional member loan business, the MPF Program is highly subject to competitive pressures, more susceptible to loan losses, and also carries more interest rate risk, prepayment risk and operational complexity. The residential mortgage loan origination business historically has been a cyclical industry, enjoying periods of strong growth and profitability followed by periods of shrinking volumes and industry-wide losses. General changes in market conditions could have a negative effect on the mortgage loan market. These would include, but are not limited to, the following: rising interest rates slowing mortgage loan originations; an economic downturn creating increased defaults and lowered housing prices; and increased innovation resulting in products that do not currently meet the criteria of the MPF Program. Any of these changes could have a negative impact on the profitability of the MPF Program.

 

The rate and timing of unscheduled payments and collections of principal on mortgage loans are difficult to predict and can be affected by a variety of factors, including the level of prevailing interest rates, the availability of lender credit, and other economic, demographic, geographic, tax and legal factors. The Bank manages prepayment risk through a combination of consolidated obligation issuance and, to a lesser extent, derivatives. If the level of actual prepayments is higher or lower than expected, the Bank may experience a mismatch with a related consolidated obligation issuance, resulting in a gain or loss to the Bank. Also, increased prepayment levels will cause premium amortization to increase, reducing net interest income, and increase the potential for debt overhang. To the extent one or more of the geographic areas in which the Bank’s MPF loan portfolio is concentrated experiences considerable declines in the local housing market, declining economic conditions or a natural disaster, the Bank could experience an increase in the required allowance for loan losses on this portfolio.

 

Delinquencies and losses with respect to residential mortgage loans continued to increase in the first half of 2009, but stabilized somewhat in the last six months of the year. In addition, residential property values in many states continued to decline or, at best, remained stable. However, the Bank’s MPF loan portfolio has continued to perform better than many residential loan portfolios. The geographic span of the Bank’s portfolio is limited in those high-risk states and regions of the country which are experiencing significant property devaluations. The residential mortgage loans in the Bank’s portfolio are of a higher credit quality overall. The MPF portfolio is analyzed for risk of loss through the allowance for loan losses process. If delinquency and loss rates on mortgage loans increase, and/or there is rapid decline in residential real estate values, the Bank could experience an increase in the allowance for loan losses, and potentially realized losses, on its MPF portfolio. In the event the Bank was forced to liquidate the entire portfolio, additional losses could be incurred which would adversely impact the Bank’s profitability and financial condition.

 

If FHLBank of Chicago changes the MPF Program or ceases to operate the Program, this would have a negative impact on the Bank’s mortgage purchase business, and, consequently, a related decrease in the Bank’s net interest

margin, financial condition and profitability. Additionally, if FHLBank of Chicago, or its third party vendors, experiences operational difficulties, such difficulties could have a negative impact on the Bank’s financial condition and profitability.

 

For the MPF Plus product, Supplemental Mortgage Insurance (SMI) coverage has typically been available for PFIs to purchase. As of December 31, 2009, Genworth Mortgage Insurance Corp. and Mortgage Guaranty Insurance Company provided 83.8% and 5.9%, respectively, of SMI coverage for MPF Plus product loans. However, due to a lack of insurers writing new SMI policies, the MPF Plus product is not currently being offered to members. For the MPF Original product, the ratings model currently requires additional credit enhancement from the PFI to compensate for the lower mortgage insurer rating for loans subject to private mortgage insurance requirements (i.e., LTV greater than 80%). Historically, there have been no losses claimed against an SMI insurer. However, a default on the insurance obligations by one or both of these SMI insurers and an increase in losses on MPF loans would adversely affect the Bank’s profitability.

 

For a description of the MPF Program, the obligations of the Bank with respect to loan losses and a PFI’s obligation to provide credit enhancement, see the sections entitled Mortgage Partnership Finance Program in Item 1. Business, and Item 7. Management’s Discussion and Analysis in this 2009 Annual Report filed on Form 10-K. See additional details regarding SMI insurers in the “Credit and Counterparty Risk — Mortgage Loans, BOB Loans and Derivatives” discussion in Risk Management in Item 7. Management’s Discussion and Analysis in this 2009 Annual Report filed on Form 10-K.

 

The Bank’s Affordable Housing Program and other related community investment programs may be severely affected if the Bank’s annual net income is reduced or eliminated.

 

The Bank is required to establish an Affordable Housing Program (AHP). The Bank provides subsidies in the form of direct grants and/or below-market interest rate advances to members who use the funds to assist in the purchase, construction or rehabilitation of housing for very low-, low-, and moderate-income households.

 

If the Bank experienced a net loss, as defined in Note 17 to the audited financial statements in Item 8. Financial Statements and Supplementary Financial Data in this 2009 Annual Report filed on Form 10-K, for a full year, the Bank would have no obligation to the AHP for the year except in the following circumstance: if the result of the aggregate ten percent calculation described above is less than $100 million for all twelve FHLBanks, then the Act requires that each FHLBank contribute such prorated sums as may be required to assure that the aggregate contributions of the FHLBanks equal $100 million. The proration would be made on the basis of an FHLBank’s income in relation to the net earnings of all FHLBanks for the previous year. Each FHLBank’s required annual AHP contribution is limited to its annual net earnings. If an FHLBank finds that its required contributions are contributing to the financial instability of that FHLBank, it may apply to the Finance Agency for a temporary suspension of its contributions.

 

For the year ended December 31, 2009, the Bank did experience a net loss and did not set aside any AHP funding to be awarded during 2010. However, as allowed by AHP regulations, the Bank has elected to allot up to $2 million of future periods’ required AHP contributions to be awarded during 2010 (referred to as Accelerated AHP). The Accelerated AHP allows the Bank to commit and disburse AHP funds to meet the Bank’s mission when it would otherwise be unable to do so, based on its normal funding mechanism. The Bank will credit the Accelerated AHP contribution against required AHP contributions over the next five years.

 

The Bank relies on externally developed models to manage market and other risks, to make business decisions and for financial accounting and reporting purposes. These models are run and maintained by the Bank. In addition, the Bank relies on externally developed models to perform cash flow analysis on MBS to evaluate for OTTI. These models are run and maintained outside of the Bank. In both cases, the Bank’s business could be adversely affected if these models fail to produce reliable and useful results.

 

The Bank makes significant use of business and financial models for managing risk. For example, the Bank uses models to measure and monitor exposures to interest rate and other market risks and credit risk, including prepayment risk. The Bank also uses models in determining the fair value of financial instruments for which independent price quotations are not available or reliable. 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.

 

Models are inherently imperfect predictors of actual results because they are based on assumptions about future performance. The Bank’s models could produce unreliable results for a number of reasons, including invalid or incorrect assumptions underlying the models or incorrect data being used by the models. The risk metrics, valuations and loan loss reserve estimations produced by the Bank’s models may be different from actual results, which could adversely affect the Bank’s business results, cash flows, fair value of net assets, business prospects and future earnings. 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 or the Bank does not use them appropriately, the Bank could make poor business decisions, including asset and liability management decisions, or other decisions, which could result in an adverse financial impact. Further, any strategies that the Bank employs to attempt to manage the risks associated with the use of models may not be effective. See “Quantitative Disclosures Regarding Market Risk — The Bank’s Market Risk Model” discussion in Risk Management in Item 7. Management’s Discussion and Analysis for more information.

 

In performing the cash flow analysis on the Bank’s private label MBS to determine OTTI, the Bank uses two third party models. The first model considers borrower characteristics and the particular attributes of the loans underlying the Bank’s securities, in conjunction with assumptions about future changes in home prices and interest rates, to project prepayments, defaults and loss severities. The month-by-month projections of future loan performance derived from the first model, which reflect the projected prepayments, defaults and loss severities, were then input into a second model that allocated 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. A table of the significant inputs (including default rates, prepayment rates and loss severities) used on those securities on which an OTTI was determined to have occurred during the quarter ended December 31, 2009 is included in Note 8 to the audited financial statements in Item 8. Financial Statements and Supplementary Financial Data included in this 2009 Annual Report filed on Form 10-K.

 

These models and assumptions have a significant effect on determining whether any of the investment securities are other-than-temporarily impaired. The use of different assumptions, as well as changes in market conditions, could result in materially different net income, retained earnings and total capital for the Bank. Based on the structure of the Bank’s private label MBS and the interaction of assumptions to estimate cash flows, the Bank is unable to isolate the impact of the assumption changes or performance deterioration on estimated credit losses recorded by the Bank. See the OTTI discussion in the “Credit and Counterparty Risk — Investments” section in Risk Management in Item 7. Management’s Discussion and Analysis for additional details regarding these models.

