Federal Home Loan Bank of Pittsburgh 10-K

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K



þ		ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2006
or
o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from to

Commission File Number: 000-51395

FEDERAL HOME LOAN BANK OF PITTSBURGH

(Exact name of registrant as specified in its charter)


Federally Chartered Corporation		25-6001324
(State or other jurisdiction of incorporation or organization)		(IRS Employer Identification No.)

601 Grant Street Pittsburgh, PA 15219		15219 (Zip Code)
(Address of principal executive offices)

(412) 288-3400

(Registrant’s telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act:

None


Title of Each Class		Name of Each Exchange on Which Registered

None		None

Securities registered pursuant to Section 12(g) of the Act:

Capital Stock, putable, par value $100

(Title of Class)

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. o Yes þ No

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. o Yes þ No

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. þ Yes o No

Indicate by check mark 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. þ

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

o Large accelerated filer o Accelerated filer þ Non-accelerated filer

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). o Yes þ No

Registrant’s stock is not publicly traded and is only issued to members of the registrant. Such stock is issued and redeemed at par value, $100 per share, subject to certain regulatory and statutory limits. At June 30, 2006, the aggregate par value of the stock held by members of the registrant was approximately $3,219 million. There were 30,906,450 shares of common stock outstanding at February 28, 2007.

PART I


Item 1:	Business

General

History. The Federal Home Loan Bank of Pittsburgh (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 (the FHLBanks’ fiscal agent) and the Federal Housing Finance Board (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 (see below) 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) (the FHLBanks are required by Finance Board regulation to register a class of their equity securities under the Securities Exchange Act of 1934 (1934 Act)); (3) having public interest directors appointed by its regulator; and (4) having a line of credit with the United States Treasury.

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. 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 issues debt to the public (consolidated obligation bonds and discount notes) in the capital markets through the Office of Finance (OF) and uses these funds to provide its member financial institutions with a reliable source of credit for housing and community development. The United States government does not guarantee, either directly or indirectly, the debt securities or other obligations of the Bank or the FHLBank System. 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 non-credit 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.

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 derives from its ability to raise funds in the capital markets at narrow spreads to the U.S. Treasury yield curve. This fundamental competitive advantage, coupled with the joint and several cross-guarantee on FHLBank System debt, distinguishes the Bank in the capital markets and enables it to present attractively priced funding to members. Though chartered by Congress, the Bank is privately capitalized by its member institutions, which are voluntary participants in its cooperative structure. The character 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 is derived not only from a dividend on the capital investment, but also from the availability of favorably priced liquidity. It is important for the Bank to generate a reliable stream of net income in order to provide dividends on capital stock and management recognizes that financial institutions choose membership in the Bank principally for 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 334 institutions, there is a need to balance the dividend expectations of shareholders with the pricing expectations of customers, although both are the same institutions. By charging wider spreads on loans to customers, the Bank could generate higher dividends for shareholders. Yet these same shareholders viewed as customers would generally prefer narrower loan spreads. The Bank strives to achieve a balance between the twin goals of generating an attractive dividend and providing liquidity and other services to members at advantageous prices. The Bank 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.

Finally, 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 maximize the value of Bank membership.

Supervision and Regulation. The Bank is supervised and regulated by the Federal Housing Finance Board (Finance Board), which is an independent agency in the executive branch of the United States government. The Finance Board 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 Board 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).

Business Segments. The Bank reviews its operations by grouping its products and services within two business segments. The measure of profit or loss and total assets for each segment is contained in Note 22 to the audited financial statements for the years ended December 31, 2006, 2005 and 2004. The products and services provided through these segments reflect the manner in which financial information is evaluated by management of the Bank. These business segments are:


	•	Traditional Member Finance

	•	Mortgage Partnership Finance^® (MPF^®) Program

Regulatory Oversight, Audits and Examinations

Regulation. The Finance Board supervises and regulates the FHLBanks and the OF. The Finance Board 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 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. Department of the Treasury receives the Finance Board’s annual report to Congress, monthly reports reflecting securities transactions of the FHLBanks, and other reports reflecting the operations of the FHLBanks. The Bank is also subject to regulation by the SEC.

Examination. The Finance Board 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 Board 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. 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 of the United States of America and

Government Auditing Standards issued by the Comptroller General. The Bank, the Finance Board, and Congress all receive the RPAF audit reports.

Business Segments

Traditional Member Finance

Loan Products

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

The following table presents a summary and brief description of the loan products offered by the Bank as of December 31, 2006. Information presented below relates to loans to members and excludes mortgage loans held for portfolio and loans relating to the Banking on Business (BOB) program, which are discussed in detail below.

Member Loan Portfolio as of December 31, 2006


				Pct. of Total
Product	Description	Pricing⁽¹⁾	Maturity	Portfolio


RepoPlus	Short-term fixed-rate loans; principal and interest paid at maturity.	8-30 bps	1 day up to 3 months		11.5	%


Mid-Term RepoPlus	Mid-term fixed-rate and adjustable-rate loans; principal paid at maturity; interest paid quarterly.	8-30 bps	3 months to 3 years		43.6	%


Term Loans	Long-term fixed-rate and adjustable-rate loans; principal paid at maturity; interest paid quarterly; (includes amortizing loans with principal and interest paid monthly); Affordable Housing Loans and Community Investment Loans	10-35 bps	3 years to 30 years		21.9	%


Convertible Select	Long-term fixed-rate and adjustable-rate loans with conversion options sold by member; principal paid at maturity; interest paid quarterly.	20-45 bps	1 year to 15 years		18.1	%


Hedge Select	Long-term fixed-rate and adjustable-rate loans with embedded options bought by member; principal paid at maturity; interest paid quarterly.	8-35 bps	1 year to 10 years		0.1	%


Returnable	Loans in which the member has the right to prepay the loan after a specified period.	10-35 bps	3 years to 30 years		4.8	%

Note:


⁽¹⁾		Pricing spread over the Bank’s cost of funds at origination, quoted in basis points (bps). One basis point equals 0.01%. Premium pricing tier receives five basis points over standard pricing, due to credit risk.

RepoPlus. The Bank serves as a major source of liquidity for its members. Access to the Bank’s loans for liquidity purposes can reduce the amount of low-yielding liquid assets a member would otherwise need to hold for liquidity purposes. The Bank has two primary RepoPlus loan products that serve member short-term liquidity needs, RepoPlus and Open RepoPlus. RepoPlus is a short-term (1-89 day) fixed-rate product and Open RepoPlus is a revolving line of credit which allows members to borrow, repay and reborrow based on the terms of the lines. As of December 31, 2006, the total par value of these two products was $5.7 billion. These short-term balances tend to be extremely volatile as members borrow and repay frequently.

Mid-Term RepoPlus. The Bank’s loan products also help members in asset/liability management. The Bank offers loans to minimize the risks associated with the maturity, amortization and prepayment characteristics of mortgage loans. Such loans from the Bank can reduce a member’s interest rate risk associated with holding long-term fixed-rate mortgages. The Mid-Term RepoPlus 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 with maturity terms between 3 months and 3 years. Adjustable-rate, Mid-Term RepoPlus can be priced based on the prime rate, Federal funds rate, 1-month London Interbank Offered Rate (LIBOR) or 3-month LIBOR indices. The LIBOR indices are most popular with the Bank’s members. As of December 31, 2006, the par value of Mid-Term RepoPlus loans totaled $21.6 billion. The loan balances tend to be somewhat variable as these loans are not always replaced as they mature; the Bank’s members’ liquidity needs drive these fluctuations.

Term Loans. For managing longer-term interest rate risk and to assist with asset/liability management, the Bank primarily offers long-term fixed-rate loans for terms from 3 to 30 years. Amortizing long-term fixed-rate loans 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, 2006, the par value of term loans totaled $10.8 billion.

Convertible Select, Hedge Select and Returnable. Some of the Bank’s loans 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, 2006, the par value of loans to members for which the Bank had the right to convert the loan, called Convertible Select, constituted $8.9 billion of the loan portfolio. Loans in which the members purchased an option from the Bank, called Hedge Select, constituted $50.0 million par value of the loan portfolio. Loans in which members have the right to prepay the loan, called Returnable, constituted $2.4 billion par value of the loan portfolio.

Collateral

The Bank is required to obtain and maintain a security interest in eligible collateral at the time it originates or renews a loan. Eligible collateral includes: 1) whole first mortgages on improved residential property, or securities representing a whole interest in such mortgages; 2) securities issued, insured, or guaranteed by the United States government or any of its agencies, including without limitation the Government National Mortgage Association (Ginnie Mae); 3) mortgage-backed securities issued or guaranteed by Federal National Mortgage Association (Fannie Mae) or Federal Home Loan Mortgage Corporation (Freddie Mac) neither of which are guaranteed by the U.S. Government; 4) cash or deposits in the Bank; and 5) other real estate-related collateral acceptable to the Bank provided that such collateral has a readily ascertainable value and the Bank can perfect a security interest in such property. An affiliate of a member may pledge eligible collateral to secure the indebtedness of the member. The affiliate does not have to be an insured financial institution.

Community Financial Institutions (CFIs), which are members that have less than $587 million in average assets over the past three years, may pledge a broader array of collateral as security for loans from the Bank, including small-business loans, farm loans, and agriculture loans. This type of collateral pledged by CFIs comprises about 1% of the Bank’s collateral pool as of December 31, 2006.

The Bank determines the type and amount of collateral each member has available to pledge as security for Bank loans by reviewing the call reports the members file with their primary banking regulators. Approximately 46.5% of the collateral used to secure loans made by the Bank is single-family, residential mortgage loans, which include a very low amount of manufactured housing loans. The next major category of collateral is high quality securities, including U.S. Treasuries, U.S. agencies, GSE securities, U.S. agency and GSE mortgage-backed

securities and private label mortgage-backed securities with a credit rating of at least double-A, all of which account for approximately 27.1% of the total amount of collateral held by members. The Bank also accepts other real estate-related collateral (ORERC), which is primarily commercial mortgages. ORERC accounts for approximately 23.7% of the total amount of eligible collateral held by the members as of December 31, 2006. Multi-family mortgages comprise 2.7% of the collateral used to secure loans at December 31, 2006. The Bank does not have a loan secured by a member’s pledge of any form of non-residential mortgage asset other than ORERC, eligible securities and CFI collateral.

As additional security for each member’s indebtedness, the Bank has a statutory lien on the member’s capital stock in the Bank.

Priority. 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; or (2) parties that are secured by actual perfected security interests.

Blanket Lien and Perfection. Generally, the Bank lends to member institutions under a blanket lien, which grants the Bank a security interest in all eligible assets of the member. At the request of the member, and upon the Bank’s approval the Bank will limit its security interest to specific assets pledged by the member. The Bank generally perfects its security interest under Article 9 of the Uniform Commercial Code (UCC) by filing a financing statement. With respect to non-blanket lien borrowers (typically insurance companies and housing associates), the Bank takes control of all collateral at the time the loan is made through the delivery of securities or mortgages to the Bank or its custodian. In the event of a deterioration in the financial condition of a blanket lien member, the Bank will take control of sufficient eligible collateral to perfect its security interest in collateral pledged to secure the borrowers’ indebtedness to the Bank.

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, 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

In addition to the loans to members discussed above, since 2000 the Bank has also offered the BOB loan program to members, which is specifically targeted at 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 business, including both the start-up and expansion of these businesses. The Bank makes funds available to the members to extend credit to an approved small business borrower, thereby enabling small businesses to qualify for credit that would otherwise not be available to them. The intent of the BOB program had been to use the program as a grant program to 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. Therefore, the accounting for the program follows the provision of a loan program whereby a loan is recorded for the disbursements to members and an allowance for credit losses is estimated and established through a provision for credit losses. As the members collect directly from the borrowers, the members remit to the Bank repayment of the loans as stated in the agreements. If the business is unable to repay the loan, it may be forgiven at the Bank’s option.

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 are not eligible to become Bank members and purchase capital stock in the Bank. 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 as collateral for Bank loans: 1) U.S. Treasury and agency securities; 2) single and multifamily mortgages; 3) securities backed by single and multifamily mortgages; and 4) deposits with the Bank. As of December 31, 2006, the Bank had approved two state housing finance agencies as housing associate borrowers. One of the housing associates has borrowed from the Bank from time to time, although as of December 31, 2006, neither had any outstanding loans from the Bank.

Investments

Overview. The Bank maintains a portfolio of investments for two main purposes: liquidity and additional earnings. For liquidity purposes, the Bank invests in shorter-term securities to ensure the availability of funds to meet member credit needs. These short-term investments comprise primarily overnight Federal funds, term Federal funds, interest-bearing certificates of deposit and commercial paper. The Bank also maintains a secondary liquidity portfolio of agency securities that can be sold in securities repurchase agreement transactions to raise additional funds.

The Bank further enhances interest income by maintaining a long-term investment portfolio, which currently includes securities issued by the U.S. Treasury, U.S. government agencies, GSEs, state and local government agencies, and mortgage-backed securities. Securities currently in the portfolio carry the top two ratings from Moody’s Investors Service, Inc., Standard & Poor’s or Fitch Ratings at the time of purchase. The long-term investment portfolio provides 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.

Prohibitions. Under Finance Board regulations, the Bank is prohibited from investing in certain types of securities, including:


	•	instruments, such as common stock, that represent an ownership interest in an entity, other than stock in investment companies or certain investments targeted to low-income persons or communities;

	•	instruments issued by non-U.S. entities, other than those issued by United States branches and agency offices of foreign commercial banks;

	•	non-investment-grade debt instruments, other than certain investments targeted to low-income persons or communities and instruments that were downgraded after purchase by the Bank;

	•	whole mortgages or other whole loans, other than: (1) those acquired under the Bank’s mortgage purchase program; (2) certain investments targeted to low-income persons or communities; (3) certain marketable direct obligations of state, local or tribal government units or agencies, having at least the second highest credit rating from a Nationally Recognized Statistical Rating Organization (NRSRO); (4) mortgage-backed securities or asset-backed securities backed by manufactured housing loans or home equity loans; and (5) certain foreign housing loans authorized under Section 12(b) of the Act; and

	•	non-U.S. dollar denominated securities.

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


	•	interest-only or principal-only stripped mortgage-backed securities;


	•	residual-interest or interest-accrual classes of collateralized mortgage obligations and real estate mortgage investment conduits;

	•	fixed-rate or floating-rate MBS that on the trade date are at rates equal to their contractual cap and that have average lives that vary by more than six years under an assumed instantaneous interest rate change of 300 basis points.