 

The Bank’s business is dependent upon its computer information systems. An inability to process information or implement technological changes, or an interruption in the Bank’s systems, may result in lost business.

 

The Bank’s business is dependent upon its ability to effectively exchange and process information using its computer information systems. The Bank’s products and services require a complex and sophisticated computing environment, which includes purchased and custom-developed software. Maintaining the effectiveness and efficiency of the Bank’s operations is dependent upon the continued timely implementation of technology solutions and systems, which may require ongoing capital expenditures. If the Bank were unable to sustain its technological capabilities, it may not be able to remain competitive, and its business, financial condition and profitability may be significantly compromised.

 

In addition to internal computer systems, the Bank relies on third party vendors and service providers for many of its communications and information systems needs. Any failure, interruption or breach in security of these systems, or any disruption of service, could result in failures or interruptions in the Bank’s ability to conduct and manage its business effectively, including, and without limitation, its hedging and advances activities. While the Bank has implemented a Business Continuity Plan, there is no assurance that such failures or interruptions will not occur or, if they do occur, that they will be adequately addressed by the Bank or the third parties on which the Bank relies. Any failure or interruption could significantly harm the Bank’s customer relations and business operations, which could negatively affect its financial condition, profitability and cash flows.

The Bank’s accounting policies and methods are fundamental to how the Bank reports its market value of equity, financial condition and results of operations, and they require management to make estimates about matters that are inherently uncertain.

 

The Bank has identified several accounting policies as being critical to the presentation of its financial condition and results of operations because they require management to make particularly subjective or complex judgments about matters that are inherently uncertain and because of the likelihood that materially different amounts would be recorded under different conditions or using different assumptions. These critical accounting policies relate to the Bank’s accounting for OTTI for investment securities, determination of fair values and accounting for derivatives, among others.

 

Bank management applies significant judgment in assigning fair value to all of its assets and liabilities. These fair values are reported in Note 22 to the audited financial statements in Item 8. Financial Statements and Supplementary Financial Data in this 2009 Annual Report filed on Form 10-K. The fair values assigned to all assets and liabilities have a considerable impact on the Bank’s market value of equity. Management monitors market conditions and takes what it deems to be appropriate action to preserve the value of equity and earnings. The ability for management to appropriately manage the market value of equity is dependent on the market conditions in which the Bank is operating. During the recent market disruption and ongoing decline in the housing and financial markets, the Bank’s market value of equity has been adversely impacted. For additional discussion regarding market value of equity and OTTI, see Risk Management in Item 7. Management’s Discussion and Analysis and Note 8 to the audited financial statements in Item 8. Financial Statements and Supplementary Financial Data, both in this 2009 Annual Report filed on Form 10-K.

 

Because of the inherent uncertainty of the estimates associated with these critical accounting policies, the Bank cannot provide absolute assurance that there will not be any adjustments to the related amounts recorded at December 31, 2009. For more information, please refer to the Critical Accounting Policies section in Item 7. Management’s Discussion and Analysis in this 2009 Annual Report filed on Form 10-K.

 

The Bank may be adversely affected by litigation.

 

From time to time, the Bank’s customers or counterparties may make claims or take legal action relating to performance of contractual responsibilities. The Bank may also face other legal claims, regulatory or governmental inquiries or investigations. In any such claims or actions, demands for substantial monetary damages may be asserted against the Bank and may result in financial liability or an adverse effect on the Bank’s reputation. In regulatory enforcement matters, claims for disgorgement, the imposition of penalties and the imposition of other remedial sanctions are possible.

 

For details regarding the Bank’s legal action with respect to the Lehman bankruptcy and related collateral receivable, and the Bank’s legal actions filed against various defendants regarding private label MBS purchases, see discussion in Item 3. Legal Proceedings in this 2009 Annual Report filed on Form 10-K.

 

The Bank’s controls and procedures may fail or be circumvented, risk management policies and procedures may be inadequate and circumstances beyond the Bank’s control could cause unexpected operating losses. In addition, the loss of key employees may have an adverse effect on the Bank’s business and operations.

 

The Bank may fail to identify and manage risks related to a variety of aspects of its business, including, but not limited to, operational risk, interest rate risk, legal and compliance risk, people risk, liquidity risk, market risk and credit risk. The Bank has adopted many controls, procedures, policies and systems to monitor and manage risk. Management cannot provide complete assurance that those controls, procedures, policies and systems are adequate to identify and manage the risks inherent in the Bank’s various businesses. In addition, these businesses are continuously evolving. The Bank may fail to fully understand the implications of changes in the businesses and fail to enhance the risk governance framework in a timely or adequate fashion to address those changes. If the risk governance framework is ineffective, the Bank could incur losses.

 

The Bank relies heavily upon its employees in order to successfully execute its business and strategies. Certain key employees are important to the continued successful operation of the Bank. Failure to attract and/or retain such key individuals may adversely affect the Bank’s business operations.

Operating risk is the risk of unexpected operating losses attributable to human error, systems failures, fraud, noncompliance with laws, regulations and the Bank’s internal Code of Conduct, unenforceability of contracts, and/or inadequate internal controls and procedures. Although management has systems and procedures in place to address each of these risks, some operational risks are beyond the Bank’s control, and the failure of other parties to adequately address their operational risks could adversely affect the Bank as well.

 

 

None

 

 

The Bank leases 96,240 square feet of office space at 601 Grant Street, Pittsburgh, Pennsylvania, 15219 and additional office space at 1301 Pennsylvania Avenue, Washington, DC 20004; 2300 Computer Avenue, Willow Grove, Pennsylvania, 19090; 435 N. DuPont Highway, Dover, Delaware 19904; 140 Maffett Street, Wilkes Barre, Pennsylvania, 18705; and 580 and 768 Vista Park Drive, Pittsburgh, Pennsylvania 15205. The Washington, DC office space is shared with the FHLBank of Atlanta. The Vista Park Drive space is the Bank’s offsite backup facility. Essentially all of the Bank’s operations are housed at the Bank’s headquarters at the Grant Street location.

 

 

As discussed in “Current Financial and Mortgage Market Events and Trends” in Item 7. Management’s Discussion and Analysis section of this 2009 Annual Report filed on Form 10-K, the Bank terminated multiple interest rate swap transactions with Lehman Brothers Special Financing, Inc. (LBSF) effective September 19, 2008. On October 7, 2008, the Bank filed an adversary proceeding against J.P. Morgan Chase Bank, N.A. (J.P. Morgan) and LBSF in the United States Bankruptcy Court in the Southern District of New York alleging constructive trust, conversion, breach of contract, unjust enrichment and injunction claims (Complaint) relating to the right of the Bank to the return of the $41.5 million in Bank posted cash collateral held by J.P. Morgan in a custodial account established by LBSF as a fiduciary for the benefit of the Bank. Chase Bank USA, N.A. (Chase Bank), an affiliate of J.P. Morgan, is a Bank member and was a greater than 5% shareholder as of October 6, 2008 and at December 31, 2009.

 

During discovery in the Bank’s adversary proceeding against LBSF, the Bank learned that LBSF had failed to keep the Bank’s posted collateral in a segregated account in violation of the Master Agreement between the Bank and LBSF. In fact, the posted collateral was held in a general operating account of LBSF, the balances of which were routinely swept to other Lehman Brother entities, including Lehman Brothers Holdings, Inc. among others. After discovering that the Bank’s posted collateral was transferred to other Lehman entities and not held by J.P. Morgan, the Bank agreed to discontinue the LBSF adversary proceeding against J.P. Morgan. J.P. Morgan was dismissed from the Bank’s proceeding on June 26, 2009. In addition, the Bank discontinued its LBSF adversary proceeding and pursued that claim in the LBSF bankruptcy through the proof of claim process, which made pursuing the adversary proceeding against LBSF unnecessary. The Bank has filed proofs of claim against Lehman Brothers Holdings, Inc. and Lehman Brothers Commercial Corp. as well.

 

The Bank has filed a new complaint against Lehman Brothers Holding Inc., Lehman Brothers, Inc., Lehman Brothers Commercial Corporation, Woodlands Commercial Bank, formerly known as Lehman Brothers Commercial Bank, and Aurora Bank FSB (Aurora), formerly known as Lehman Brothers Bank FSB, alleging unjust enrichment, constructive trust, and conversion claims. Aurora is a member of the Bank. Aurora did not hold more than 5% of the Bank’s capital stock as of December 31, 2009. The Bank filed this complaint on July 29, 2009 in the United States Bankruptcy Court for the Southern District of New York.

 

On September 23, 2009, the Bank filed two complaints in state court, the Court of Common Pleas of Allegheny County, Pennsylvania relating to nine PLMBS bonds purchased from J.P. Morgan Securities, Inc. (J.P. Morgan) in an aggregate original principal amount of approximately $1.68 billion. In addition to J.P. Morgan, the parties include: J.P. Morgan Mortgage Acquisition Corp.; J.P. Morgan Mortgage Acceptance Corporation I; Chase Home Finance L.L.C.; Chase Mortgage Finance Corporation; J.P. Morgan Chase & Co.; Moody’s Corporation; Moody’s Investors Service Inc.; The McGraw-Hill Companies, Inc.; and Fitch, Inc. The Bank’s complaints assert claims for fraud,

negligent misrepresentation and violations of state and Federal securities laws. Chase Bank USA, N.A. (Chase Bank), which is affiliated with J.P. Morgan Chase & Co., is a member of the Bank but is not a defendant in these actions. Chase Bank held 6.0% of the Bank’s capital stock as of December 31, 2009.

 

On October 2, 2009, the Bank also filed a complaint in the Court of Common Pleas of Allegheny County, Pennsylvania against: The McGraw-Hill Companies, Inc.; Fitch Inc., Moody’s Corporation; and Moody’s Investors Service, Inc., the rating agencies for certain PLMBS bonds purchased by the Bank in the aggregate original principal amount of approximately $640.0 million. The Bank’s complaint asserts claims for fraud, negligent misrepresentation and violations of Federal securities laws.

 

On October 13, 2009, the Bank filed an additional complaint in the Court of Common Pleas of Allegheny County, Pennsylvania against: Countrywide Securities Corporation, Countrywide Home Loans, Inc., various other Countrywide related entities; Moody’s Corporation; Moody’s Investors Service, Inc.; The McGraw-Hill Companies, Inc.; and Fitch, Inc. in regard to five Countrywide PLMBS bonds in the aggregate original principal amount of approximately $366.0 million purchased by the Bank. The Bank’s complaint asserts claims for fraud, negligent misrepresentation and violations of state and Federal securities laws.

 

The Bank may also be subject to various legal proceedings arising in the normal course of business. After consultation with legal counsel, management is not aware of any other proceedings that might have a material effect on the Bank’s financial condition or results of operations.

 

 

Item 5: Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

 

The capital stock of the Bank can be purchased only by members. There is no established marketplace for the Bank’s stock; the Bank’s stock is not publicly traded and may be repurchased or redeemed by the Bank at par value. The members may request that the Bank redeem all or part of the common stock they hold in the Bank five years after the Bank receives a written request by a member. In addition, the Bank, at its discretion, may repurchase shares held by members in excess of their required stock holdings upon one business day’s notice. Excess stock is Bank capital stock not required to be held by the member to meet its minimum stock purchase requirement under the Bank’s capital plan. On December 23, 2008 in its notice to members, the Bank announced its decision to suspend excess capital stock repurchases until further notice. The members’ minimum stock purchase requirement is subject to change from time to time at the discretion of the Board of the Bank in accordance with the capital plan. Par value of each share of capital stock is $100. As of December 31, 2009, 316 members owned Bank capital stock and four nonmembers owned Bank capital stock. These four nonmembers consisted of one former member of the Bank who merged with a nonmember, one member who voluntarily dissolved its charter with the Office of Thrift Supervision (OTS) and two former members placed in receivership by the FDIC, resulting in cancellation of the members’ charters. The total number of shares of capital stock outstanding as of December 31, 2009 was 40,263,207, of which members held 40,219,939 shares and nonmembers held 43,268 shares. Member stock includes 38,992 shares held by one institution which has given notice of withdrawal, with 32,493 due April 2010 and 6,499 due in April 2014, as well as 100 shares of one additional institution which is in receivership and has also given notice of withdrawal. Member stock also includes 196 shares received by a member through its acquisition of a former member. Lastly, 663 shares were transferred from mandatorily redeemable capital stock back to capital stock due to a merger of a member into a nonmember and the application of such shares against the required minimum stock purchase requirement when the nonmember institution subsequently applied for membership and was approved as a Bank member.

 

The Bank’s cash dividends declared in each quarter are reflected in the table below.

 

 

On December 23, 2008, the Bank announced its decision to voluntarily suspend dividend payments until further notice. See the Dividends section in “Capital Resources” in Item 7. Management’s Discussion and Analysis in this 2009 Annual Report filed on Form 10-K for information concerning restrictions on the Bank’s ability to pay dividends and the Bank’s current dividend policy.

 

See Note 19 to the audited financial statements in Item 8. Financial Statements and Supplementary Financial Data in this 2009 Annual Report filed on Form 10-K for further information regarding statutory and regulatory restrictions on capital stock redemption.

 

 

The following tables should be read in conjunction with the financial statements and related notes and Item 7. Management’s Discussion and Analysis, each included in this 2009 Annual Report filed on Form 10-K.

 

The Statement of Operations data for the three years ended December 31, 2009, 2008 and 2007, and the Statement of Condition data as of December 31, 2009, 2008 and 2007 are derived from the audited financial statements included in Item 8. Financial Statements and Supplementary Financial Data in this 2009 Annual Report filed on Form 10-K. The Condensed Statement of Condition data as of December 31, 2006 is derived from the audited financial statements in Item 8. Financial Statements and Supplementary Financial Data included in the Bank’s 2007 Annual Report filed on Form 10-K. The Statement of Operations data for the year ended December 31, 2005, and the Condensed Statement of Condition data as of December 31, 2005, are derived from the restated financial statements included within the Bank’s registration statement on Form 10, as amended.

 

Statement of Operations

 

 

Notes:

 

 

Condensed Statement of Condition

 

Notes:

 

 

 

Because of the nature of (1) the derivatives and hedging gains and contingency reserve resulting from the Lehman-related transactions and (2) the OTTI charges recorded during the years ended December 31, 2009 and 2008, the Bank believes that the presentation of adjusted non-GAAP financial measures below provides a greater understanding of ongoing operations and enhances comparability of results with prior periods.

 

Statement of Operations
Reconciliation of GAAP Earnings to Adjusted Earnings to Exclude Impact of
Lehman-Related Transactions, Net OTTI Charges and Related Assessments

 

 

Note:

 

 

For further information regarding the Lehman-related transactions, see the “Current Financial and Mortgage Market Events and Trends” discussion in Earnings Performance in Item 7. Management’s Discussion and Analysis in this 2009 Annual Report filed on Form 10-K. For additional information on OTTI, see Critical Accounting Policies and Risk Management, both in Item 7. Management’s Discussion and Analysis, and Note 8 to the audited financial statements in Item 8. Financial Statements and Supplementary Financial Data, all in this 2009 Annual Report filed on Form 10-K.

 

Item 7:  Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

 

Forward-Looking Information

 

Statements contained in or incorporated by reference in this 2009 Annual Report filed on Form 10-K, including statements describing the objectives, projections, estimates, or predictions of the future of the Bank, may be “forward-looking statements.” These statements may use forward-looking terms, such as “anticipates,” “believes,” “could,” “estimates,” “may,” “should,” “will,” or their negatives or other variations on these terms. The Bank cautions that by their nature, forward-looking statements involve risk or uncertainty and that actual results could differ materially from those expressed or implied in these forward-looking statements or could affect the extent to which a particular objective, projection, estimate, or prediction is realized. These forward-looking statements involve risks and uncertainties including, but not limited to, the following: economic and market conditions, including, but not limited to, real estate, credit and mortgage markets; volatility of market prices, rates, and indices; political, legislative, regulatory, litigation, or judicial events or actions; changes in the Bank’s capital structure; changes in the Bank’s capital requirements; membership changes; changes in the demand by Bank members for Bank advances; an increase in advances prepayments; competitive forces, including the availability of other sources of funding for Bank members; changes in investor demand for consolidated obligations and/or the terms of interest rate exchange agreements and similar agreements; the ability of the Bank to introduce new products and services to meet market demand and to manage successfully the risks associated with new products and services; the ability of each of the other FHLBanks to repay the principal and interest on consolidated obligations for which it is the primary obligor and with respect to which the Bank has joint and several liability; and timing and volume of market activity.

 

This Management’s Discussion and Analysis should be read in conjunction with the Bank’s audited financial statements in Item 8. Financial Statements and Supplementary Financial Data and footnotes and Risk Factors included herein.