The FHLBanks are 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 announced that, beginning in July 2006, it would require Reserve Banks 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 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. See the “Liquidity and Funding Risk” section in Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations for further information.

The Bank does not have any special-purpose entities or any other type of off-balance-sheet conduits. Please see Note 3 to the audited financial statements for additional discussion.

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 provide some of the Bank’s funding resources, while also giving 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.

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 five- 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 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 held approximately $6.9 billion and $7.6 billion in mortgage loans at par under this Program at December 31, 2006 and December 31, 2005 respectively. As of December 31, 2006 and 2005, net mortgage loans represented approximately 9.0% and 10.5% of total assets, respectively. In terms of income, mortgage loans contributed about 9.9% to total interest income in 2006, and contributed 16.4% to total interest income in 2005. For additional financial information regarding the MPF segment, see Note 22 to the audited financial statements for the years ended December 31, 2006, 2005 and 2004.

A key difference between the MPF Program and other secondary market alternatives is the separation of various activities and risks associated with mortgage lending. 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 acquire servicing of mortgage loans, the MPF Program gives control of the functions that relate to credit risk to participating members. 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 mortgage loan portfolios sold to the Bank. 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.

The FHLBank of Chicago, in its role as MPF Provider, provides the programatic and operational support for the MPF Program and is responsible for the development and maintenance of the origination, underwriting and servicing guides. The Bank pays the MPF Provider a transaction services fee for these services. This fee is calculated each month based on the aggregate outstanding principal balance of the Bank’s retained interest in loans (purchased on or after May 1, 2006) as of the end of the prior month. Prior to May 1, 2006, in lieu of paying a transaction services fee, the Bank had historically sold a 25% participation interest to the MPF Provider in most mortgage loans purchased by the Bank under the MPF Program. All credit losses on individual mortgage loans or pools of loans with participations are shared with the FHLBank of Chicago or other FHLBanks on a pro rata basis to the extent of each FHLBank’s participation. The Bank may sell participations to any members of the FHLBank System. Sales of participation interests can occur contemporaneously with or at any time subsequent to the purchase of a loan, at a price to be determined at the time of sale. The credit enhancement would be conveyed with the sale of the participation interest on a pro rata basis.

The Bank offers various products under the MPF Program that are differentiated primarily by their credit risk structures. While the credit risk structure may vary, the Finance Board requires that all pools of MPF loans purchased by the Bank have the credit risk exposure equivalent of a double-A 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 $853 thousand and $657 thousand in an allowance for credit losses for this program at December 31, 2006 and 2005, respectively.

The Bank offers the following three products under the MPF Program: Original MPF, MPF Plus, and MPF Government (formerly called Original MPF for Federal Housing Administration/Veterans Administration (FHA/VA) loans). The credit risk structure for each of the products can be briefly summarized as follows:

Original MPF. Under Original MPF, the first layer of losses for each pool of loans (following any primary mortgage insurance coverage) is applied to a first loss account (FLA), which generally increases over the life of the loans. Any losses allocated to this FLA are the responsibility of the Bank. Losses in excess of the FLA are allocated to the member under their credit enhancement obligation for each pool of loans. The member is paid a fixed credit enhancement fee for providing this credit enhancement obligation. Finally, losses in excess of the member’s credit enhancement obligation are absorbed by the Bank based on the Bank’s participation interest.

MPF Plus. Under MPF Plus, the first layer of losses (following any primary mortgage insurance coverage) is applied to a FLA equal to a specified percentage of the loans in the pool as of the sale date. Any losses allocated to this FLA are the responsibility of the Bank. The member obtains additional credit enhancement in the form of a supplemental mortgage insurance policy to cover losses in excess of the deductible of the policy, which is equal to the FLA. Loan losses not covered by the FLA and supplemental mortgage insurance are paid by the member, up to the amount of the member’s credit enhancement obligation, if any, for each pool of loans. If applicable, the member is paid a fixed credit enhancement fee and a performance-based fee for providing the credit enhancement obligation. Loan losses applied to the FLA as well as losses in excess of the combined FLA, the supplemental mortgage insurance policy amount, and the member’s credit enhancement obligation are recorded by the Bank based on the Bank’s participation interest.

MPF Government. Effective February 1, 2007, the name “Original MPF for FHA/VA” was changed to “MPF Government” and has been expanded from FHA and VA to also include U.S. Department of Housing and Urban Development (HUD) Section 184 and Rural Housing Service (RHS) Section 502 loan programs. For 2006, with MPF Government loans, participating members obtained FHA insurance or a VA guarantee, were responsible for all unreimbursed servicing expenses and received a 44 basis point servicing fee; in addition, the member received a government loan fee. Since the member servicing these mortgage loans takes the risk with respect to amounts not reimbursed by either the FHA or VA, this product results in the Bank having mortgage loans that are expected to perform similar to Federal agency securities.

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 of Financial Condition and Results of Operations.

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

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, and the United States does not guarantee them, either directly or indirectly. Moody’s has rated consolidated obligations Aaa/P-1, and Standard & Poor’s has rated them AAA/A-1+. The total par value of the consolidated obligations of the Bank and the FHLBank System are as follows:


	December 31,		December 31,
(in thousands)	2006		2005


Consolidated obligation bonds	$	57,012,583	$	56,716,786
Consolidated obligation discount notes		17,933,218		14,620,012


Total Bank consolidated obligations	$	74,945,801	$	71,336,798


Total FHLBank System combined consolidated obligations	$	951,989,643	$	937,459,530

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 (FICO), and manages the Banks’ relationship with the rating agencies with respect to the consolidated obligations.

Consolidated Obligation Bonds. On behalf of the Bank, the OF issues consolidated bonds that the Bank uses to provide loans to members. The Bank also uses consolidated 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. Consolidated bonds can be issued and distributed through negotiated or competitively bid transactions with approved underwriters or selling group members. To reduce interest rate risk, the Bank swaps much of its term debt issuance to floating rates through the use of interest rate swaps.

Consolidated 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 bonds. Consolidated bonds can also be issued through a selling group, which typically has multiple lead investment banks on each issue. The third way consolidated bonds can be issued is through a negotiated transaction with one or more dealers. The process for issuing consolidated 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 consolidated discount notes to provide short-term funds for loans to members for seasonal and cyclical fluctuations in savings flows and 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 16-member 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.

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 risk-based capital for the FHLBanks. The FHLBanks were also required to develop new capital plans to replace the previous statutory structure.

The Bank implemented its new capital plan on December 16, 2002 (capital plan). 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 can be issued, exchanged, redeemed, and repurchased only 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.

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 of Directors may declare and pay dividends in either cash or capital stock. The Bank currently pays only a cash dividend. In the fourth quarter of 2003, the Bank’s Board of Directors adopted a methodology for determining the Bank’s target level of retained earnings based on a number of criteria, including certain risk factors. The objective of this target is to provide reasonable protection against the possibility of a temporary impairment of value in the Bank’s capital stock and to promote greater stability of dividends. The Bank’s retained earnings plan calls for the Bank to achieve a balance of retained earnings of $200 million over time. This level was met in the first quarter of 2006. As of December 31, 2006, the balance in retained earnings was $254.8 million. Prior to reaching the retained earnings target, and continuing through the remainder of 2006, the Bank paid out less than 100% of net income in dividends. Any future dividend payments, including the payout percentage relative to the level of net income, are subject to the approval of the Board of Directors. The Board of Directors of the Bank will continue to review the targeted amount of retained earnings on a regular basis.

Derivatives and Hedging Activities

The Bank enters into interest rate swaps, swaptions, interest rate cap and floor agreements and TBA securities contracts (collectively known as 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 three 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) as an asset/liability management tool, such as a non-SFAS 133 economic hedge. See Note 16 to the audited financial statements 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 market 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 Board 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, 2006.

Derivative Transactions Classified as Fair Value Hedges


			Notional Amount
			Outstanding at
Derivative Hedging			December 31, 2006
Instrument	Hedged Item	Purpose of Hedge Transaction	(in millions)


Receive fixed, pay floating interest rate swap, with a call option	Callable fixed-rate consolidated obligation bonds	To protect against a decline in interest rates by converting the fixed-rate to a floating-rate	$	22,661


Pay fixed, receive floating interest rate swap	Mid-term and long-term fixed-rate loans to members	To protect against an increase in interest rates by converting the member loan’s fixed-rate to a floating-rate		19,050


Receive fixed, pay floating interest rate swap	Noncallable fixed-rate consolidated obligation bonds	To protect against a decline in interest rates by converting the fixed-rate to a floating-rate		8,204


Pay fixed, receive floating interest rate swap, with a put option	Convertible Select loans and fixed-rate loans with put options	To protect against an increase in interest rates by converting the member loan’s fixed-rate to a floating-rate		10,970


Receive float with a cap, pay floating interest rate swap, with call options	Callable floating-rate consolidated obligation bond with a cap	To convert the capped rate to a floating- rate		1,675


Forward starting pay fixed, receive floating interest rate swap	Firm commitment to enter into a fixed-rate or convertible loan at a specified future date	To protect against a change in interest rates prior to the issuance of the fixed-rate loan to member		53


Receive fixed-rate convertible to floating-rate with a cap, pay floating interest rate swap, with call options	Callable fixed-rate consolidated obligation bond convertible to a floating-rate with a cap	To convert the fixed-rate or capped rate to a floating-rate		235


Index amortizing receive fixed, pay floating interest rate swap	Consolidated obligation bonds	To convert an amortizing prepayment linked debt instrument to a floating-rate		101

Derivative Transactions Classified as Economic Hedges


			Notional Amount
			Outstanding at
Derivative Hedging			December 31, 2006
Instrument	Hedged Item	Purpose of Hedge Transaction	(in millions)


Receive fixed, pay floating (Federal funds rate) interest rate swap	Not applicable	To protect against changes in short-term interest rates	$	1,200


Receive fixed, pay floating interest rate swap, with a call option	Not applicable	To protect against a decline in interest rates by converting the fixed-rate to a floating-rate		90


Option on receive fixed, pay floating interest rate swap (swaption)	Not applicable	To offset the acceleration of mortgage loan premium amortization experienced in declining interest rate environments		750


Pay fixed, receive floating interest rate swap, with a put option	Not applicable	To protect against an increase in interest rates by converting the member loan’s fixed-rate to a floating-rate		296


Pay floating, receive floating interest rate swap	Not applicable	To hedge the spread between two different interest rate indices		12


Interest rate swaps for intermediation	Not applicable	To facilitate member access to swap instruments		27


Receive fixed rate convertible to floating with a cap, pay floating interest rate swap, with call options	Not applicable	To convert the fixed rate or capped rate to a floating-rate		35


Pay fixed, receive floating interest rate swap	Not applicable	To protect against an increase in interest rates by converting the asset’s fixed-rate to a floating-rate		81


Mortgage delivery commitments	Not applicable	Commitments to purchase a pool of mortgages		4

Competition

Loans to Members. The Bank competes with other suppliers of wholesale funding, both secured and unsecured, including investment banking firms, commercial banks, and brokered deposits, largely on the basis of cost. Competition may be greater in regard to larger members, which have greater access to the capital markets as well as the other alternatives listed above. 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.

Purchase of Mortgage Loans. Members have several alternative outlets for their mortgage loan production including Fannie Mae, Freddie Mac, mortgage banker correspondent programs and the national secondary loan market. 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 the increase in interest rates, the availability of competitive products such as hybrid, adjustable-rate mortgages, which the Bank does not purchase, and the loss of a large PFI due to charter consolidation. If this trend continues, the demand for the MPF product could decline.

Issuance of Consolidated Obligations. The Bank competes with 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 or lesser amounts of debt issued at the same cost than otherwise would be the case. 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 sale 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.

Please see the risk factor entitled “The Bank faces competition for loans, mortgage loan purchases and the access to funding, which could negatively impact earnings” in Item 1A. Risk Factors for further discussion regarding competition.

Personnel

As of December 31, 2006, the Bank had 239 full-time employee positions and 7 part-time employee positions, for a total of 242.5 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 except for 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 Board 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 Board, in consultation with the Secretary of the Treasury, selects the appropriate discounting factors used in this calculation. See Note 18 to the audited financial statements 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% of current year’s income before charges for AHP, but after expenses for REFCORP and restoring any interest expense related to dividends on capital stock treated as a liability under Statement of Financial Accounting Standards No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity. Currently, combined assessments for REFCORP and AHP are the equivalent of approximately a 26.6% effective rate for the Bank. The combined REFCORP and AHP assessments for the Bank were $78.3 million, $69.3 million, and $42.9 million for the years ended December 31, 2006, 2005 and 2004, respectively.

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 on Form 10-K, quarterly reports on Form 10-Q, current reports 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 Section 302 of the Sarbanes-Oxley Act of 2002 with respect to this 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 by contacting the Legal Department at the Bank.


Item 1A:	Risk Factors

There are many factors — several beyond the Bank’s control — that could cause results to differ significantly from expectations. The following discussion summarizes some of the more important factors. 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, which are described elsewhere in this report (see the “Risk Management” section in Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations), that could cause results to differ from the Bank’s expectations. 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’s inability to pay dividends on its common stock.

Economic, Industry, Regulatory and Legislative Factors

An economic downturn, geopolitical conditions or a natural disaster, especially one affecting the Bank’s district, could adversely affect the Bank’s profitability or financial condition.

The Bank’s business and earnings are affected by general business and economic conditions in the United States and the Bank’s district. These conditions include short-term and long-term interest rates, inflation, monetary supply, fluctuations in both debt and equity capital markets, and the strength of the U.S. economy and the local economies in which the Bank operates. If any of these conditions were to worsen, the Bank’s business and earnings could be adversely affected. For example, a prolonged economic downturn could increase the number of members and mortgage loans which default or otherwise become delinquent.

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 capital markets.

Damage caused by natural disasters or acts of terrorism 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 mortgage-backed securities 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 investments and the Bank may be severely impaired with respect to the value of these assets.

Fluctuating interest rates or changing interest rate levels may adversely affect the amount of net interest income the Bank receives.

Like many financial institutions, the Bank realizes income primarily from the spread between interest earned on loans and investments and interest paid on borrowings and other liabilities, as measured by the net interest spread. 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 Board. The Federal Reserve Board’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 either interest-bearing liabilities will be more sensitive to changes in interest rates than its interest-earning assets, or vice versa.