 

 

Earnings Performance

 

The following is Management’s Discussion and Analysis of the Bank’s earnings performance for the years ended December 31, 2009, 2008 and 2007, which should be read in conjunction with the Bank’s audited financial statements and notes included in in Item 8. Financial Statements and Supplementary Financial Data this 2009 Annual Report filed on Form 10-K.

 

Summary of Financial Results

 

Net Income and Return on Average Equity.  The Bank recorded a net loss of $37.4 million for full year 2009, compared to net income of $19.4 million for full year 2008. The year-over-year variance was driven primarily by lower net interest income, higher operating expenses, lower derivatives and hedging activities and a $35.3 million contingency reserve recorded in first quarter 2009, partially offset by lower net OTTI charges. Decreases in interest income on investments and advances were partially offset by lower interest expense on consolidated obligations. Net OTTI charges for the years ended December 31, 2009 and 2008 were $228.5 million and $266.0 million, respectively. Full year 2008 results also included the benefit of the one-time gains on derivatives and hedging activities related to the termination and replacement of Lehman Brothers Special Financing, Inc. (LBSF) derivatives as discussed in the Bank’s Third Quarter 2008 quarterly report filed on Form 10-Q on November 12, 2008. The Bank’s return on average equity was (0.98)% for full year 2009, compared to 0.45% in the same year-ago period.

2008 vs. 2007.  The Bank’s net income totaled $19.4 million for full year 2008, compared to $236.8 million for full year 2007. The $217.4 million decrease was driven primarily by net OTTI charges of $266.0 million and lower net interest income in 2008. Decreases in interest income on investments and advances were partially offset by lower interest expense on consolidated obligations. Full year 2008 results also reflected significant net gains on derivatives and hedging activities related to the termination and replacement of LBSF derivatives mentioned above. The Bank’s return on average equity was 6.47% for full year 2007.

 

Dividend Rate.  Management regards quarterly dividend payments as an important vehicle through which a direct investment return is provided to the Bank’s members. On December 23, 2008, the Bank announced its decision to voluntarily suspend payment of dividends for the foreseeable future. Therefore, there were no dividends declared or paid in 2009. The Bank’s weighted average dividend rate was 3.64% for 2008 and 5.96% for 2007. See additional discussion regarding dividends and retained earnings levels in the Financial Condition discussion in this Item 7. Management’s Discussion and Analysis in this 2009 Annual Report filed on Form 10-K.

 

Adjusted Earnings Comparison.  Adjusted earnings for full year 2009 reflect net income of $166.3 million, compared to net income of $164.6 million for full year 2008. As noted above, adjusted earnings exclude the impact of (1) the derivatives and hedging gains and contingency reserve resulting from the Lehman-related transactions and (2) the OTTI charges recorded during the years ended December 31, 2009 and 2008. The $1.7 million increase in net income year-over-year was driven by higher gains on derivatives and hedging activities, higher other income and a benefit for credit losses, partially offset by lower net interest income and higher operating expenses. The Bank’s return on average equity on an adjusted basis was 4.34%, for full year 2009 compared to 3.79% on an adjusted basis for the prior year.

 

Current Financial and Mortgage Market Events and Trends

 

Conditions in the Financial Markets.  Housing and financial markets have been in tremendous turmoil since the middle of 2007, with repercussions throughout the U.S. and global economies. Continued global financial market disruptions during 2009, coupled with the recession, have sustained market uncertainty and unpredictability. Limited liquidity in the credit markets, increasing mortgage delinquencies and foreclosures, falling real estate values, the collapse of the secondary market for MBS, loss of investor confidence, a highly volatile stock market, interest rate fluctuations, and the failure of a number of large and small financial institutions are all indicators of the severe economic crisis faced by the U.S. and the rest of the world. These economic conditions, particularly in the housing and financial markets, combined with ongoing uncertainty about the depth and duration of the financial crisis and the recession, continued to affect the Bank’s business and results of operations, along with that of its members, throughout 2009. Specifically, the weakness in the U.S. economy continues to affect the credit quality of the collateral underlying all types of private label MBS in the Bank’s investment portfolio, resulting in OTTI charges on more securities. To build retained earnings and preserve the Bank’s capital, the Bank maintained its suspension of dividend payments and excess capital stock repurchases throughout 2009 and has no expectation that this will change in the near term.

 

While the significant deterioration in economic conditions that followed the disruptive financial market events of September 2008 has not reversed, and the economy has remained weak since that time, there is indication that the pace of economic decline may have started to slow and that the economy may begin to emerge from the recession. Government programs that were put in place in 2008 have worked to create more confidence in the credit markets and get capital flowing once again.

 

However, despite early signs of improvement, the prospects for, and potential timing of, renewed economic growth (employment growth in particular) remain uncertain. The ongoing weak economic outlook, along with continued uncertainty regarding those conditions, will extend future losses at many financial institutions to a wider range of asset classes, and the nature and extent of the ongoing need for the government to support the banking industry, have combined to maintain market participants’ somewhat cautious approach to the credit markets.

 

First Quarter 2009.  Several government programs that were either introduced or expanded during the fourth quarter of 2008 helped to support a greater degree of stability in the capital markets. Those programs include the implementation of TARP authorized by Congress in October 2008 and the FRB’s purchases of commercial paper, agency debt securities (including FHLBank debt) and MBS. In addition, the FRB’s discount window lending and

Term Auction Facility (TAF) for auctions of short-term liquidity and the expansion of insured deposit limits and the TLGP provided by the FDIC have provided additional liquidity support for depository institutions. The effect of these government initiatives, in combination with other positive developments, resulted in improved investor demand for GSE bonds.

 

On January 16, 2009, the FDIC announced that it would expand the TLGP to insure some assets for ten years, up from three years, in order to accommodate the longer maturities associated with covered bonds. On February 10, 2009, in a joint statement, the U.S. Treasury, the Federal Reserve, the FDIC, the Comptroller of the Currency and the OTS announced the Capital Assistance Program, the Public-Private Investment Fund (PPIF), a “dramatic” expansion of the TALF and the extension of the TLGP by four months to October 31, 2009. In order to gradually phase out the program, the FDIC announced that it would assess a surcharge on TLGP debt that is issued in the second quarter of 2009 with a maturity date of one year or longer. On March 19, 2009, the Federal Reserve announced that the range of eligible collateral for TALF funding commencing in April 2009 would be expanded to include asset-backed securities backed by mortgage servicing advances, loans or leases relating to business equipment, leases of vehicle fleets and floor-plan loans

 

On March 18, 2009, the Federal Reserve announced that economic conditions had continued to deteriorate in the first quarter of 2009 as indicated by job losses, declining equity and housing wealth, tight credit conditions and slumping U.S. exports. On the same day, to provide greater support to mortgage lending and the housing market, the Federal Reserve announced that it would purchase up to an additional $750 billion of agency mortgage-backed securities, increasing its total purchase authority to $1.25 trillion. Furthermore, the Federal Reserve announced that it would purchase up to an additional $100 billion in agency debt issued by Fannie Mae, Freddie Mac, and the FHLBanks, increasing its total purchase authority up $200 billion. Additionally, to help improve conditions in private credit markets, the Federal Reserve announced that it would purchase up to $300 billion of longer-term U.S. Treasury securities over the following six months.

 

On March 23, 2009, the U.S. Treasury, Federal Reserve and FDIC announced a framework for the Public-Private Investment Program (PPIP). This two-part program was designed to remove “toxic” assets from bank balance sheets and improve credit availability to households and businesses. The first part of the program, known as the legacy loan program, was designed to attract private capital to purchase troubled loans from banks. These transactions would be facilitated by FDIC guarantees and equity provided by the U.S. Treasury using TARP funds. The second part of the program was known as the legacy securities program and included (1) an expansion of the TALF to include legacy securitization assets and (2) PPIF whereby pre-qualified fund managers would purchase legacy securities with a combination of private capital and U.S. Treasury funds.

 

Second Quarter 2009.  As the U.S. government continued multiple programs designed to improve the credit markets, financial market conditions appeared to reflect greater strength during the second quarter of 2009. Financial services companies turned toward the equity markets in order to pay off TARP borrowings and raise additional capital required by the results of bank stress testing. During May 2009, the U.S. Treasury announced plans to inject TARP funds into several insurance companies. Furthermore, financial market participants and regulators turned their attention toward the safety and security of money market funds resulting in industry-wide recommendations and SEC-proposed rule changes. While economic data remained mixed during the second quarter of 2009, funding was both accessible and attractively priced for the FHLBanks.