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


	•	Increases in interest rates may reduce overall demand for loans and mortgages, thereby reducing the origination of loans, new mortgage loans and volume of MPF loans acquired by the Bank, which could have a material adverse effect on business, financial condition and results of operations, and may increase the cost of funds; and

	•	Decreases in interest rates typically cause mortgage prepayments to increase and may result in increased premium amortization expense and substandard performance in the Bank’s mortgage portfolio as the Bank experiences a return of principal that it must re-invest in a lower rate environment, adversely affecting net interest income over time.

Inability to access the capital markets could adversely affect the Bank’s liquidity.

The Bank’s primary source of funds is the sale of consolidated obligations in the capital markets. 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 terms acceptable to it, if at all. If the Bank cannot access funding when needed, its ability to support and continue its operations 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.

The Bank is subject to legislative and regulatory actions, including a complex body of regulations, primarily Finance Board 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.

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.

While no Federal legislation affecting the FHLBanks has been enacted since the Gramm-Leach-Bliley Act of 1999, legislation to reform the regulatory structure of the three U.S. housing GSEs, the FHLBanks, Fannie Mae and Freddie Mac, has been introduced and considered in each of the past several Congresses. In the 110th Congress, the chairmen of both the Senate Banking Committee and the House Committee on Financial Services have indicated their intention to work on legislation to create a new independent agency to oversee the safety and soundness and mission compliance of the housing GSEs.

Given the nature of the legislative process, it is impossible to predict the provisions of any final bill, whether such bill will ultimately be signed by the President and enacted into law, or if enacted, what effect such changes would have on the Bank’s business, results of operations or financial condition.

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 Board, an independent agency in the executive branch of the Federal government. The Finance Board’s extensive statutory and regulatory authority over the FHLBanks includes the authority to liquidate, merge or consolidate FHLBanks and the Bank cannot predict if or how the Finance Board could exercise such authority in regard to any FHLBank or the potential impact of such action on members’ investment in the Bank. The Finance Board also has extensive statutory and regulatory authority over the scope of permissible FHLBank products and activities, including the authority to impose limits on FHLBank products and activities. The Finance Board supervises the Bank and establishes the regulations governing the Bank. New or modified regulations adopted by the Finance Board could have a negative effect on the Bank’s ability to conduct business, the cost of doing business and members’ investment in Bank capital stock.

On December 22, 2006, the Finance Board approved a final regulation prohibiting an FHLBank with excess capital stock (the amount of capital stock in excess of members’ minimum investment requirement) in an amount greater than one percent of its assets from issuing additional excess stock or paying stock dividends. This rule became effective on January 29, 2007. The final regulation did not establish a required minimum amount of retained earnings for the FHLBanks which had been a component of the proposed regulation issued in March 2006. The Finance Board plans to conduct a comprehensive review of the FHLBank System’s risk-based capital requirements and it is expected that the level of retained earnings will be considered in that process.

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 Board regulations and Finance Board regulatory actions could result in, among other things, an increase in the Banks’ cost of funding, a change in permissible business activities, or a decrease in the size, scope, or nature of the Banks’ lending, investment or mortgage purchase program activities, which could negatively affect its financial condition and results of operations and members’ investment in the Bank.

The Bank is jointly and severally liable for the consolidated obligations of 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, 2006, out of a total of $952.0 billion in par value of consolidated obligations outstanding, the Bank was the primary obligor on $74.9 billion, or approximately 7.9% of the total.

The Finance Board, in its discretion, may 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 due to the failure of other FHLBanks to meet their 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. Due to the high credit quality of every other FHLBank, no liability has ever been recorded for the joint and several obligations related to the other FHLBanks’ share of the consolidated obligations. See Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations for further information.

On July 1, 2004, the Finance Board announced an agreement with the FHLBank of Chicago for an independent review of risk management, internal audit, capital management, and accounting and financial recordkeeping practices as a result of a 2004 examination. The agreement called for the FHLBank of Chicago to submit a three-year business and capital plan, which has been submitted to and accepted by the Finance Board. The FHLBank of Chicago was also required to maintain a 5.1% regulatory capital ratio and limit the growth of acquired member

assets. On April 18, 2006, the Finance Board and the FHLBank of Chicago entered into an amendment of the agreement that reduces the required minimum regulatory capital ratio to 4.50% and also allows the FHLBank of Chicago to issue subordinate debt in order to redeem capital stock of withdrawing members. Based on discussions with the FHLBank of Chicago, management of the Bank does not believe that this agreement will impact the Bank’s mortgage purchase program. As of December 31, 2006, the FHLBank of Chicago was the primary obligor on $80.9 billion in par value of consolidated obligations.

On December 10, 2004, the Finance Board announced an agreement with the FHLBank of Seattle that imposed certain requirements on the FHLBank of Seattle that were intended to strengthen its risk management, capital structure, governance and capital plan. The FHLBank of Seattle was required to maintain a 4.15% minimum regulatory capital-to-asset ratio and to limit the growth of its acquired member assets. On January 11, 2007, this agreement was terminated. The FHLBank of Seattle attributed the termination to being in full compliance with the terms of the agreement and the significant progress made in implementing an updated business and capital management plan. As of December 31, 2006, the FHLBank of Seattle was the primary obligor on $49.7 billion in par value of consolidated obligations.

The requirements of the above agreements, or the impact of other accounting, operational or regulatory issues that may occur in the future, may affect the timeliness of the FHLB System combined financial statements. Delays in publishing the combined financial statements due to various FHLBank financial restatements have not adversely affected the Bank’s cost of funds or access to the capital markets; however, future delays could have that effect.

Until recently, all of the FHLBanks possessed a triple-A credit rating from both Standard & Poor’s and Moody’s Investor Services, Inc. Fitch does not rate the FHLB System or the FHLBanks. However, Standard & Poor’s has downgraded and subsequently restored the credit ratings of various FHLBanks over the past few years. The Bank does not believe that the recent actions by Standard & Poor’s or by the Finance Board impact the Bank’s joint and several liability under these consolidated obligations.

The following table presents the most recent Standard & Poor’s and Moody’s ratings for the FHLBank System and each of the FHLBanks within the System.


	Moody’s Investor Service	Standard & Poor’s


Consolidated obligation discount notes	P-1	A-1+
Consolidated obligation bonds	Aaa	AAA


	Moody’s Senior Unsecured	S&P Senior Unsecured
	Long-Term Debt	Long-Term
FHLBank	Rating/Outlook	Debt Rating/Outlook


Atlanta	Aaa/Stable	AAA/Stable
Boston	Aaa/Stable	AAA/Stable
Chicago	Aaa/Stable	AA+/Negative
Cincinnati	Aaa/Stable	AAA/Stable
Dallas	Aaa/Stable	AAA/Stable
Des Moines	Aaa/Stable	AAA/Negative
Indianapolis	Aaa/Stable	AAA/Stable
New York	Aaa/Stable	AAA/Stable
Pittsburgh	Aaa/Stable	AAA/Stable
San Francisco	Aaa/Stable	AAA/Stable
Seattle⁽¹⁾	Aaa/Stable	AA+/Stable
Topeka	Aaa/Stable	AAA/Stable


⁽¹⁾		At December 31, 2006, the S&P outlook for the FHLBank of Seattle was Negative; on January 19, 2007, S&P revised its outlook on the FHLBank of Seattle from Negative to Stable.

Bank-Specific Factors

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 investment returns and higher borrowing costs for remaining members.

One or more significant Bank members or borrowers could withdraw their membership or decrease their business levels as a result of a consolidation with an institution that is not one of the Bank’s members, or for other reasons, which could lead to a significant decrease in the Bank’s total assets and capital. In some cases, acquired banks are merged into banks chartered outside the Bank’s district. Under the Act and the Finance Board’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 redemption of capital stock. For example, as of December 31, 2006, the Bank had 64.6% of its loans outstanding to three members, Sovereign Bank, GMAC Bank and Citicorp Trust Bank, and 50.1% of its capital stock was owned by the same three members. If Sovereign Bank, GMAC Bank or Citicorp Trust Bank paid off their outstanding loans or if they withdrew from membership, the Bank could experience a material adverse effect on its outstanding loan and capital stock levels and lower demand for its products and services.

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 lowering dividend rates, 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.

On December 21, 2006, Sovereign Bank, the Bank’s largest customer, announced a balance sheet restructuring. The announcement included a de-leveraging of approximately $10 billion in assets and $10 billion in wholesale funding, including FHLBank System loans, during the first quarter of 2007. As of March 13, 2007, Sovereign’s loans outstanding have declined $2.1 billion from a December 31, 2006 balance of $18.0 billion.

The Bank may be limited in its ability to pay dividends or to pay dividends at rates consistent with past practices.

Under Finance Board 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 and is highly dependent on the Bank’s ability to continue to generate future net income. The Bank may not be able to maintain past or current levels of net income, which could limit the ability to pay dividends or change the future level of dividends that the Bank may be willing or able to pay. Additionally, if the Bank is not in compliance with its minimum capital requirements or if the payment of dividends would make it noncompliant, dividends may be suspended. Payment of dividends would 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 liquidity requirements or satisfy its current obligations.

The Bank’s profitability and the market value of its equity may be adversely affected if the Bank is not successful in managing its interest rate risk.

Like most financial institutions, the Bank’s results of operations and the market value of its equity are significantly affected by its ability to manage interest rate risks. The Bank uses a number of measures to monitor and manage interest rate risk, including income simulations and duration/market value sensitivity analyses. Given the unpredictability of the financial markets, capturing all potential outcomes in these analyses is extremely difficult. Key assumptions include loan volumes and pricing, market conditions for the Bank’s consolidated obligations, prepayment speeds and cash flows on mortgage-related assets and others. 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. The Bank’s ability to continue to maintain a positive spread between the interest earned on its earning assets and the interest paid on its interest-bearing liabilities may be affected by the unpredictability of changes in interest rates.

The Bank relies upon derivative instruments to reduce its interest rate risk, and the Bank may not be able to enter into effective derivative instruments on acceptable terms.

The Bank uses derivative instruments to attempt to reduce its interest rate risk and, to a lesser extent, its mortgage prepayment risk. Management determines the nature and quantity of hedging transactions based on various factors, including market conditions and the expected volume and terms of loans. As a result, the effective use of these instruments depends upon the ability of management to determine the appropriate hedging positions in light of the Bank’s assets, liabilities, and prevailing and anticipated market conditions. In addition, the effectiveness of hedging strategies depends upon the ability to enter into these instruments with acceptable parties, upon terms satisfactory to the Bank, and in the quantities necessary to hedge the corresponding obligations. If the Bank is unable to manage its hedging positions properly, or is unable to enter into hedging instruments upon acceptable terms, it may be unable to effectively manage its interest rate and other risks, which could negatively affect its financial condition and results of operations.

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

As part of the Bank’s business, it participates in the MPF Program with the FHLBank of Chicago, which accounts for 9.0% of the Bank’s total assets as of December 31, 2006, and approximately 9.9% of interest income net of provision for credit losses on mortgage loans held for portfolio.

The residential mortgage 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. The Mortgage Bankers Association of America has predicted that residential mortgage originations will drop approximately 5% in 2007. During periods of rising interest rates, rate and term refinancing originations decrease, as higher interest rates provide reduced economic incentives for borrowers to refinance their existing mortgages. The rate and timing of unscheduled payments and collections of principal on mortgage loans are difficult to predict accurately 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 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 be required to make a payment under a related derivative agreement or 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.

The MPF Program’s historical performance may not be indicative of results in a rising interest rate environment, and the Bank’s results of operations may be materially and adversely affected if interest rates continue to rise. In addition, if the FHLBank of Chicago changes the 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 net interest margins.

The MPF Program, as compared to the Bank’s traditional member loan business, is more susceptible to loan losses, and also carries more interest rate risk and operational complexity. Supplemental Mortgage Insurance (SMI) coverage is available for Participating Financial Institutions (PFIs) to purchase. As of December 31, 2006, Mortgage Guaranty Insurance Company and GE Mortgage Insurance Corp. provided 60.7% and 28.0%, respectively, of SMI coverage for MPF loans. Although historically there have been no losses claimed against an SMI insurer, if one or both of these SMI insurers were to default on their insurance obligations and losses on MPF loans were to increase, the Bank may experience increased losses.

For a description of the MPF Program, the obligations of the Bank with respect to loan losses and the PFIs obligation to provide credit enhancement, see the section entitled “Mortgage Partnership Finance Program” in Item 1. Business.

The Bank faces competition for loans, mortgage loan purchases and the 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 investment banks, commercial banks, 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.

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. Lower earnings may result in lower absolute dividend yields to members.

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. Some of these mortgage loan competitors have greater resources, larger volumes of business and longer operating histories. 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 lower net income from this business segment.

The Finance Board does not currently permit multidistrict membership; however, a decision by the Finance Board 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. Department of the 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.

Beginning in July 2006, the Federal Reserve Board required Reserve Banks 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. To comply with this new Federal Reserve Daylight Overdraft Policy, the Bank implemented a number of actions and the Bank, along with the other FHLBanks, entered into an agreement to facilitate timely funding by the FHLBanks of their payments under their respective consolidated obligations, in accordance with the Federal Reserve policy. See discussion in the “Liquidity and Funding Risk” section of Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

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

The Bank’s business is dependent upon its ability to interface effectively with other FHLBanks, PFIs, members and other third parties, and its products and services require a complex and sophisticated operating environment supported by operating systems, both purchased and custom-developed. Maintaining the effectiveness and

efficiency of the technology used in the Bank’s operations is dependent on the continued timely implementation of technology solutions and systems necessary to effectively manage the Bank and mitigate risk, and may require significant capital expenditures. If the Bank were to become unable to maintain these technological capabilities, it may not be able to remain competitive and its business, financial condition and results of operations may be significantly compromised.

The Bank relies heavily on communications and information systems furnished by third party service providers to conduct its business. 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, without limitation, its hedging and loan 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, risk management and profitability, which could negatively affect its financial condition, results of operations and cash flows.

The Bank is subject to credit risk due to default which could adversely affect its profitability or financial condition.

The Bank faces credit risk on loans, mortgage loans, investment securities, derivatives and other financial instruments. The Bank protects against credit risk on loans through credit underwriting standards and collateralization of all loans. In addition, the Bank can call for 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. In addition, members that qualify as Community Financial Institutions 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. The types of collateral pledged by members are evaluated and assigned a borrowing capacity, generally based on a percentage of its market value. The volatility of market prices, interest rates and indices 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. Based on the collateral held and the repayment history of the Bank’s loans to members, management has not established an allowance for credit losses on loans to members.