 

Third Quarter 2009.  The FHLBanks continued to maintain access to debt funding at desirable levels during the third quarter of 2009. The FHLBanks had ready access to term debt-funding, pricing slightly fewer consolidated bonds than in the second quarter of 2009. However, the increase in TAP volume during the third quarter of 2009 demonstrated an increased willingness by dealers to assume risk positions in the sector. Meanwhile, agency discount note spreads deteriorated considerably during the quarter, making discount notes a less desirable funding option for the FHLBanks.

 

During the third quarter of 2009, the mix of consolidated bonds priced by the FHLBanks changed slightly, with the FHLBanks relying less on negotiated bullet bonds and floating-rate securities and relying more on negotiated callable bonds and step-up bonds. In addition, TAP issuance rose in the third quarter of 2009.

Fourth Quarter 2009.  Building on the third quarter of 2009, the credit markets remained stable in the fourth quarter of 2009 and the FHLBanks had improved access to the capital markets. Providing further confidence to the credit markets, at the end of October 2009 the U.S. Department of Commerce estimated that the U.S. gross domestic product (GDP) grew at an annual rate of 3.5% during the third quarter of 2009 and later revised this number to a 2.2% annual growth rate, making the third quarter of 2009 the first report of positive quarterly GDP in over a year.

 

On December 24, 2009, the U.S. Treasury announced modifications to the Preferred Stock Purchase Agreements with Fannie Mae and Freddie Mac, including an increased capacity to absorb losses from the housing GSEs beyond the original $200 billion per agency and a portfolio cap of $900 billion for each institution which will shrink by 10 percent each year. These modifications were implemented in place of reducing the actual portfolio amounts by 10 percent each year starting in 2010.

 

Specific Program Activity

 

Federal Reserve Bank of New York (FRBNY).  Throughout 2009, the FRBNY continued to support the capital markets through the purchase of GSE term debt, agency MBS, and U.S. Treasuries. Since inception in 2008 and throughout 2009, the FRBNY purchased a total of $160 billion in GSE debt securities, almost 91% of the $175 billion allocated to this program, including $34.4 billion in FHLBank mandated Global bullet bonds.

 

In addition to purchasing agency securities, the FRBNY purchased a total of $1.1 trillion in gross agency MBS, approximately 89% of the $1.25 trillion committed to this program. The agency MBS purchases included approximately $389 billion in dollar rolls. Dollar rolls, similar to repurchase agreements, provide holders of MBS with a form of short-term financing. This program, initiated to drive mortgage rates lower, makes housing more affordable, and helps stabilize home prices, which may lead to continued artificially low agency-mortgage pricing. Comparative MPF Program price execution, which is a function of the FHLBank debt issuance costs, may not be competitive as a result. MPF price execution, which is a function of the FHLBank debt issuance costs, has been less competitive and resulted in weakened member demand for MPF products throughout 2009 and into 2010.

 

FRBNY purchased a total of $292 billion of U.S. Treasuries in 2009, approximately 97% of the $300 billion committed to this program. As noted in a statement by the FRBNY on August 12, 2009, the Federal Reserve anticipated that the full amount of U.S. Treasury securities would be purchased by the end of October 2009 and the program ended with total purchases just shy of the $300 billion commitment level.

 

Consolidated Obligations of the FHLBanks.  During the second half of 2008, the credit markets tightened and, by November 2008, the FHLBanks were only able to price an unusually low $8.8 billion in consolidated bonds. However, following the turn of the year, the effect of government initiatives, in combination with other positive developments, resulted in improved investor demand for GSE bonds. Improved access to consolidated bond funding, plus falling demand for FHLBank advances, provided the FHLBanks with greater flexibility to access term funding. The volume of FHLBank consolidated bonds priced in the first quarter of 2009 was more than double the dollar volume priced during the fourth quarter of 2008. Volume increased in negotiated bullet bonds, auctioned callable bonds and floating-rate bonds.

 

Despite the initial increase in volume in first quarter 2009, the FHLBanks’ consolidated obligations outstanding continued to shrink considerably throughout the remainder of 2009, as redemptions from both scheduled maturities and exercised calls outpaced FHLBank debt issuance. Consolidated obligations outstanding declined $320.9 billion during the year, with consolidated discount notes decreasing proportionally more than consolidated bonds. Total FHLBank consolidated obligations outstanding closed the third quarter of 2009 at levels last seen in late July 2007. This trend continued through fourth quarter 2009, ending 2009 with a total of $930.6 billion FHLBank consolidated obligations outstanding, a decrease of more than 25 percent compared to year-end 2008. Meanwhile, agency discount note spreads deteriorated considerably during the 2009, making discount notes a less desirable funding option for the FHLBanks. A continued decline in money market fund assets could further weaken the agency discount note market in the near term.

 

On a stand-alone basis, discount notes accounted for 17.2% and 27.1% of total Bank consolidated obligations at December 31, 2009 and December 31, 2008, respectively. Total bonds decreased $12.3 billion, or 20.0%, in the same comparison, but comprised a greater percentage of the total debt portfolio, increasing from 72.9% at December 31, 2008 to 82.8% at December 31, 2009.

During 2009, the mix of bonds priced by the FHLBanks changed slightly, with the FHLBanks relying less on negotiated bullet bonds and floating-rate securities and relying more on negotiated callable bonds and step-up bonds. Furthermore, TAP issuance rose since third quarter 2009, indicating dealers’ willingness to commit balance sheet resources to the agency sector. The FHLBanks priced $9.5 billion in TAPs during the fourth quarter of 2009, compared to $4.1 billion during the third quarter of 2009, and only $30 million during the second quarter of 2009. In terms of FHLBank bond funding costs, while weighted-average consolidated bond funding costs during the third quarter of 2009 deteriorated slightly compared to those of the second quarter of 2009, they were still above the average for the previous twelve months. In 2009, the FHLBanks implemented a calendar for its mandated Global bullet bond program, issuing a total of $39 billion in mandated Global bullet bonds during the year.

 

Foreign Official Holdings and Money Fund Assets.  While foreign investor holdings of agency debt and agency MBS, increased slightly during the fourth quarter of 2009, the total still closed 2009 down almost $56 billion from prior year levels. Meanwhile, after stabilizing in the first quarter of 2009, taxable money market fund assets began to decline during the second quarter of 2009, falling $404 billion, over the course of the year, with assets allocated to other U.S. agency securities dropping $216 billion. On February 23, 2010, the SEC published a final rule on money market fund reform, which includes the imposition of new liquidity requirements on money market funds. Under this final rule, FHLBank debt obligations with remaining maturities of 60 days or less are considered liquid assets for purposes of meeting the new liquidity requirement. The final rule also contains new provisions that may impact short bullet and floater issuance and the demand for money market funds. The OF and the FHLBanks are currently assessing the impact of these additional provisions.

 

Interest Rate Trends.  The primary external factors that affect net interest income include market interest rates and volatility, as well as credit spreads. Interest rates prevailing during any reporting period affect the Bank’s profitability for that reporting period, due primarily to the short-term structure of earning assets and the effect of interest rates on invested capital. A portion of the Bank’s advances has been hedged with interest-rate exchange agreements in which a short-term, variable rate is received. Generally, due to the Bank’s cooperative structure, the Bank earns relatively narrow net spreads between the yield on assets and the cost of corresponding liabilities.

 

The following table presents key market interest rates for the periods indicated (obtained from Bloomberg L.P.).

 

 

 

Note:

 

 

The Bank is also heavily affected by the residential mortgage market through the collateral securing member loans and holdings of mortgage-related assets. As of December 31, 2009, 49.1% of the Bank’s eligible collateral value, after collateral weightings, was concentrated in 1-4 single family residential mortgage loans or multi-family residential mortgage loans, compared with 42.0% at December 31, 2008. The remaining 50.9% at December 31, 2009 was concentrated in other real estate-related collateral and high quality investment securities, compared to

58.0% at December 31, 2008. For the top ten borrowers, 1-4 single family residential mortgage loans or multi-family residential mortgage loans accounted for 48.9% of total eligible collateral, after collateral weightings, at December 31, 2009, compared to 43.5% at December 31, 2008. The remaining 51.1% at December 31, 2009 was concentrated in other real estate-related collateral and high quality investment securities, compared to 56.5% at December 31, 2008. Due to collateral policy changes implemented in third quarter 2009, the mix of collateral types within the total portfolio shifted. The new requirement to deliver all securities pledged as collateral, as well as refinements in collateral reporting and tracking made through the Qualifying Collateral Report (QCR) process, impacted the concentration of collateral types by category. As of December 31, 2009, the Bank’s private label MBS portfolio represented 9.1% of total assets, while net mortgage loans held for portfolio represented 7.9% of total assets. At December 31, 2008, the comparable percentages were 9.4% and 6.8%, respectively.