The Bank offers various products under the MPF Program that are differentiated primarily by their credit risk structures. While the credit risk structure may vary, the Finance Board requires that all pools of MPF loans purchased by the Bank have the credit risk exposure equivalent of a double-A rated mortgage instrument. The Bank maintains an allowance for loan losses on its mortgage loans that management believes is adequate to absorb any probable losses incurred beyond the credit enhancements provided by its PFIs.

In addition, the Bank is subject to risk and potential credit losses related to the BOB loan portfolio. All BOB loans are classified as nonaccrual loans. The Bank maintains an allowance for credit losses on the BOB portfolio which takes into consideration both probability of default and loss given default. Loss given default is considered to be 100%, as the BOB program has no collateral or credit enhancement requirements.

The Bank is also subject to credit risk on some investment securities and derivative financial instruments. The Bank follows conservative guidelines established by its Board of Directors on unsecured extensions of credit, whether on- or off-balance sheet, which limit the amounts and terms of unsecured credit exposure to highly rated counterparties, the U.S. Government and other FHLBanks. 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. The insolvency or other inability of a significant counterparty to perform its obligations under such transactions or other agreement could have an adverse effect on the Bank’s financial condition and results of operations. For the three years ended December 31, 2006, the Bank has experienced no credit losses on unsecured credit exposure.

The Bank’s accounting policies and methods are fundamental to how the Bank reports its financial condition and results of operations, and they may 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 losses and its accounting for derivatives under Statement of Financial Accounting Standard No. 133, Accounting for Derivative Instruments and Hedging Activities (SFAS 133), among others.

Consistent with the Bank’s policy regarding accounting for derivatives, various cash and derivative financial instruments are used to provide a level of protection against interest rate risks, but no hedging strategy can protect the Bank completely. When benchmark interest rates (i.e. LIBOR) change, the Bank expects the gain or loss on derivatives to be substantially offset by a related but inverse change in the value of the hedged item in hedging relationships in which the Bank applies fair value hedge accounting under the requirements of SFAS 133. Certain other hedging strategies are designed to hedge the economic risks of the Bank, and may result in earnings volatility. Although the Finance Board’s regulations, its Financial Management Policy and the Bank’s risk management policies establish guidelines with respect to the use of derivative financial instruments, there is no assurance that the Bank’s use of derivatives will fully offset the economic risks related to changes in interest rates. In addition, hedging strategies involve transaction and other costs. Any hedging strategy or derivatives the Bank uses may not adequately offset the risk of interest rate volatility and the hedging transactions themselves may result in earnings volatility and losses.

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, 2006. For more information, please refer to the “Critical Accounting Policies” section in Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

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

In October 2003, Standard & Poor’s issued a report placing the Bank on “negative outlook” for possible future downgrade, while retaining the Bank’s triple-A rating. The outlook change and rating affirmation reflected the change in the Bank’s business profile, with increased activity in MPF and its impact on interest rate risk exposure. At the same time, Moody’s reaffirmed the Bank’s rating at triple-A. On September 21, 2006, Standard & Poor’s issued a report which revised its outlook on the Bank to “stable” from “negative” and reaffirmed the Bank’s triple-A credit rating. In revising the Bank’s outlook, the report cited progress in following a traditional low-risk member loan business profile and an increase in retained earnings to counter incremental risks and accounting volatility. In addition, Moody’s had previously reaffirmed the Bank’s rating at triple-A on February 9, 2006.

It is possible that either rating 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 current business profile, with mortgage-based assets, exposes it to a higher level of interest rate risk, requiring prudent risk management.

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 losses. Standard & Poor’s has assigned two FHLBanks a negative outlook rating and also assigned long-term counterparty credit ratings of double-A+ on two FHLBanks (see the FHLBank ratings table in the Risk Factor entitled “The Bank is jointly and severally liable for the consolidated obligations of other FHLBanks.”).

Although the credit ratings of the consolidated obligations of the FHLBanks have not been affected by these actions, 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 triple-A.

Circumstances beyond the Bank’s control could cause unexpected losses.

Operating risk is the risk of unexpected losses attributable to human error, systems failures, fraud, unenforceability of contracts, 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.


Item 1B:	Unresolved Staff Comments

None


Item 2:	Properties

The Bank leases 118,013 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; 30 South New Street, Dover, Delaware, 19904; 140 Maffett Street, Wilkes Barre, Pennsylvania, 18705 and 580 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.


Item 3:	Legal Proceedings

The Bank is not currently aware of any pending or threatened legal proceedings against it that could have a material adverse effect on the Bank’s financial condition or results of operations.


Item 4:	Submission of Matters to a Vote of Security Holders

Under the Act, no matters are submitted to shareholders for votes with the exception of the annual election of the Bank’s elected directors. The majority of the Bank’s directors are elected by and from the membership; the Bank’s regulator, the Finance Board, appoints the remainder. Voting rights and process with regard to the election of directors are set forth at 12 C.F.R. Section 915. Specifically, institutions which are members required to hold stock in the Bank as of the record date (i.e., December 31^st of the year prior to the year in which the election is held) are entitled to participate in the election process. Each eligible institution may nominate representatives from member institutions in its respective state to serve three-year terms on the Board of Directors of the Bank. After the slate of nominees is finalized, each eligible institution may vote for the number of open director seats in the state in which its principal place of business is located. The Board of Directors of the Bank does not solicit proxies, nor are eligible institutions permitted to solicit or use proxies to cast their votes in an election. The nomination and election of directors is conducted by mail. No meeting of the members is held. No director (except a director acting in his personal capacity), officer, employee, attorney, or agent of the Bank may, directly or indirectly, support the nomination or election of a particular individual for an elective directorship. Each eligible institution is entitled to cast one vote for each share of stock that it was required to hold as of the record date; however, the number of votes that each institution may cast for each directorship cannot exceed the average number of shares of stock that were required to be held by all member institutions located in that state on the record date.

The only matter submitted to a vote of shareholders in 2006 was the election of certain directors, which occurred in the fourth quarter of 2006. The Bank conducted this election to fill all open elective directorships for 2007 designated by the Finance Board. The election was conducted in accordance with 12 C.F.R. Section 915 as described above. Information about the results of the election was reported in an 8-K filed on November 17, 2006, included as Exhibit 22.1 to this Annual Report on Form 10-K. Additional information regarding the election, including the votes cast is set forth in the Bank’s letter to members sent in November, 2006 and filed as Exhibit 99.2 to this Annual Report on Form 10-K.

The following directors serve on the Bank’s Board of Directors following the vote:


Marvin N. Schoenhals (Chair)
Dennis S. Marlo (Vice Chair)
Basil R. Battaglia
David W. Curtis
David R. Gibson
H. Charles Maddy, III
Frederick A. Marcell, Jr.
Edward J. Molnar
Paul E. Reichart
Gerard M. Thomchick
Cecil Underwood
Patrick J. Ward

For more information on the Bank’s Board of Directors see Item 10. “Directors, Executive Officers and Corporate Governance.”

PART II


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

The member financial institutions own all the capital stock of the Bank. There is no established marketplace for the Bank’s stock; the Bank’s stock is not publicly traded and may be redeemed by the Bank only 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 may repurchase shares held by members in excess of their required stock holdings at the Bank’s discretion upon one 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. The members’ minimum stock purchase requirement is subject to change from time to time at the discretion of the Board of Directors of the Bank. Par value of each share of capital stock is $100. As of December 31, 2006, 334 members owned Bank capital stock and 2 nonmembers held capital stock. The total number of shares of capital stock outstanding as of December 31, 2006 was 33,922,501, of which members held 33,882,677 shares and nonmembers held 39,824 shares. Member stock includes 38,992 shares held by one institution which has given notice of withdrawal effective April 2010 and 100 shares of another institution which is in receivership.

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


(in thousands)
Quarter	2006		2005


First	$	24,014	$	17,365
Second		42,322		18,251
Third		42,500		20,804
Fourth		41,328		24,096

Please see the “Capital Resources — Dividends” section included in Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations for information concerning restrictions on the Bank’s ability to pay dividends and the Bank’s current dividend policy.


Item 6:	Selected Financial Data

The following tables should be read in conjunction with the financial statements and related notes and Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations, each included in this report.

The Statement of Operations data for the three years ended December 31, 2006, 2005, and 2004, and the Statement of Condition data as of December 31, 2006 and 2005, are derived from the audited financial statements included in this report. The Statement of Operations data for the years ended December 31, 2003 and 2002, and the Statement of Condition data as of December 31, 2004, 2003 and 2002, are derived from the restated financial statements included within the Bank’s registration statement on Form 10, as amended.

Statement of Operations


	Year ended December 31,
(in thousands)	2006			2005			2004			2003			2002


Net interest income before provision for credit losses	$	344,330		$	309,543		$	299,770		$	278,730		$	213,651
Provision (benefit) for credit losses		2,248			2,089			308			(6,575	)		3,664
Other income, excluding net gain (loss) on derivatives and hedging activities		6,593			3,217			4,678			4,421			11,641
Net gain (loss) on derivatives and hedging activities		7,039			4,185			(106,327	)		(158,005	)		(223,454	)
Other expense		60,916			53,726			45,798			38,225			34,880
Income (loss) before assessments		294,798			261,130			152,015			93,496			(36,706	)
Assessments		78,336			69,325			42,948			24,805			(9,738	)
Income (loss) before cumulative effect of change in accounting principle		216,462			191,805			109,067			68,691			(26,968	)
Cumulative effect of change in accounting principle⁽¹⁾		—			—			9,788			—			—
Net income (loss)	$	216,462		$	191,805		$	118,855		$	68,691		$	(26,968	)


Earnings (loss) per share⁽²⁾	$	6.76		$	6.72		$	4.53		$	2.99		$	(1.38	)


Dividends	$	150,164		$	80,516		$	44,310		$	50,182		$	69,305
Weighted average dividend rate⁽³⁾		4.69	%		2.82	%		1.69	%		2.20	%		3.56	%
Return on average capital		6.29	%		6.41	%		4.46	%		3.01	%		(1.35	)%
Return on average assets		0.29	%		0.29	%		0.20	%		0.13	%		(0.06	)%
Net interest margin⁽⁴⁾		0.47	%		0.47	%		0.52	%		0.55	%		0.47	%
Total capital ratio (at period-end)⁽⁵⁾		4.70	%		4.47	%		4.52	%		4.39	%		4.03	%
Total average capital to average assets		4.58	%		4.52	%		4.58	%		4.42	%		4.37	%

Notes:


⁽¹⁾		The Bank changed its method of amortizing and accreting deferred premiums and discounts on mortgage-backed securities (MBS) and MPF loans as of June 30, 2004, and September 30, 2004, respectively. These changes were applied retroactively as of January 1, 2004. These changes resulted in cumulative income effects of $263,000 for the MBS and $9.5 million for the MPF loans that are reflected in the Statement of Operations for the year ended December 31, 2004. Please see Note 4 to the audited financial statements for further information.

⁽²⁾		Earnings (loss) per share calculated based on net income (loss), and weighted average shares outstanding.

⁽³⁾		Weighted average dividend rates are dividends divided by the average of the daily balances of outstanding capital stock during the year.

⁽⁴⁾		Net interest margin is net interest income before provision (benefit) for credit losses as a percentage of average interest-earning assets.

⁽⁵⁾		Total capital ratio is capital stock plus retained earnings and accumulated other comprehensive income (loss) as a percentage of total assets at year-end.

Statement of Condition


	December 31,
(in thousands)	2006		2005		2004		2003		2002


Loans to members	$	49,335,377	$	47,492,959	$	38,980,353	$	34,662,219	$	29,250,691
Investments — Federal funds sold, interest-bearing deposits and investment securities⁽¹⁾		19,994,932		16,945,821		12,929,857		9,994,951		10,206,226
Mortgage loans held for portfolio, net		6,966,345		7,651,914		8,644,995		8,015,647		4,852,816
REFCORP receivable		—		—		—		7,605		17,535
Total assets		77,376,458		72,898,211		61,068,598		53,158,472		45,121,983
Deposits and other borrowings⁽²⁾		1,433,889		1,100,488		1,067,843		1,388,223		2,435,711
Consolidated obligations, net⁽³⁾		71,472,618		67,723,337		56,235,449		47,878,708		39,055,190
AHP payable		49,386		36,707		20,910		12,914		17,097
REFCORP payable		14,531		14,633		3,363		—		—
Capital stock — putable		3,384,358		3,078,583		2,695,802		2,341,627		1,839,742
Retained earnings (deficit)		254,777		188,479		77,190		2,645		(15,864	)
Total capital		3,633,974		3,259,546		2,761,324		2,334,485		1,818,249

Notes:


⁽¹⁾		None of these securities were purchased under agreements to resell.

⁽²⁾		Includes mandatorily redeemable capital stock.

⁽³⁾		Aggregate FHLB System-wide consolidated obligations (at par) were $952.0 billion, $937.5 billion, $869.2 billion, $759.5 billion and $680.7 billion at December 31, 2006 through 2002, respectively.


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

Forward-Looking Information

Statements contained in or incorporated by reference into Management’s Discussion and Analysis of Financial Condition and Results of Operations, including statements describing the objectives, projections, estimates or future predictions of the Bank and the Office of Finance may be “forward-looking statements.” These statements may use forward-looking terminology, 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 risks and uncertainties including, but not limited to, those risk factors set forth in Item 1A.

This Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with the Bank’s audited financial statements and notes included herein.

Earnings Performance

The following is Management’s Discussion and Analysis of the Bank’s earnings performance for the years ended December 31, 2006, 2005 and 2004, which should be read in conjunction with the Bank’s audited financial statements and notes included in this report.

Summary of Financial Results

The Bank’s net income totaled $216.5 million for full year 2006, compared to $191.8 million for full year 2005. This $24.7 million, or 12.9%, increase was driven mainly by higher net interest income, which increased $34.8 million, or 11.2%. Increases in interest income on the investments and loans to members portfolio was partially offset by higher interest expense on consolidated obligations. Additional details are discussed more fully below.

Dividend Rate. Because members may purchase and redeem their Bank capital stock shares only at par value, management regards quarterly dividend payments as an important vehicle through which a direct investment return is received. The Bank’s dividend rate averaged 4.69% in 2006 compared to 2.82% in 2005. As discussed more fully below, beginning in the fourth quarter of 2003, the Bank began to limit its quarterly dividend payments to 50% of current period estimated net income in order to increase its retained earnings balance. Retained earnings were $254.8 million at December 31, 2006, compared to $188.5 million at December 31, 2005.

Key Determinants of Financial Performance

Many variables influence the financial performance of the Bank, but on the whole, the following five factors exert the greatest effect: (1) Earnings on Capital; (2) Net Interest Spread; (3) Leverage; (4) Duration; and (5) Interest Rates and Yield Curve Shifts. Any discussion of the financial condition and performance of the Bank must necessarily focus on the interrelationship of these five factors. Key statistics regarding these five factors are presented in the table below.


	2006			2005			2004


Earnings on Capital
Average capital balance (in millions)	$	3,440		$	2,995		$	2,664
Impact of net noninterest-bearing funds to net interest margin		0.22	%		0.17	%		0.12	%
Average six-month U.S. Treasury bill yield for the year		4.80	%		3.10	%		1.36	%


Net Interest Spread
Net interest spread		0.25	%		0.30	%		0.40	%
Net interest margin		0.47	%		0.47	%		0.52	%


Leverage
Assets to capital ratio at December 31		21.3 times			22.4 times			22.1 times


Duration
Duration of equity at December 31 in the base case		2.0 years			2.7 years			1.6 years


Interest Rates and Yield Curve Shifts
Average ten-year U.S. Treasury note yield		4.78	%		4.26	%		4.25	%
Net mortgage loan premium at period-end (in thousands)	$	52,491		$	69,611		$	96,208

Earnings on Capital. Member institutions held $3.4 billion in capital stock in the Bank at December 31, 2006 and $3.2 billion on average throughout the year. This capital represents a source of funding for the Bank and is invested in the Bank’s asset portfolios. The maturities of the Bank’s assets are generally short-term in nature, or they have interest rate resets that refer to short-term interest rates, or they have been hedged with derivatives in which a short-term interest rate is received. As a result, the rates earned on the Bank’s capital reflect short-term interest rates in the capital markets. If short-term interest rates are rising, the absolute dollar earnings of the Bank will increase because the spread between asset yields and interest-free capital will widen. Similarly, if short-term interest rates

are declining, the Bank will earn less in absolute dollars on its capital. Earnings on capital are a major component of net interest income in absolute terms and will rise or fall with prevailing short-term interest rates, assuming constant capital levels. The Bank’s earnings on capital reflect the impact of net noninterest-bearing funds to the net interest margin. This impact is calculated as the difference between the net interest margin and the net interest spread. The Bank monitors this impact as a part of the net interest margin evaluation. As noted above, the impact of the net noninterest-bearing funds can represent a significant portion of the net interest margin, ranging from 12 to 22 basis points over the three years ended 2006.

The Bank strives to earn a dividend that is attractive relative to short-term interest rates in the market. If rates are trending downward, the Bank’s net income will trend downward due to lower earnings on capital. The decline in net income is not of concern in regard to dividends, however, since the dividend target is also falling downward with interest rates. Excluding other effects, the higher and increasing level of short-term interest rates in 2005 and 2006 had the effect of increasing Bank net interest income because of the wider spread earned on capital. At the same time, however, a higher level of short-term interest rates may raise the expectations of members for an upward-adjusting dividend yield.

Net Interest Spread. Earnings on capital represent one of two components in the Bank’s net interest margin. The other component is the net interest spread that the Bank earns between the yield on interest-earning assets and the cost of interest-bearing liabilities. These liabilities included $1.4 billion in member deposits and $71.5 billion in consolidated obligation bonds and discount notes at December 31, 2006. Because of the Bank’s GSE status and joint and several obligation, the Bank is able to issue consolidated obligations in the capital markets at spreads to the U.S. Treasury yield curve which are narrower than non-GSE issuers. This spread advantage is a strategic competitive advantage for the Bank. The spreads are generally directional, narrowing as rates fall and widening as rates rise. However, other factors which impact spreads include interest rate swap spreads and supply-demand dynamics. Recently, supply-demand dynamics have been a key factor as other GSEs have reduced long-term debt issuance and foreign investors, large buyers of government-sponsored enterprise debt, have been increasingly interested in purchasing longer-dated securities.

The Bank deploys its GSE-priced funding in three broad categories of assets. First, as a ready source of liquidity for members, the Bank maintains ample liquid asset portfolios of various money market investments that can be promptly converted into cash to meet member loan demand. Because these liquid assets are short-term in nature and of high asset quality, spreads between these assets and consolidated obligation funding can be as low as six basis points or less.

A second asset category is loans to members, which totaled $49.3 billion at December 31, 2006, and represented 63.8% of total assets. In order to maximize the value of membership, the Bank strives to price its loans at levels that members will find not only competitive, but positively advantageous relative to their other sources of wholesale funding. Typically, the aggregate spread on the Bank’s loan portfolio averages approximately 15 to 28 basis points over the Bank’s cost of funds. In effect, members of the Bank receive funding as if they were drawing funds from the capital markets as double-A rated financial institutions.

Over the past year, the Bank has experienced net interest spread compression in the loans to members portfolio for several reasons. First, the competition for lending to members has increased over the past year. The flat to inverted yield curve has reduced the number of investment options. This has caused Wall Street firms and correspondent commercial banks to look for other investment opportunities. To fill that balance sheet void, they have been offering very competitive pricing for structured repurchase transactions to money center, regional and large community banks. Second, growth in the brokered CD market across all market segments has produced additional competitive pressure on wholesale lending opportunities to members. Third, the softening of the residential real estate market has lowered the overall demand for wholesale funding. This softer demand for funding has resulted in a narrowing of the Bank’s pricing spreads to maintain the loans to members portfolio. Management expects this trend of narrowing net interest spreads in the loans to members portfolio to continue for the foreseeable future.

The Bank holds a third segment of its assets in mortgage-based investments. Mortgage-based investments are deemed to be consistent with the Bank’s housing mission and produce wider spreads against consolidated obligation funding. At December 31, 2006, the Bank held $10.9 billion in MBS. A second category of mortgage-based assets

held by the Bank is originated through the Mortgage Partnership Finance (MPF) Program. At December 31, 2006, MPF loans totaled $7.0 billion and represented 9.0% of the Bank’s assets. In terms of financial performance and impact on spread, MPF is similar to MBS in that the Bank expects to earn a wider spread on MPF loans in order to enhance the weighted average net interest spread on total assets.

The Bank’s spread between asset yields and the cost of underlying funds is an area of keen focus for management. While earnings on capital are driven by market interest rates, the spread that the Bank earns between interest-earning assets and interest-bearing funds is determined by several factors. The Bank must successfully intermediate between the amount, timing, structure and hedging of its debt issuance and the deployment of funds in loans to members or in attractive investment opportunities as they arise. The Bank must maintain balance sheet liquidity for which the cost is holding a portfolio of lower-yielding assets. Management is challenged to find and position investment assets that conform to standards of triple-A or double-A rated credit quality while respecting limits on interest rate risk exposure.

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-paying capacity. The higher the degree of leverage allowed and attained, the higher the potential return on capital that the Bank can achieve. During periods of a weak economy and reduced demand for loans by members, the Bank’s loan portfolio may shrink in size, and with limits on the size of allowable investment portfolios, the overall balance sheet size of the Bank may contract noticeably. The Bank may strive to maintain an optimal degree of leverage by repurchasing excess capital stock held by its members. Since the leverage limit of 25 times capital cannot be exceeded, it is necessary as a practical matter for the Bank to operate at a lower degree of leverage to allow for the day-to-day flow of assets and funds. Management strives to maintain leverage generally in a range of 21 times to 24 times capital. This serves to optimize the Bank’s return on capital within applicable regulatory limits.

Duration. The Bank uses various metrics to measure, monitor and control its interest rate risk exposure. Policies on interest rate risk management established by the Board of Directors focus on duration of equity as a key measurement and control device for managing and reporting on the Bank’s exposure to changing interest rate environments. Under Board policy, the Bank must maintain a base case duration of equity within 4.5 years, and in shock cases of +/- 200 basis points, within 7 years. Management believes that these duration limits are relatively conservative compared to a conventional banking institution. It is the intent of the Board and management to maintain a comparatively low interest rate risk profile. The Bank’s liquid asset portfolios, because of their short-term maturity, do not expose the Bank to meaningful interest rate risk. The Bank’s member loan portfolio is hedged to a relatively balanced interest rate risk position. The interest rate risk in the Bank’s balance sheet is principally located in the MBS and MPF portfolios and their associated funding. These mortgage portfolios may be short-funded to a degree, giving rise to duration risk. Because of the extension and prepayment risk inherent in mortgage assets, the mortgage portfolios are also the principal source of convexity risk in the Bank.

The flow of assets, funding and capital in the Bank causes the Bank’s duration position to fluctuate on a daily basis. Also, rising interest rates exert upward pressure on the Bank’s duration of equity, while falling rates tend to have the opposite effect. Interest rates in the two- to ten-year portion of the yield curve were at their lowest of the year in early January 2006. These rates then trended upward into June 2006 before trending back down into December 2006. In all, these rates ended the year approximately 30 to 50 basis points higher than where they were at the start of the year. The incremental costs of hedging duration and convexity by issuing fixed-rate debt or purchasing option contracts have the impact of reducing the Bank’s earnings.

In a strengthening economy with rising interest rates, the Bank’s financial performance may be improved by 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 spend resources to reduce this exposure. Conversely, weak economic circumstances and falling rates typically reduce the Bank’s duration profile and the costs of policy compliance, but this benefit may be offset by declining earnings on capital.

Interest Rates and Yield Curve Shifts. The final important determinant in the financial performance of the Bank involves shifting movements 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. As a rule, 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.

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. When rates decline, prepayments increase, resulting in a shorter average loan life which can cause an accelerated write-off of any associated premiums or discounts. In addition, when higher coupon mortgage loans prepay at a faster pace, the resulting aggregate yield on the remaining loan portfolio declines.

The volatility of yield curve shifts may also exert 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 optimize net interest spread, maintain duration of equity compliance at the least cost and hedge the volatility of mortgage loan premium expense.

Key Business Strategies and 2007 Outlook

In addition to the five principal determinants of Bank performance described above, in 2006, the Bank adopted a new strategic plan with key goals to set future direction and shape performance. The five strategic goals are: (1) Renew a Strong Customer-Centric Focus; (2) Maximize Member Value; (3) Champion Affordable Housing and Community Development; (4) Foster a Stimulating Work Environment; and (5) Enhance Infrastructure.

Over the past several years, management has been internally focused on several major initiatives driven primarily by regulatory requirements. Now that these initiatives — including registration with the SEC, updating systems and processes to become compliant with the Sarbanes-Oxley Act and creating a Risk Management function — have been successfully completed, management’s strategic focus once again returns to the Bank’s members, both as customers expecting valuable products and services, as well as shareholders expecting excellent financial performance.

Renew a Strong Customer-Centric Focus. Management defines customer-centric focus to include the careful targeting and pursuit of various membership segments in order to anticipate and meet customers’ evolving business strategies. Meeting this goal will require making the most of the unique opportunities provided by the Bank’s geography and identifying and maximizing the Bank’s abilities to tailor products and services.

This goal has three specific business imperatives. First is to deepen relationships with existing customers to further penetrate the market. This requires enhancing current products, broadening acceptance of certain collateral types, enhancing delivery channels and reducing time-to-market with new and existing products. The second imperative is to broaden the customer base. This requires recruiting additional members, including de novo chartered banks, insurance companies and credit unions, while also acting as a capital markets partner with customers. The third imperative is to engage in emerging business opportunities jointly with other FHLBanks. By combining talent and resources, management envisions new capacity to develop new products and services as well as more creative and efficient ways to serve members.

Maximize Member Value. Because FHLBank members are both customers and stockholders, management defines member value as both attractively priced products and services and a suitable dividend. Both components of value must be delivered while management, at the same time, works to protect the stockholders’ investment and enhance the Bank’s ability to provide resources to support affordable housing and community development.

This goal includes two business imperatives. First, management must balance risks while providing long-term earnings growth and modest earnings volatility. In addition, the Bank must improve its decision-making processes and management information with enhanced financial analysis capabilities.

Champion Affordable Housing and Community Development. In addition to the Bank’s mandate to provide programs for affordable housing and community development, management strives to provide leadership and opportunities for members to expand their participation in both affordable housing and community/economic development. Accordingly, this strategic goal focuses on leveraging the Bank’s financial and human resources to promote quality community and neighborhood revitalization.

Business imperatives in this goal include investing in emerging communities, addressing the critical housing needs throughout the district, expanding the participation of member banks in FHLBank programs, providing outreach and education for community banks that may not have sufficient staff for CRA-type programs and seeking new opportunities in community-oriented ventures.

Foster a Stimulating Work Environment. Because the Bank’s employees are critical to its ongoing success, this goal recognizes the need to attract, develop and retain talented, hardworking, motivated employees who are driven to meet the needs of the Bank’s customers and communities. Management strives to instill a culture of dignity, respect, integrity, responsibility, work/life balance and competitive compensation. This environment should foster personal development opportunities and encourage individual and team contributions that serve member needs.

Enhance Infrastructure. Because infrastructure is a necessary foundation for continuing success in a changing world, this goal focuses on enhancing the Bank’s organizational capacity, through technology processes and expertise, to create an atmosphere of “competitive compliance.” Management will continue to cultivate staff and deploy technology at levels that anticipate changing business and regulatory requirements while respecting the need for cost efficiency and long-term profitability. The business imperatives in this goal include improving the Bank’s ability to prioritize and deliver infrastructure improvements and leveraging infrastructure to maintain a sound internal control environment that supports and enhances the business.

Net Interest Income

The following table summarizes the rate of interest income or interest expense, the average balance for each of the primary balance sheet classifications and the net interest margin for each of three years ended December 31.