 

The Bank continues to have high concentrations of its advance portfolio outstanding to its top ten borrowers. The Bank’s advance portfolio declined from December 31, 2008 to December 31, 2009, decreasing $21.0 billion, or 33.8%, due to a slowing of new loan growth and increased access by members to other government funding sources. Also, many of the Bank’s members have reacted to the Bank’s temporary actions of not paying dividends and not repurchasing excess capital stock by limiting their use of the Bank’s advance products. In addition, members increased liquidity positions and the recession has decreased the members’ need for funding from the Bank.

 

In addition, see the “Credit and Counterparty Risk” and “Qualitative/Quantitative Disclosures Regarding Market Risk” discussions, both in Risk Management in this Item 7. Management’s Discussion and Analysis in this 2009 Annual Report filed on Form 10-K for information related to derivative counterparty risk and overall market risk of the Bank.

 

Lehman Brothers Holdings, Inc. (Lehman) and Lehman Brothers Special Financing, Inc.  On September 15, 2008, Lehman filed for bankruptcy. At that time, Lehman’s subsidiary, Lehman Brothers Special Financing, Inc. (LBSF) was the Bank’s largest derivatives counterparty, with a total of 595 outstanding derivative trades having a total notional value of $16.3 billion. Lehman was a guarantor under the Bank’s agreement with LBSF such that Lehman’s bankruptcy filing triggered an event of default. The Bank posted cash collateral to secure its exposure to Lehman on its derivative transactions. As a result of the bankruptcy filing, the Bank evaluated the outstanding trades it had with LBSF to assess which individual derivatives were most important to the Bank’s overall risk position. Of the 595 trades, 63 represented approximately half of the total LBSF notional value and almost 100% of the base case duration impact of the LBSF portfolio. Therefore, the Bank elected to enter into 63 identical new trades with different counterparties on September 18, 2008.

 

Management determined that it was in the Bank’s best interest to declare an event of default and designate September 19, 2008 as the early termination date of the Bank’s agreement with LBSF, as provided for in the agreement. Accordingly, all LBSF derivatives were legally terminated at that time and the Bank began the process of obtaining third party quotes for all of the derivatives in order to settle its position with LBSF in accordance with the International Swaps Dealers Association, Inc. (ISDA) Master Agreement (Master Agreement). The Bank sent a final settlement notice to LBSF and demanded return of the balance of posted Bank collateral, which, including dealer quotes for all trades, the collateral position, and the applicable accrued interest netted to an approximate $41.5 million receivable from LBSF.

 

The Bank filed an adversary proceeding against LBSF and J.P. Morgan Chase Bank, N.A. (J.P. Morgan) to return the cash collateral posted by the Bank associated with the derivative contracts. In its 2008 Annual Report filed on Form 10-K, the Bank disclosed that it was probable that a loss has been incurred with respect to this receivable. However, the Bank had not recorded a reserve with respect to the receivable from LBSF because the Bank was unable to reasonably estimate the amount of loss that had been incurred. Continuing developments in the adversary proceeding have occurred during 2009. The discovery phase of the adversary proceeding began, which has provided management information related to its claim. Based on this information, management’s most probable estimated loss is $35.3 million and a reserve was recorded in the first quarter of 2009. As of December 31, 2009, the Bank maintained a $35.3 million reserve on this receivable as this remains the most probable estimated loss.

 

During discovery in the Bank’s adversary proceeding against LBSF, the Bank learned that LBSF had failed to keep the Bank’s posted collateral in a segregated account in violation of the Master Agreement between the Bank and LBSF. In fact, the posted collateral was held in a general operating account of LBSF the balances of which were

routinely swept to other Lehman Brother entities, including Lehman Brothers Holdings, Inc. among others. After discovering that the Bank’s posted collateral was transferred to other Lehman entities and not held by J.P. Morgan, the Bank agreed to discontinue the LBSF adversary proceeding against J.P. Morgan. J.P. Morgan was dismissed from the Bank’s proceeding on June 26, 2009. In addition, the Bank discontinued its LBSF adversary proceeding and pursued its claim in the LBSF bankruptcy through the proof of claim process, which made continuing the adversary proceeding against LBSF unnecessary. The Bank has filed proofs of claim against Lehman Brothers Holdings, Inc. and Lehman Brothers Commercial Corp. as well.

 

The Bank has filed a new complaint against Lehman Brothers Holding Inc., Lehman Brothers, Inc., Lehman Brothers Commercial Corporation, Woodlands Commercial Bank, formerly known as Lehman Brothers Commercial Bank, and Aurora Bank FSB (Aurora), formerly known as Lehman Brothers Bank FSB, alleging unjust enrichment, constructive trust, and conversion claims. Aurora is a member of the Bank. Aurora did not hold more than five percent of the Bank’s capital stock as of December 31, 2009.

 

See Item 3. Legal Proceedings for additional information concerning the adversary proceedings discussed above.

 

Key Determinants of Financial Performance

 

Many variables influence the financial performance of the Bank. Key among those variables are the following: (1) Net Interest Margin; (2) OTTI losses; (3) Leverage; (4) Duration of Equity, Return Volatility and Projected Capital Stock Price (PCSP); (5) Interest Rates and Yield Curve Shifts; (6) Credit Spreads; and (7) Liquidity Requirements. Any discussion of the financial condition and performance of the Bank must necessarily focus on the interrelationship of these seven factors. Key statistics regarding five of these seven factors are presented in the table below; in addition, each is discussed in detail in the narrative following the table. The remaining factors are also discussed in the narrative following the table.

 

 

n/a — not applicable

 

Note:

 

 

Net Interest Margin.  Net interest margin is the dollar difference between interest income and interest expense expressed as a percentage of total interest-earning assets. This performance metric measures the return on the Bank’s investments relative to its cost of funds. As a result of the Bank’s GSE status and the joint and several obligation of the twelve FHLBanks for consolidated obligations, the Bank has historically been able to issue debt at spreads to the U.S. Treasury yield curve which are typically narrower than non-GSE issuers. This spread advantage is considered a strategic competitive advantage for the Bank. Due in part to the market’s wariness regarding any investments linked to the

U.S. housing market, spreads widened compared to the U.S. Treasury yield curve and LIBOR and term debt costs increased. This increase began in fourth quarter 2008 and continued through the first six months of 2009.

 

The Bank funds three broad categories of assets. The first asset category is advances, which totaled $41.2 billion at December 31, 2009, and represented 63.1% of total assets. In order to maximize the value of membership, the Bank strives to price its advances at levels that members will find not only competitive, but advantageous relative to their other sources of wholesale funding. Historically, the aggregate spread on the Bank’s advance portfolio ranged from 15 to 28 basis points over the Bank’s marginal cost of funds. In effect, members have typically been able to borrow from the Bank at levels comparable to those levels at which a AA-rated financial institution could borrow in the capital markets. However, during 2009, the Bank lost some of the competitive advantage it had experienced in the past due to increased competition from the FRBs and other new government-supported lending programs. For additional discussion regarding these government programs, see Legislative and Regulatory Developments in this Item 7. Management’s Discussion and Analysis in this 2009 Annual Report filed on Form 10-K.

 

A second category of the Bank’s assets are in mortgage-related investments. Mortgage-related investments are deemed to be consistent with the Bank’s housing mission and typically produce wider spreads against consolidated obligation funding. At December 31, 2009, the Bank held $9.0 billion in MBS, representing 13.8% of the Bank’s total assets. A second category of mortgage-related assets held by the Bank are loans generated through the MPF Program. At December 31, 2009, net MPF loans totaled $5.2 billion and represented 7.9% of the Bank’s assets. In terms of financial performance and impact on spread, MPF is similar to MBS in that the Bank typically expects to earn a wider spread on MPF loans, which enhances the weighted average net interest spread on total assets. Additional information regarding the Bank’s MBS and MPF loan portfolios is available in Item 1. Business and in the Mortgage Partnership Finance Program discussion in Item 7. Management’s Discussion and Analysis, both in this 2009 Annual Report filed on Form 10-K.

 

Third, the Bank maintains an investment portfolio, which includes TLGP investments, U.S. Treasury and agency securities, securities issued by GSEs and state and local government agencies. U.S. Treasury securities are the primary source for derivative counterparty collateral. The longer-term investment portfolio serves to further enhance interest income and the Bank’s profitability, providing the Bank with higher returns than those available in the short-term money markets.