Average Balances and Interest Yields/Rates Paid


	Year ended December 31,

	2006							2005							2004
				Interest		Avg.					Interest		Avg.					Interest		Avg.
	Average			Income/		Rate		Average			Income/		Rate		Average			Income/		Rate
(dollars in millions)	Balance			Expense		(%)		Balance			Expense		(%)		Balance			Expense		(%)


Assets
Federal funds sold⁽¹⁾	$	4,324		$	219		5.06	$	1,744		$	57		3.28	$	2,048		$	28		1.39
Interest-bearing deposits		3,527			179		5.07		1,711			62		3.60		877			12		1.39
Investment securities⁽²⁾		11,904			558		4.69		9,706			402		4.14		8,544			323		3.78
Loans to members⁽³⁾		46,809			2,435		5.20		44,225			1,529		3.46		37,653			614		1.63
Mortgage loans held for portfolio⁽³⁾		7,330			372		5.08		8,312			402		4.83		8,577			406		4.73


Total interest-earning assets		73,894			3,763		5.09		65,698			2,452		3.73		57,699			1,383		2.40
Allowance for credit losses		(6	)						(5	)						(4	)
Other assets		1,230							613							464


Total assets	$	75,118						$	66,306						$	58,159



Liabilities and capital
Deposits	$	1,216			58		4.79	$	1,060			31		2.90	$	1,309			15		1.12
Consolidated obligation discount notes		13,190			655		4.97		16,410			528		3.22		14,741			193		1.31
Consolidated obligation bonds		56,177			2,704		4.81		44,858			1,579		3.52		37,891			872		2.30
Other borrowings		29			2		7.51		120			4		3.00		234			3		1.46


Total interest-bearing liabilities		70,612			3,419		4.84		62,448			2,142		3.43		54,175			1,083		2.00
Other liabilities		1,066							863							1,320
Total capital		3,440							2,995							2,664


Total liabilities and capital	$	75,118						$	66,306						$	58,159


Net interest spread							0.25							0.30							0.40
Impact of net noninterest- bearing funds							0.22							0.17							0.12


Net interest income/net interest margin				$	344		0.47				$	310		0.47				$	300		0.52


Average interest-earning assets to interest-bearing liabilities		104.6	%						105.2	%						106.5	%

Notes:


⁽¹⁾		The average balance of Federal funds sold, related interest income and average yield calculations include loans to other FHLBanks.

⁽²⁾		The average balance of investment securities available-for-sale represents fair values. Related yield, however, is calculated based on cost.

⁽³⁾		Nonaccrual loans are included in average balances in determining the average rate.

Net interest income increased $34 million, or 11.2%, to $344 million for 2006, compared with the prior year. Although average interest-earning assets and interest-bearing liabilities increased 12.5% and 13.1%, respectively, compared to 2005, the increase in net interest income was primarily rate driven, as indicated in the table below. The net interest margin remained flat at 0.47%. The compression of interest rate spreads resulted in a 5 basis point decrease in the impact of net interest-earning assets. This was offset by a 5 basis point increase in the impact of net noninterest-bearing funds.

Rate/Volume Analysis. Changes in both volume and interest rates influence changes in net interest income and net interest margin. The following table summarizes changes in interest income and interest expense between 2006 and 2005 and between 2005 and 2004.


	2006 compared to 2005								2005 compared to 2004

(in millions)	Volume			Rate		Total			Volume			Rate		Total


Increase (decrease) in interest income due to:
Federal funds sold	$	85		$	77	$	162		$	(5	)	$	34	$	29
Interest-bearing deposits		65			52		117			19			31		50
Investment securities		91			65		156			46			33		79
Loans to members		89			817		906			123			792		915
Mortgage loans held for portfolio		(48	)		18		(30	)		(12	)		8		(4	)


Total		282			1,029		1,311			171			898		1,069
Increase (decrease) in interest expense due to:
Deposits		4			23		27			(3	)		19		16
Consolidated obligation discount notes		(104	)		231		127			24			311		335
Consolidated obligation bonds		399			726		1,125			182			525		707
Other borrowings		(3	)		1		(2	)		(2	)		3		1


Total		296			981		1,277			201			858		1,059


Increase (decrease) in net interest income	$	(14	)	$	48	$	34		$	(30	)	$	40	$	10

The increases in average interest-earning assets from 2005 to 2006 were a result of increases in investment securities, Federal funds sold, interest-bearing deposits and loans to members. The Bank has focused on increasing liquidity, through increases in short-term investments, in response to the new consolidated obligation repayment funding requirements by the Federal Reserve, which became effective July 20, 2006. As a result of that strategy, the Bank has invested in short-term liquid assets when short-term rates have been increasing, thus providing an increase to interest income from both volume and rates.

The $2.6 billion, or 5.8%, increase in loans to members in the current year over year comparison had a positive impact on interest income from the volume side. However, the primary driver, as noted in the above table, was interest rate related. The Bank’s loans to members portfolio has experienced a fundamental shift in the type of loans that the Bank’s members are requiring, with growth in longer-term loans with slightly higher interest rates. The average loans to members portfolio detail is provided in a table below.

The mortgage loans held for portfolio impact was primarily volume related as this portfolio declined from 2005 to 2006. This decline was due to a reduction in mortgages available to be purchased from members, which resulted in portfolio run-off exceeding new loans being purchased.

The composition of the consolidated obligation portfolio has changed to longer-term bonds from short-term notes, coinciding with the shift in the Bank’s loans to members portfolio. Consolidated obligation bonds funded the additional asset levels, with averages increasing the year over year comparisons. Average discount notes negatively impacted interest expense on the volume side. The primary driver of the increase in interest expense on consolidated obligations in total was the increase in short-term interest rates.

2005 compared with 2004

Net interest income increased slightly by $10.0 million, or 3.3%, to $310 million in 2005. This increase was due to a 13.9% increase in average interest-earning assets to $65.7 billion, partially offset by a 9.6% reduction in the net interest margin to 0.47% in 2005 from 0.52% in 2004. The increase in average interest-earning assets resulted from substantial increases in loans to members and moderate growth in investment securities. Continued strength in the residential real estate market and in small business loans resulted in increased loan demand in 2005. Increases in investment securities were primarily due to higher levels of mortgage-backed securities. MBS purchases are limited by regulatory limitations to 300% of capital. Increased capital stock levels in 2005 allowed the Bank to increase the

mortgage-backed securities portfolio by 20.2% as of December 31, 2005, compared to December 31, 2004. Consolidated obligation discount notes and bonds funded these asset increases, increasing by $8.6 billion on average, or 16.4%, from 2004 to 2005. The modest reduction in the net interest margin of 5 basis points was partially due to a $276 million increase in net interest-bearing liabilities and concurrent reduction in net interest-free funds. The remainder of the margin reduction was due to a significantly higher percentage of comparatively lower margin loans to members as well as the compression of interest rate spreads on interest-earning assets due to the flat yield curve.

Loans to Members Portfolio Detail:


		Average Balances
(in millions)		Year ended December 31,
Product	Description	2006			2005


RepoPlus	Short-term fixed-rate loans; principal and interest paid at maturity.	$	4,679.3		$	12,804.4
Mid-Term RepoPlus	Mid-term fixed-rate and adjustable-rate loans; principal paid at maturity; interest paid quarterly.		20,412.4			13,242.3
Term Loans	Long-term fixed-rate and adjustable-rate loans; principal paid at maturity; interest paid quarterly; (includes amortizing loans with principal and interest paid monthly); Affordable Housing Loans and Community Investment Loans.		10,518.5			7,635.1
Convertible Select	Long-term fixed-rate and adjustable-rate loans with conversion options sold by member; principal paid at maturity; interest paid quarterly.		9,718.5			9,737.4
Hedge Select	Long-term fixed-rate and adjustable-rate loans with embedded options bought by member; principal paid at maturity; interest paid quarterly.		75.8			250.8
Returnable	Loans in which the member has the right to prepay the loan after a specified period.		1,601.9			246.6


Total par value		$	47,006.4		$	43,916.6
Discount on AHP loans to members			(1.6	)		(1.8	)
Deferred prepayment fees			(0.3	)		(0.8	)
SFAS 133 hedging adjustment			(195.4	)		310.5


Total book value		$	46,809.1		$	44,224.5

As noted in the chart above, there has been a significant shift from the RepoPlus product to the Mid-Term RepoPlus product. This is due in part to management efforts to extend the loans to members portfolio maturity and in part to the short-term interest rate environment. As short-term interest rates rise, overnight Federal funds and other sources of overnight funding become more attractive to members than Bank overnight loans. In addition, the growth of this portfolio may also be impacted by the following: (1) the Federal Reserve Daylight Overdraft Policy, which has put pressure on the Bank’s overnight cost of funds; (2) the slowing housing market; and (3) any potential Finance Board retained earnings rule, which could limit the Bank’s ability to declare dividends. These factors

continue to put pressure on the Bank’s ability to grow the loans to members portfolio in the current pricing environment.

Net Interest Income Derivative Effects. The following tables separately quantify the effects of the Bank’s derivative activities on its interest income and interest expense for the full years 2006, 2005 and 2004. Derivative and hedging activities are discussed below in the other income (loss) section.

2006

Interest Inc./

Avg.

Interest Inc./

Avg.

Incr./

Average

Exp. with

Rate

Exp. without

Rate

Impact of

(Decr.)

(dollars in millions)

Balance

Derivatives

(%)

Derivatives

(%)

Derivatives

(%)

Assets

Federal funds sold

4,324

219

5.06

219

5.06

—

Interest-bearing deposits

3,527

179

5.07

179

5.07

—

Investment securities

11,904

558

4.69

558

4.69

—

Loans to members

46,809

2,435

5.20

2,206

4.71

229

0.49

Mortgage loans held for portfolio

7,330

372

5.08

376

5.14

)

(0.06

)

Total interest-earning assets

73,894

3,763

5.09

3,538

4.79

225

0.30

Allowance for credit losses

)

Other assets

1,230

Total assets

75,118

Liabilities and capital

Deposits

1,216

4.79

—

Consolidated obligation discount notes

13,190

655

4.97

655

4.97

—

Consolidated obligation bonds

56,177

2,704

4.81

2,474

4.40

230

0.41

Other borrowings

7.51

—

Total interest-bearing liabilities

70,612

3,419

4.84

3,189

4.52

230

0.32

Other liabilities

1,066

Total capital

3,440

Total liabilities and capital

75,118

Net interest income/net interest spread

344

0.25

349

0.27

)

(0.02

)

2005


				Interest Inc./		Avg.		Interest Inc./		Avg.					Incr./
	Average			Exp. with		Rate		Exp. without		Rate		Impact of			(Decr.)
(dollars in millions)	Balance			Derivatives		(%)		Derivatives		(%)		Derivatives			(%)


Assets
Federal funds sold	$	1,744		$	57		3.28	$	57		3.28		—			—
Interest-bearing deposits		1,711			62		3.60		62		3.60		—			—
Investment securities		9,706			402		4.14		402		4.14		—			—
Loans to members		44,225			1,529		3.46		1,724		3.90	$	(195	)		(0.44	)
Mortgage loans held for portfolio		8,312			402		4.83		411		4.94		(9	)		(0.11	)


Total interest-earning assets		65,698			2,452		3.73		2,656		4.04		(204	)		(0.31	)
Allowance for credit losses		(5	)
Other assets		613


Total assets	$	66,306



Liabilities and capital
Deposits	$	1,060			31		2.90		31		2.90		—			—
Consolidated obligation discount notes		16,410			528		3.22		528		3.22		—			—
Consolidated obligation Bonds		44,858			1,579		3.52		1,675		3.74		(96	)		(0.22	)
Other borrowings		120			4		3.00		4		3.00


Total interest-bearing liabilities		62,448			2,142		3.43		2,238		3.58		(96	)		(0.15	)
Other liabilities		863
Total capital		2,995


Total liabilities and capital	$	66,306


Net interest income/net interest spread				$	310		0.30	$	418		0.46	$	(108	)		(0.16	)

2004


				Interest Inc./		Avg.		Interest Inc./		Avg.					Incr./
	Average			Exp. with		Rate		Exp. without		Rate		Impact of			(Decr.)
(dollars in millions)	Balance			Derivatives		(%)		Derivatives		(%)		Derivatives			(%)


Assets
Federal funds sold	$	2,048		$	28		1.39	$	28		1.39		—			—
Interest-bearing deposits		877			12		1.39		12		1.39		—			—
Investments securities		8,544			323		3.78		323		3.78		—			—
Loans to members		37,653			614		1.63		1,221		3.24	$	(607	)		(1.61	)
Mortgage loans held for portfolio		8,577			406		4.73		419		4.88		(13	)		(0.15	)


Total interest-earning assets		57,699			1,383		2.40		2,003		3.47		(620	)		(1.07	)
Allowance for credit losses		(4	)
Other assets		464


Total assets	$	58,159



Liabilities and capital
Deposits	$	1,309			15		1.12		15		1.12		—			—
Consolidated obligation discount notes		14,741			193		1.31		193		1.31		—			—
Consolidated obligation Bonds		37,891			872		2.30		1,345		3.55		(473	)		(1.25	)
Other borrowings		234			3		1.46		3		1.46


Total interest-bearing liabilities		54,175			1,083		2.00		1,556		2.87		(473	)		(0.87	)
Other liabilities		1,320
Total capital		2,664


Total liabilities and capital	$	58,159


Net interest income/net interest spread				$	300		0.40	$	447		0.60	$	(147	)		(0.20	)

The Bank uses derivatives to hedge the fair market value changes attributable to the change in the London Interbank Offered Rate (LIBOR) benchmark interest rate. The loans to members hedge strategy generally converts fixed-rate member loans to three-month LIBOR variable-rate loans. This strategy has the impact of significantly lowering the Bank’s yield on member loans, but it also reduces the Bank’s sensitivity to interest rate fluctuations. Additionally, this hedge strategy allows the Bank to offer loans to members in whatever product structure best meets their needs. Similarly, the consolidated obligation bond’s hedge strategy converts fixed-rate bonds to variable-rate bonds. A majority of these bonds are also converted to three-month LIBOR. This strategy also has the impact of lowering the Bank’s cost of funds and reducing interest rate sensitivity.

The mortgage loans held for portfolio derivative impact increased from 2005 to 2006, to (0.06)% from (0.11)%. This was due to the amortization of fair value adjustments created under previous hedge strategies. The prior strategy hedged the fair value of the commitment to purchase mortgage loans. Currently, the Bank treats mortgage loan commitments as derivatives and no longer applies hedge accounting, pursuant to SFAS No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities (SFAS 149).

In general, the total effect of the implementation of all of these derivative and hedge strategies was to reduce the interest rate spread by 2 basis points in 2006 compared to 16 basis points in 2005.

Mortgage Loan Premium/Discount. When mortgage loans are acquired by the Bank under the MPF Program, a premium or discount is typically paid to the participating financial institution. There are two primary reasons for these premiums or discounts: (1) prevailing market rates change between the date the mortgage loan is priced to the homeowner and the date the originating member locks in a commitment price at which to sell the loans to the Bank; and (2) borrowers elect to pay a higher than market rate on their mortgage loan in exchange for a reduction in up-front loan points, fees, and/or other loan closing costs. This practice of “financing the closing costs” results in a market-wide prevalence of premiums as opposed to discounts, which is reflected in the Bank’s mortgage

loan portfolio. When mortgage loans pay off prior to their contractual terms, any associated unamortized premiums or discounts are recorded in net interest income.

The change in the amount of amortization and accretion of premiums and discounts on mortgage loans impacts the total and variability of the Bank’s net interest income. The combination of historically low residential mortgage rates, aggressive marketing by loan originators and the availability of low cost loan products to prospective borrowers, has resulted in high levels of prepayment activity in the Bank’s mortgage loan portfolio. However, in 2006, prepayment activity decreased from those prior levels, resulting in lower net premium/discount amortization. During 2006, amortization and accretion of mortgage loan premiums and discounts resulted in a net expense of $13.5 million compared with $29.1 million in 2005.

The table below provides key information related to the Bank’s premium/discount on mortgage loans.


	Year ended December 31,

(dollars in thousands)	2006			2005			2004


Net premium / (discount) expense for the period	$	13,522		$	29,128		$	40,374
Mortgage loan related net premium balance at period-end	$	52,491		$	69,611		$	96,208
Mortgage loan par balance at period-end	$	6,894,595		$	7,558,972		$	8,514,395
Premium balance as a percent of mortgage loans		0.76	%		0.92	%		1.13	%

Other Income (Loss)


									% Change		% Change
	Year ended December 31,								2006 vs.		2005 vs.
(in thousands)	2006		2005			2004			2005		2004


Services fees	$	4,369	$	4,007		$	4,127			9.0		(2.9	)
Net gain (loss) on sale of trading securities		—		(999	)		(3,286	)		100.0		69.6
Net gain on sale of held-to-maturity securities		—		—			2,576			—		(100.0	)
Net gain (loss) on derivatives and hedging activities		7,039		4,185			(106,327	)		68.2		103.9
Other, net		2,224		209			1,261			—		(83.4	)


Total other income (loss)	$	13,632	$	7,402		$	(101,649	)		84.2		107.3

Investment Securities Gains and Losses. Certain investment securities within the Bank’s portfolio are classified as trading and changes in the market value of such securities are recorded in income regardless of whether they are sold. During 2005, losses of $1.0 million were recorded on the sale of trading securities. At December 31, 2006 and 2005, the Bank no longer held any trading securities.

Derivatives and Hedging Activities. The Bank enters into interest rate swaps, caps, floors, swaption agreements and TBA securities, referred to collectively as interest rate exchange agreements and more broadly as derivative instruments. The Bank enters into derivatives transactions to offset all or portions of the financial risk exposures inherent in its member lending, investment and funding activities. All derivatives are recorded on the balance sheet at fair value. Changes in derivatives fair values are either recorded in the Statement of Operations or accumulated other comprehensive income within the capital section of the Statement of Condition depending on the hedge strategy.

The Bank’s hedging strategies consist of fair value and cash flow accounting hedges as well as economic hedges. Fair value and cash flow accounting hedges are discussed in more detail below. Economic hedges address specific risks inherent in the Bank’s balance sheet, but they do not qualify for hedge accounting. As a result, income recognition on the derivatives in economic hedges may vary considerably compared to the timing of income recognition on the underlying asset or liability. The Bank does not enter into derivatives for speculative purposes to generate profits.

Regardless of the hedge strategy employed, the Bank’s predominant hedging instrument is an interest rate swap. At the time of inception, the fair market value of an interest rate swap generally equals or is close to a zero value. Notwithstanding the exchange of interest payments made during the life of the swap, which are recorded as

either interest income / expense or as a gain (loss) on derivative, depending upon the accounting classification of the hedge instrument, the fair value of an interest rate swap returns to zero at the end of its contractual term. Therefore, although the fair value of an interest rate swap is likely to change over the course of its full term, upon maturity any unrealized gains and losses net out to zero.

The following table details the net gains and losses on derivatives and hedging activities, including hedge ineffectiveness.


(in thousands)		Year ended December 31,
Type of Hedge	Asset/Liability Hedged	2006			2005			2004


Fair value hedge ineffectiveness	Loans to members	$	1,822		$	105		$	(17	)
	Mortgage loans held for portfolio		—			—			339
	Consolidated obligations		7,716			6,525			17,424


	Total fair value hedge ineffectiveness		9,538			6,630			17,746
Cash flow hedge ineffectiveness	Consolidated obligations		—			—			62
Economic hedges			(3,480	)		(714	)		(126,101	)
Intermediary transactions			(104	)		(483	)		383
Other			1,085			(1,248	)		1,583


Net gain (loss) on derivatives and hedging activities		$	7,039		$	4,185		$	(106,327	)

Fair Value Hedges. The Bank uses fair value hedge accounting treatment for most of its fixed-rate loans to members and consolidated obligations using interest rate swaps. The interest rate swaps convert these fixed-rate instruments to a variable-rate (i.e. LIBOR). For the full year 2006, total ineffectiveness related to these fair value hedges resulted in a gain of $9.5 million compared to a gain of $6.6 million in 2005. During the same period, the overall notional amount decreased from $64.0 billion in 2005 to $62.9 billion in 2006. Fair value hedge ineffectiveness represents the difference between the change in the fair value of the derivative compared to the change in the fair value of the underlying asset/liability hedged. The $2.9 million increase in fair value hedge ineffectiveness was caused by an increase in interest rates and a change in the composition of the portfolio.

Cash Flow Hedges. Cash flow hedges are occasionally used by the Bank to hedge anticipated debt issuance. This hedge strategy was not used in 2006, only used once in 2005, but was used more frequently during 2004.

Economic Hedges. For economic hedges, the Bank includes the net interest income and the changes in the fair value of the hedges in net gain (loss) on derivatives and hedging activities. Total amounts recorded for economic hedges were losses of $3.5 million in 2006 compared to a loss of $0.7 million in 2005. Losses reported for economic hedges were higher in 2006 compared to 2005 due to increases in interest rates and changes in the portfolio composition. The overall notional amount of economic hedges decreased from $4.0 billion at December 31, 2005 to $2.5 billion at December 31, 2006.

During 2004 and 2005, a significant portion of the mortgage loans acquired by the Bank under the MPF Program were being hedged using index amortizing swaps whose notional principal is tied to the outstanding balance of mortgage loans in a reference pool with similar attributes to the MPF loans being hedged. As prepayments occur in the reference pool, the notional principal of the swap declines, although the prepayment behavior between the hedged mortgage loans and the mortgage reference pools are not perfectly correlated. The Bank previously accounted for these hedges as fair value hedges receiving hedge accounting treatment. However, during 2005, management subsequently determined that these hedge relationships did not qualify for hedge accounting treatment. Therefore, as part of the restatement of the Bank’s previously issued financial statements, the Bank has recorded these index amortizing swaps as economic hedges. During the second half of 2005, all of these economic hedges were terminated.

Other Hedging Techniques. Other hedging techniques used by the Bank to offset the potential earnings effects of loan prepayments include inclusion of callable debt instruments in the funding mix and the purchase of interest rate option contracts. Costs associated with callable debt instruments are reflected in the overall cost of

funding included in the calculation of net interest margin. Gains and losses on purchased option positions are included in other net gain (loss) on derivatives and hedging activities.

Fair Value Hedge Methodology Change. During the second quarter of 2005, the Bank evaluated its estimation methodology for determining fair value hedge adjustments for certain consolidated obligation bonds for which interest rate swaps were designated as hedges of changes in fair value due to changes in the benchmark interest rate under SFAS 133. As a result of this evaluation, management changed the estimation methodology in favor of a method that more accurately calculates the fair value of the hedged item, as further described below.

In general, when an interest rate swap is designated as a hedge of changes in fair value of the hedged item attributable to changes in the benchmark LIBOR yield curve, a constant spread adjustment to the LIBOR yield curve is determined that reflects a market interest rate on the hedged item at the inception of the hedging relationship. Prior to the change in estimation methodology, the unamortized debt issuance cost was used as a component of the market value of the bond. Management has determined that a different discount spread adjustment methodology would have more accurately reflected the changes in fair value due to changes in the benchmark interest rate.

Management has determined that the differences between the previous estimation methodology and the new estimation methodology are immaterial to prior periods. The change was implemented as of November 30, 2005 and has been reflected as a change in estimate. As of November 30, 2005, the cumulative difference between the two estimation methodologies was a reduction to income before assessments of approximately $4 million, which has been recorded in net gain (loss) on derivatives and hedging activities. Additionally, it is expected that the use of the new methodology will lead to increased volatility in reported ineffectiveness associated with these hedging relationships due to the introduction of a difference in the initial valuation basis between the bond and the interest rate swap that is subject to fluctuation with interest rates. Therefore, there will be increased volatility in the amount of gains and losses from derivative and hedging activities and reported net income in future periods.

Intermediary Transactions. The following table details the net gains and losses on intermediary transactions.


	Year ended December 31,
(in thousands)	2006			2005			2004


Contracts with members — fair value change	$	(1,812	)	$	(2,328	)	$	(1,353	)
Contracts with counterparties — fair value change		1,699			1,721			1,551


Net fair value change		(113	)		(607	)		198
Interest income due to spread		9			124			185


Net gain (loss) on intermediary derivative activities	$	(104	)	$	(483	)	$	383

From time to time, the Bank serves as an intermediary for its member institutions by entering into offsetting interest rate exchange agreements between its members and other counterparties. This intermediation allows smaller members access to the derivatives market. The derivatives used in intermediary activities do not qualify for hedge accounting treatment and are separately marked-to-market through other income in “net gain (loss) on derivatives and hedging activities.” The net result of the accounting for these derivatives does not significantly affect the operating results of the Bank. All derivative contracts which the Bank enters into with a member for this purpose are generally accompanied by counterparty trades that offset the member trade except for a negligible spread that the Bank receives as compensation for this member service. Generally, no fees are charged to the members for this type of transaction. The gross notional amount (including both the member and offsetting counterparty contracts) of intermediary contracts for the years ended December 31, 2006 and 2005, were $27.4 million, and $94.4 million, respectively. The table above displays the gross change in fair value for both intermediary member contracts and the offsetting intermediary counterparty contracts.

2005 compared with 2004

Investment Securities Gains and Losses. During 2005, losses of $1.0 million were recorded on the sale of trading securities. The Bank no longer holds any trading securities. A net gain of $2.6 million relating to the sale of

municipal security investments previously classified as held-to-maturity was recorded in 2004. Sales of held-to-maturity securities are permissible given a change in one or more specified circumstances.

Derivative and Hedging Activities. The Bank uses fair value hedge accounting treatment for most of its fixed-rate loans to members and consolidated obligations using interest rate swaps. For the full year 2005, total ineffectiveness related to these fair value hedges resulted in a gain of $6.6 million compared to a gain of $17.7 million in 2004. A large component of the gain in 2005 resulted from a change in fair value valuation methodology used on consolidated obligations.

For economic hedges, a loss of $0.7 million was recorded in 2005 compared to a loss of $126.1 million in 2004. The decline in losses was due to large gains in the index amortizing swap portfolio.

Other Expense


							% Change			% Change
	Year ended December 31,						2006 vs.			2005 vs.
(in thousands)	2006		2005		2004		2005			2004


Operating — salaries and benefits	$	35,165	$	30,792	$	24,925		14.2			23.5
Operating — occupancy		3,293		2,594		2,385		27.0			8.8
Operating — other		18,510		16,070		15,029		15.2			6.9
Finance Board		2,076		2,206		1,743		(5.9	)		26.6
Office of Finance		1,872		2,064		1,716		(9.3	)		20.3


Total other expenses	$	60,916	$	53,726	$	45,798		13.4			17.3

Other expenses totaled $60.9 million in 2006 compared to $53.7 million in 2005. Excluding the operating expenses of the Finance Board and Office of Finance described below, other expenses increased $7.5 million, or 15.2%, compared to the prior year. The majority of this increase was due to higher salaries and employee benefits expense, which increased $4.4 million, or 14.2%. This increase was due primarily to an overall increase in staffing on a full year comparison basis. In addition, the current year expense included $1.0 million related to a retirement plan lump sum payment made in the first quarter of 2006.

Collectively, the twelve FHLBanks are responsible for the operating expenses of the Finance Board and the Office of Finance. These payments, allocated among the FHLBanks according to a cost-sharing formula, are reported as other expense on the Bank’s Statement of Operations and totaled $3.9 million in 2006 and $4.3 million in 2005. The Bank has no control over the operating expenses of the Finance Board. The FHLBanks are able to exert a limited degree of control over the operating expenses of the Office of Finance due to the fact that two directors of the Office of Finance are also FHLBank presidents.

2005 compared with 2004

Other expense totaled $53.7 million in 2005, compared to $45.8 million in 2004, an increase of 17.3%. Excluding the operating expenses of the Finance Board and Office of Finance described below, total other expense increased $7.1 million, or 16.8%. This increase was due almost entirely to higher salaries and employee benefits, which increased $5.9 million for the full year 2005 compared to 2004. As of December 31, 2005, full-time equivalent staff were 242 positions, an increase of 24 positions from December 31, 2004. During 2005, the Bank significantly expanded staffing levels in the capital markets, mortgage, accounting, risk management and information technology departments.

As noted above, the twelve FHLBanks are responsible for the operating expenses of the Finance Board and the Office of Finance. These payments are reported as other expense on the Bank’s Statement of Operation and totaled $4.3 million in 2005 and $3.5 million in 2004.

Affordable Housing Program (AHP) and Resolution Funding Corp. (REFCORP) Assessments


							% Change		% Change
	Year ended December 31,						2006 vs.		2005 vs.
(in thousands)	2006		2005		2004		2005		2004


Affordable Housing Program (AHP)	$	24,218	$	21,374	$	13,234		13.3		61.5
REFCORP		54,118		47,951		29,714		12.9		61.4


Total assessments	$	78,336	$	69,325	$	42,948		13.0		61.4

The Bank’s mission includes the important public policy goal of making funds available for housing and economic development in the communities served by the Bank’s member financial institutions. In support of this goal, the Bank administers a number of programs, some mandated and some voluntary, which make funds available through member financial institutions. In all of these programs, Bank funds flow through member financial institutions into areas of need throughout the region.

The Affordable Housing Program (AHP), mandated by statute, is the largest and primary public policy program. The AHP funds, which are offered on a competitive basis, provide grants and below-market loans for both rental and owner- occupied housing for households at 80% or less of the area median income. The AHP program is mandated by the Act, and the Bank is required to contribute approximately 10% of its net earnings after REFCORP to AHP and makes these funds available for use in the subsequent year. Each year, the Bank’s Board of Directors adopts an implementation plan that defines the structure of the program pursuant to the AHP regulations.