 

Net interest margin also includes the impact from earnings on capital. Member institutions held $4.0 billion in capital stock in the Bank at December 31, 2009 and on average throughout the year. The Bank typically invests its interest-free funds (i.e., capital) in shorter-term assets. As a result, the yield on the investment of the Bank’s interest-free funds reflects short-term interest rates and will rise or fall with prevailing short-term interest rates, assuming constant capital levels. The Bank monitors this impact as a part of the net interest margin evaluation.

 

The Bank’s spread between asset yields and the cost of associated funds is an area of keen focus for management. While the impact from earnings on capital is driven by market interest rates, the spread that the Bank earns between interest-earning assets and the related interest-bearing liabilities is driven by several different factors. These factors include, but are not limited to, the amount, timing, structure and hedging of its debt issuance and the use of funds for advances or for attractive investment opportunities as they arise. With respect to investments, 2009 was again a difficult year, as ongoing market disruptions led to widening spreads on agencies and a reduction in liquidity in the mortgage issuance sector. The Bank must maintain balance sheet liquidity for which the cost is holding a portfolio of lower-yielding assets. Management is also challenged to find and position investment assets that conform to standards of AAA- or AA-rated credit quality while respecting limits on interest rate risk exposure.

 

Other-Than-Temporary Impairment.  During the financial crisis, which began in mid-2007, global financial markets suffered significant illiquidity, increased mortgage delinquencies and foreclosures, falling real estate values and the collapse of the secondary market for MBS. During 2008 and into 2009, there were disruptions in the credit and mortgage markets and an overall downturn in the U.S. economy. The ongoing weakening of the U.S. housing and commercial real estate markets, decline in home prices, and loss of jobs contributed to the recent national recession. These factors also resulted in increased delinquencies and defaults on mortgage assets and reduced the value of the collateral securing these assets. In combination, these circumstances negatively impacted the value of the Bank’s private label MBS portfolio and ultimately resulted in the Bank recording OTTI on its portfolio.

For full year 2009, the Bank recognized $228.5 million in credit-related OTTI losses related to the private label MBS portfolio, after the Bank determined that it was likely that it would not recover the entire amortized cost of these securities. By comparison, the Bank recognized $266.0 million of OTTI losses in 2008, prior to the $255.9 million cumulative effect adjustment for amended OTTI guidance recorded on January 1, 2009.

 

As of December 31, 2009, the Bank has $5.9 billion (book value) in private label MBS in its investment portfolio. To the extent delinquency and/or loss rates on mortgages and/or home equity loans continue to increase, and/or a rapid decline or a continuing decline in residential real estate values continues, the Bank may experience additional material credit-related OTTI losses on these investment securities. Until economic conditions improve, OTTI losses will continue to impact the Bank’s profitability and overall performance.

 

For additional information regarding OTTI, see Critical Accounting Policies and the “Credit and Counterparty Risk – Investments” discussion in Risk Management, both in this Item 7. Management’s Discussion and Analysis in this 2009 Annual Report filed on Form 10-K.

 

Leverage.  Under the GLB Act, the Bank is required at all times to maintain a ratio of regulatory capital-to-assets at a level of four percent or higher. The reciprocal of this ratio, known as leverage, is the ratio of assets to capital and cannot exceed 25 times. The degree of leverage that the Bank maintains directly affects the Bank’s resulting return on capital and, therefore, its dividend-earning capacity. The higher the degree of leverage, the higher the potential return on capital that the Bank can achieve; this higher level of leverage also results in additional risk to the Bank. The size of the Bank’s balance sheet is heavily impacted by the volume of the advances portfolio. Management strives to maintain leverage generally in a range of 21 times to 24 times capital. This is intended to maintain an acceptable return on capital within the Bank’s applicable regulatory limits. The Bank’s leverage decreased from 22.0 times for 2008 to 17.6 times for 2009. The Bank’s leverage fell from 2008 to 2009 as the crisis in the credit markets led the Bank to voluntarily reduce its money market portfolio and to not re-enter the private label MBS market. The Bank voluntarily suspended excess capital stock repurchases and dividends until further notice in December 2008, in an attempt to preserve capital.

 

Duration of Equity, Return Volatility and PCSP.  The Bank uses various metrics to measure, monitor and control its market risk exposure. Policies established by the Board have focused on duration of equity and PCSP as key measurements and controls for managing and reporting on the Bank’s exposure to changing market environments. Under the original Board policy, the Bank was required to maintain a base case duration of equity within +/-4.5 years, and in shock cases of +/-200 basis points, within +/-7 years. In early 2008, the Bank developed an Alternative Risk Profile approach which excludes the effect of certain mortgage-related asset credit spreads. During the third quarter of 2009, the Alternative Risk Profile calculation was refined to revalue private label MBS using market-implied discount spreads from the period of acquisition. Under this alternative approach, the acceptable ranges remain the same as in the actual calculation.

 

The return volatility metric is utilized to manage the impact of interest rate risk on the Bank’s return on average capital stock compared to a dividend benchmark interest rate. This metric excludes future OTTI charges that may occur. This metric is calculated on multiple interest rate shock scenarios over rolling forward one to 12 month and 13 to 24 month time periods. The metric is presented above as a spread over 3-month LIBOR.

 

With respect to PCSP, the Board established a PCSP floor of 85% and a target of 95%. The Bank strives to manage its overall risk profile in a manner that attempts to preserve the PCSP at or near the target ratio of 95%. The difference between the actual PCSP and the floor or target, if any, represents a range of additional retained earnings that will need to be accumulated over time to restore the PCSP and retained earnings to an adequate level. The PCSP is also calculated under the Alternative Risk Profile approach. In both calculations, the floor and target are the same.

 

For additional information regarding the Alternative Risk Profile assumptions and approach, see the “Risk Governance” discussion in Risk Management in Item 7. Management’s Discussion and Analysis in this 2009 Annual Report on Form 10-K.

 

It is the intent of the Board and management to maintain a market risk profile within Board limits. The Bank’s liquid asset portfolios, because of their short-term maturity, do not expose the Bank to meaningful market risk. The Bank’s member loan portfolio has a modest amount of interest rate risk. The majority of the market risk in the Bank’s balance sheet is driven by the MBS and MPF portfolios and the associated funding. The extension and

prepayment risk inherent in mortgage assets is the major source of negative convexity risk in the Bank. The Bank’s mortgage assets are funded primarily with consolidated obligations. As a result, the mortgage portfolios are also subject to basis risk, that is, the risk that mortgage spreads and agency spreads do not move correspondingly. This basis risk had a significant impact on the Bank’s market risk measures in 2008 and 2009. Declines in the market value of equity due to further private label MBS spread widening in the fourth quarter of 2008 significantly increased the differential between the actual and Alternative Risk Profile calculations of PCSP and duration of equity. This differential decreased significantly in 2009 as private label MBS credit spreads reverted to levels below year-end 2008. The Bank is also exposed to interest rate risk with respect to the rollover of existing debt and the ability to replace maturing debt at comparable cost, as well as the risk of funding mismatch due to rate resets on both assets and liabilities.

 

The flow of assets, funding and capital causes the Bank’s duration of equity, market value of equity volatility, and PCSP positions to fluctuate on a daily basis. As a result of the extension risk within the MBS and MPF portfolios, rising interest rates typically exert upward pressure on the Bank’s duration of equity, while falling rates tend to have the opposite effect. In a rising interest rate environment, generally associated with a strong economy, the Bank’s financial performance may improve due to higher earnings on capital, widening net interest spreads and growing loan demand. Yet these positive influences are offset to some degree because the same economic circumstances increase the Bank’s duration of equity and create a need to reduce this exposure. In a falling rate environment, typical of a weakening economy, duration of equity typically declines. This reduces the Bank’s duration and the costs of policy compliance, but this benefit may be offset by declining earnings on capital.

 

Longer-term U.S. Treasury yields trended higher in 2009, with the five- and ten-year U.S. Treasuries increasing by 113 basis points and 162 basis points, respectively. Longer-term mortgage rates were more stable for the period, as primary and secondary mortgage spreads narrowed to offset a significant portion of the long-term yield increases and mitigate the upward pressure on duration from higher rates. Lower expected mortgage prepayments, driven by the weak housing market and availability of credit, extended the Bank’s duration of equity. The incremental costs of hedging duration, convexity and market value volatility, and to a lesser extent, basis risk, by issuing fixed-rate debt or purchasing option contracts reduce the Bank’s earnings.

 

See the “Quantitative Disclosures Regarding Market Risk” discussion in Risk Management in Item 7. Management’s Discussion and Analysis in this 2009 Annual Report filed on Form 10-K for further discussion of Duration of Equity and PCSP calculations and results.

 

Interest Rates and Yield Curve Shifts.  Another important determinant in the financial performance of the Bank involves interest rates and shifts in the yield curve. The Bank’s earnings are affected not only by rising or falling interest rates, but also by the particular path and volatility of changes in market interest rates and the prevailing shape of the yield curve. Theoretically, flattening of the yield curve tends to compress the Bank’s net interest margin, while steepening of the curve offers better opportunities to purchase assets with wider net interest spread. In 2009, the U.S. Treasury curve steepened significantly with short-term yields remaining low and long-term yields rising, as long-term economic outlook improved during the year. The result of this activity pushed the spread between 2-year and 10-year Treasuries to an all-time high during the second half of the year. Unfortunately, the Bank was not able to fully capitalize on the steepening of the yield curve as credit concerns and tightening spreads negatively impacted the Bank’s ability to accumulate MBS assets.

 

The performance of the Bank’s portfolios of mortgage assets is particularly affected by shifts in the ten-year maturity range of the yield curve, which is the point that heavily influences mortgage pricing and refinancing trends. Changes in the shape of the yield curve, particularly the portion that drives fixed-rate residential mortgage yields, can also have a pronounced effect on the pace at which borrowers refinance to prepay their existing loans. Since the Bank’s mortgage loan portfolio is composed of fixed-rate mortgages, changes in the yield curve can have a significant effect on earnings. Under normal circumstances, when rates decline, prepayments increase, resulting in accelerated accretion/amortization of any associated premiums/discounts. In addition, when higher coupon mortgage loans prepay, the unscheduled return of principal cannot be invested in assets with a comparable yield resulting in a decline in the aggregate yield on the remaining loan portfolio and a possible decrease in the net interest margin.

The volatility of yield curve shifts may also have an effect on the Bank’s duration of equity and the cost of duration policy compliance. Volatility in interest rates may force management to spend resources on duration hedges to maintain compliance, even though a subsequent, sudden reversal in rates may make such hedges unnecessary. Volatility in interest rate levels and in the shape and slope of the yield curve increases the cost of compliance with the Bank’s duration limit.

 

In summary, volatility in interest rates, the shifting slope of the yield curve, and movements in the ten-year maturity range of the curve challenge management as it seeks to maintain an acceptable net interest margin, maintain duration of equity compliance at the least cost and hedge mortgage-related convexity.

 

Credit Spreads.  During 2008, mortgage delinquencies increased, credit spreads widened and the universe of mortgage lenders contracted due to bankruptcies and brokers exiting the business. Banks remained reluctant to lend to one another, the liquidity of the asset-backed commercial paper market dried up, and there was little, if any, securitization of MBS.

 

This widening of mortgage spreads significantly lengthened the Bank’s duration of equity and drove the decline in the Bank’s market value of equity. This was due to the magnitude of the change in mortgage spreads, which far exceeded the movement in the Bank’s funding spread. As the economic and housing market outlooks improved in 2009, mortgage spreads narrowed and the duration of equity declined significantly.

 

In 2009, debt spreads began to narrow by the beginning of the second quarter and continued throughout the remainder of the year. Although investors have continued to be somewhat cautious of any investments linked to the U.S. housing market, including GSE debt, funding costs have improved and the availability of long-term FHLBank debt has increased as well.

 

For additional information regarding the impact of credit spreads on the Bank’s risk metrics and financials, see the Risk Management section in Item 7. Management’s Discussion and Analysis in this 2009 Annual Report filed on Form 10-K.

 

Liquidity Requirements.  The Bank maintains contingency liquidity sufficient to meet its estimated needs for a minimum of five business days without access to the consolidated obligation debt markets and to adhere to Finance Agency guidance to target as much as 15 days of liquidity under certain scenarios. To meet this additional requirement, the Bank has had to maintain significantly higher balances in shorter-term investments, earning a much lower interest rate than would have been possible in alternate investment options. These larger balances in lower-earning assets have had a negative impact on the Bank’s profitability. For additional information regarding the Finance Agency’s liquidity guidance, see the “Liquidity and Funding Risk” discussion in Risk Management in Item 7. Management’s Discussion and Analysis in this 2009 Annual Report filed on Form 10-K.

 

2010 Outlook

 

The Bank developed a 2010 operating plan focused on adding value to our membership and the communities they serve, while continuing to address the challenges that the Bank faced in 2009.

 

The Bank recognizes the importance of its members, both as customers and stockholders. It is focused on effectively managing the advance portfolio and portfolio-related activity, including identifying new opportunities to improve the overall lending process. It is expected that the advance portfolio will continue to experience runoff through the first six months of 2010, due to a decline in members’ liquidity needs, competition from various governmental programs initiated in late 2008 and early 2009, and a change in how members have been managing their business and liquidity needs. In an attempt to offset this runoff and create a platform for advance growth, the Bank is focused on recruiting new institutions for membership, providing pricing on advances to create value for the member and identifying and implementing new products, programs and services for the members as appropriate for both the members and the Bank. Management is also focused on identifying ways to improve customer service and product delivery efficiency to enhance the member’s overall experience with the Bank. While working toward these goals to improve the products and services offered to members, management will remain focused on its most important mission — ensuring that the Bank is poised and prepared to ensure a reliable flow of liquidity to its members and the communities they serve in all market cycles.

Given the current economic environment, the financial performance of the Bank has been challenged due to OTTI charges on the private label MBS portfolio. The Bank recognizes that this will continue to be a challenge in 2010 and material credit-related OTTI charges are expected in the coming year. The specific amount of credit-related OTTI charges will depend on several factors, including economic, financial market and housing market conditions and the actual and projected performance of the loan collateral underlying the Bank’s MBS. If delinquency and/or loss rates on mortgages and/or home equity loans continue to increase, and/or there is a further rapid decline in residential real estate values, the Bank could experience reduced yields or further losses on these investment securities.

 

Because Bank members are both customers and stockholders, management views member value as access to liquidity, competitively priced products, and a suitable return on investment. The Bank must deliver all of these components, while protecting the stockholders’ investment, prudently managing the Bank’s capital position and supporting community development. In the current environment, the Bank is focused on protecting the members’ investments and building adequate retained earnings. Therefore, as previously discussed, on December 23, 2008, the Bank suspended dividend payments until further notice. In addition, management continues to address ways to manage expense growth while safeguarding members’ capital stock investment and providing desired products and pricing.

 

The Bank’s mission includes focus on providing programs for affordable housing and community development. In addition, Bank management provides leadership and opportunities for members to bring about sustainable economic development within their communities. Imperatives within this area include expanding member participation in the FHLBank programs, marketing the community investment products and services to emerging communities and focusing on priority housing needs, supporting the member services initiative to increase letter of credit volume for tax-exempt bond issuances, and enhancing member opportunities for CRA-qualified lending and investing.

 

In order to safeguard members’ capital stock, the Bank is also focused on enhancing its risk management practices and infrastructure. This includes addressing the following: (1) risk governance; (2) risk appetite; (3) risk measurement and assessment; (4) risk reporting and communication; and (5) top risks and emerging risks. First, improvements to the Bank’s policies and committee structures will provide better governance over the risk management process. Second, the Bank is revising its risk appetite, integrating it with the strategic plan and reinforcing it through establishment of organizational goals. Third, all existing and potential risk measures are being reviewed to enhance market, credit, operating and business risk metrics and identify key risk indicators in each risk area. Fourth, the Bank is developing an enhanced risk reporting system which will strengthen management and Board oversight of risk and provide a clear understanding of risk issues facing the Bank. Lastly, management and the Board are actively engaged in surveying and assessing top risks and emerging risks. Top risks are existing, material risks the Bank faces; these are periodically reviewed and reconsidered to determine appropriate management attention and focus. Emerging risks are those risks that are new or evolving forms of existing risks; once identified, potential action plans are considered based on probability and severity. A strong risk management process serves as a base for building member value in the cooperative.

 

In addition to the items discussed above, infrastructure is a necessary foundation for continued success in the current business environment. Management is committed to providing the necessary technology resources to address changing business and regulatory needs to support the framework needed to achieve these goals and still prudently manage costs. These resources will be focused on areas such as enhancement of risk modeling, collateral management and analysis, business and information analysis and compliance with legal and regulatory requirements and business continuation plan enhancements.

Net Interest Income

 

The following table summarizes the interest income or interest expense, related yields and rates paid and the average balance for each of the primary balance sheet classifications as well as the net interest margin for each of three years ended December 31.

 

Average Balances and Interest Yields/Rates Paid⁽¹⁾