In 2006, the Bank held two funding rounds. The 2006A funding round received 72 eligible applications. In June 2006, grants totaling nearly $6.6 million were awarded to 28 projects. In September 2006, four back-up projects were also awarded and an additional $1.2 million in grants. These 32 projects had a total development cost of $134.7 million and provided more than 957 units of affordable housing. The 2006B funding round received 67 eligible applications. In December 2006, grants totaling more than $6.8 million were awarded to 34 projects. These 34 projects had a total development cost of $117.0 million and provided more than 1,017 units of affordable housing.

The First Front Door (FFD) program, which is a set-aside from the AHP, provides grants to qualified low-income first-time homebuyers to assist with closing costs and down payments. For 2006, $4.7 million was allocated to FFD. For the year ended December 31, 2006, commitments totaled $6.0 million and funding totaled approximately $4.0 million.

The Community Lending Program (CLP) offers loans to members at the Bank’s cost of funds, providing the full advantage of a low-cost funding source. CLP loans help member institutions finance housing construction and rehabilitation, infrastructure improvement, and economic and community development projects that benefit targeted neighborhoods and households. At December 31, 2006, the CLP loan balance totaled $421 million, as compared to $364 million at December 31, 2005, reflecting an increase of $57 million, or 15.7%.

Assessment Calculations. Although the FHLBanks are not subject to federal or state income taxes, the combined financial obligations of making payments to REFCORP (20%) and AHP contributions (10%) equate to a proportion of the Bank’s net income comparable to that paid in income tax by fully taxable entities. Inasmuch as both the REFCORP and AHP payments are each separately subtracted from earnings prior to the assessment of each, the combined effective rate is less than the simple sum of both (i.e., less than 30%). In passing the Financial Services Modernization Act of 1999, Congress established a fixed 20% annual REFCORP payment rate beginning in 2000 for each FHLBank. The fixed percentage replaced a fixed-dollar annual payment of $300 million which had previously been divided among the twelve FHLBanks through a complex allocation formula. The law also calls for an adjustment to be made to the total number of REFCORP payments due in future years so that, on a present value basis, the combined REFCORP payments of all twelve FHLBanks are equal in amount to what had been required under the previous calculation method. The FHLBanks’ aggregate payments through 2006 exceeded the scheduled payments, effectively accelerating payment of the REFCORP obligation and shortening its remaining term to a final scheduled payment during the third quarter of 2015. This date assumes that the FHLBanks pay exactly $300 million annually until 2015. The cumulative amount to be paid to REFCORP by the FHLBank is not determinable at this time due to the interrelationships of the future earnings of all FHLBanks and interest rates.

Application of the REFCORP percentage rate as applied to earnings during 2006 and 2005 resulted in annual expenses for the Bank of $54.1 million and $47.9 million, respectively. The year-to-year changes in REFCORP payments made by the Bank reflect the changes in pre-REFCORP earnings.

Financial Condition

The following is management’s discussion and analysis of the Bank’s financial condition as of December 31, 2006, which should be read in conjunction with the Bank’s audited financial statements and notes to financial statements in this report.

Asset Growth and Composition. As a result of strong loan demand by members and increases in investment securities and interest-bearing deposits, Bank assets increased by $4.5 billion to $77.4 billion at December 31, 2006, a 6.1% increase from $72.9 billion at December 31, 2005. Loans to members increased $1.8 billion while investment securities increased $1.6 billion and interest-bearing deposits increased $0.4 billion.

Total housing finance-related assets, which include MPF Program loans, loans to members, mortgage-backed securities and other mission-related investments, increased by $2.2 billion, or 3.3%, to $68.0 billion at year-end 2006, up from $65.8 billion at year-end 2005. Total housing finance-related assets accounted for 87.9% of assets as of December 31, 2006.

Loans to Members. At year-end 2006, total loans to members equaled $49.3 billion, as compared to $47.5 billion at year-end 2005, representing an increase of 3.9%. These December 31, 2006 and 2005 loan balances represent advances to 221 and 246 borrowing members, respectively. The number of the Bank’s members using the Bank’s loan products continues to be high by historical measures, although a significant concentration of the loans, and most of the increase, was from the Bank’s three largest borrowers, generally reflecting the asset concentration mix of the Bank’s membership base. See the discussion of Loan Concentrations in the “Risk Management” section of Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations for further information. The following table provides a distribution of the number of members, categorized by individual member asset size, that had an outstanding loan balance during 2006 and 2005.


Member Asset Size	2006			2005


Less than $100 million		54			61
Between $100 and $500 million		137			140
Between $500 million and $1 billion		45			39
Between $1 and $5 billion		26			28
Greater than $5 billion		13			12


Total borrowing members		275			280


Total membership		334			334
Percent of members borrowing		82.3	%		83.8	%

Growth in loans to members in 2006 continues to be driven by the residential real estate market and, to a lesser degree, by the small business loan demand of the Bank’s members’ customers. The Bank’s members also tend to rely more heavily on the Bank for their funding requirements in rising interest rate environments. Potentially, this allows the member to delay the increase in competition and higher rates required to grow deposits. In addition, some members have been opportunistically funding their balance sheets. The Bank expects the rate of growth in the loans to members portfolio to moderate during 2007 as rising interest rates reduce demand for residential real estate related loans.

The growth in the loan portfolio has been primarily in the mid-term and long-term loan product categories that do not contain options. Again due to rising rates, members have been using the long-term non-putable products to avoid the possibility of future higher interest rates. This is possible because the prepayment risk on the residential mortgage loans that the members are funding with Bank loans has been reduced. The member’s retail mortgage customers are obtaining rates that will be below market if interest rates continue to rise, reducing the likelihood of prepayment. The combined mid-term and long-term product categories increased 17.0% to $32.4 billion in 2006

and represented 65.6% and 58.2% of the portfolio in 2006 and 2005, respectively. See Item 1. Business for further information regarding the Bank’s various loan products.

Mortgage Loans Held for Portfolio. In contrast to the growth in loans to members, net mortgage loan balances have declined 9.0%, to $7.0 billion as of December 31, 2006, compared to $7.7 billion at December 31, 2005. Based on MPF Program total dollar volume purchased from participating members, National City Bank, as successor by merger to National City Bank of Pennsylvania, represented 81% of volume purchased for 2006 and accounted for 90% of the par value of mortgage loans outstanding for the Bank for the year ended December 31, 2006. National City Bank of Pennsylvania consolidated its membership in another FHLBank district and ceased to be a member of the Bank as of July 22, 2006. See Item 1. Business and the section entitled “Mortgage Partnership Finance Program” in Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations for further information regarding the Bank’s mortgage loan portfolio.

Loan Portfolio Analysis. The Bank’s outstanding loans, nonaccrual loans and loans 90 days or more past due and accruing interest are as presented in the following table. The amount of forgone interest income on BOB loans and net nonaccrual mortgage loans, respectively, for each of the periods presented was less than $1 million. The Bank recorded $114 thousand of cash basis interest income in 2006, and none for the periods 2002 through 2005.


	Year ended December 31,
(in thousands)	2006		2005		2004		2003		2002


Loans to members	$	49,335,377	$	47,492,959	$	38,980,353	$	34,662,219	$	29,250,691
Mortgage loans held for portfolio, net⁽¹⁾		6,966,345		7,651,914		8,644,995		8,015,647		4,852,816
Nonaccrual mortgage loans, net		18,771		19,451		13,607		10,290		1,814
Mortgage loans past due 90 days or more and still accruing interest⁽²⁾		15,658		21,018		26,175		33,385		9,604
Banking on Business (BOB) loans, net⁽³⁾		11,469		10,653		9,545		8,487		—

Notes:


⁽¹⁾	All of the real estate mortgages held in portfolio by the Bank are fixed-rate. Balances are reflected net of allowance for credit losses.

⁽²⁾	Government-insured loans (e.g., FHA, VA) continue to accrue interest after becoming 90 days or more delinquent.

⁽³⁾	Due to the nature of the program, all BOB loans are considered nonaccrual loans. Balances are reflected net of allowance for credit losses.

Allowance for Credit Losses. The allowance for credit losses is evaluated on a quarterly basis by management to identify the losses inherent within the portfolio and to determine the likelihood of collectibility. The allowance methodology determines an estimated probable loss for the impairment of the mortgage loan portfolio consistent with the provisions of Statement of Financial Accounting Standards No. 5, Accounting for Contingencies. The Bank has not incurred any losses on loans to members since inception. Due to the collateral held as security and the repayment history for member loans, management believes that an allowance for credit losses for member loans is unnecessary.

The Bank purchases government-insured FHA, government-guaranteed VA and conventional fixed-rate residential mortgage loans. Because the credit risk on the government-insured and government-guaranteed loans is predominantly assumed by the FHA and VA, only conventional mortgage loans are evaluated for an allowance for credit losses. The Bank’s conventional mortgage loan portfolio is comprised of large groups of smaller-balance

homogeneous loans made to borrowers by PFIs that are secured by residential real estate. A mortgage loan is considered impaired when it is probable that all contractual principal and interest payments will not be collected as scheduled in the loan agreement based on current information and events. The Bank collectively evaluates the homogeneous mortgage loan portfolio for impairment and is therefore excluded from the scope of Statement of Financial Accounting Standards No. 114, Accounting by Creditors for Impairment of a Loan. Conventional mortgage loans are generally identified as impaired when they become 90 days or more delinquent, at which time the loans are placed on nonaccrual status. Government mortgage loans that are 90 days or more delinquent remain in accrual status due to guarantees or insurance. The Bank records cash payments received on nonaccrual loans as a reduction of principal. The allowance for credit losses on the mortgage loans held for portfolio as of December 31, 2002 through 2006 was as follows:


	December 31,
(in thousands)	2006		2005			2004		2003			2002


Balance, beginning of period	$	657	$	680		$	514	$	661		$	91
Charge-offs		—		(324	)		—		—			—


Net (charge-offs)		—		(324	)		—		—			—
Provision (benefit) for credit losses		196		301			166		(147	)		570


Balance, end of period	$	853	$	657		$	680	$	514		$	661

The ratio of net (charge-offs) to average loans outstanding was less than 1 basis point for the periods presented.

The allowance for credit losses for the BOB program is based on Small Business Administration (SBA) loan loss statistics, which provide a reasonable estimate of losses inherent in the BOB portfolio based on the portfolio’s characteristics. Both probability of default and loss given default are determined and used to estimate the allowance for credit losses. Loss given default is considered to be 100% due to the fact that the BOB program has no collateral or credit enhancement requirements. All of the loans in the BOB program are classified as nonaccrual loans. The allowance for credit losses on the BOB loans as of December 31, 2002 through 2006 was as follows:


	December 31,
(in thousands)	2006		2005		2004			2003			2002


Balance, at the beginning of the year	$	4,868	$	3,394	$	3,695		$	10,194		$	4,887
Provision (benefit) for credit losses		1,867		1,474		(301	)		(6,499	)		5,307


Balance, at end of the year	$	6,735	$	4,868	$	3,394		$	3,695		$	10,194

Interest-bearing Deposits and Federal Funds Sold. At December 31, 2006, these short-term investments totaled $7.0 billion, an increase of 25.3% from the December 31, 2005 balance. This growth reflects the Bank’s strategy to continue to increase its short-term liquidity position in response to changes brought about by the Federal Reserve Daylight Overdraft Policy. See further discussion in the “Liquidity and Funding Risk” section of Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

Investment Securities. The 14.4% increase in investment securities from December 31, 2005 to December 31, 2006, was primarily due to an increase in mortgage-backed securities (MBS). These investments are collateralized and provide a return that can significantly exceed the return on other types of investments. However, the amount that the Bank can invest in MBS is limited by regulation to 300% of regulatory capital. Because the level of capital increased in 2006, the Bank was able to increase its investment in MBS.

The following tables summarize key investment securities portfolio statistics.


	As of December 31,
(in thousands)	2006		2005		2004


Trading securities:
State or local agency obligations		—		—	$	222,000
U.S. government-sponsored enterprises		—		—		—
Mortgage-backed securities		—		—		89,306


Total trading securities		—		—	$	311,306


Available-for-sale securities:
Equity mutual funds	$	5,362	$	4,773	$	4,533
Mortgage-backed securities		60,486		326,524		626,606


Total available-for-sale securities	$	65,848	$	331,297	$	631,139


Held-to-maturity securities:
Commercial paper	$	332,955	$	149,405	$	69,940
State or local agency obligations		779,780		815,533		553,135
Other U.S obligations		—		3,663		10,597
U.S. government-sponsored enterprises		984,941		556,260		200,000
Mortgage-backed securities		10,841,424		9,509,769		7,551,731


Total held-to-maturity securities	$	12,939,100	$	11,034,630	$	8,385,403

As of December 31, 2006, investment securities had the following maturity and yield characteristics.


	Book
(dollars in thousands)	Value		Yield


Available-for-sale securities:
Equity mutual funds	$	5,362		n/a
Mortgage-backed securities		60,486		5.62	%


Total available-for-sale securities	$	65,848		5.62


Held-to-maturity securities:
Commercial paper due within one year	$	332,955		5.40


State or local agency obligations:
After one but within five years		379,157		5.76
After five but within ten years		14,820		4.53
After ten years		385,803		5.64


Total state or local agency obligations		779,780		5.68


U.S. government-sponsored enterprises:
Within one year		100,000		4.88
After one but within five years		750,000		5.23
After five years		134,941		4.05


Total U.S. government-sponsored enterprises		984,941		5.03
Mortgage-backed securities		10,841,424		4.67


Total held-to-maturity securities	$	12,939,100		4.77

As of December 31, 2006, the held-to-maturity securities portfolio included unrealized losses of $207.5 million which are considered temporary. The basis for determination that these declines in fair value are temporary is explained in detail in Note 8 to the audited financial statements.

As of December 31, 2006, the Bank held securities from the following issuers with a book value greater than 10% of Bank total capital.


	Total		Total
(in thousands)	Book Value		Fair Value


Federal Home Loan Mortgage	$	1,470,319	$	1,443,665
Wells Fargo Mortgage Backed Securities Trust		1,298,588		1,286,265
Federal National Mortgage Association		1,181,493		1,153,099
J.P. Morgan Mortgage Trust		1,146,079		1,139,690
Countrywide Home Loans		613,824		600,674
Structured Adjustable Rate Mortgage Loan Trust		565,511		565,572
Structured Asset Securities Corporation		471,753		457,762
Citigroup Mortgage Loan Trust		406,988		403,059
Countrywide Alternative Loan Trust		399,465		396,576
Bear Stearns Adjustable Rate Mortgages		392,227		387,281
Washington Mutual		367,965		355,492


Total	$	8,314,212	$	8,189,135

Deposits. At December 31, 2006, time deposits in denominations of $100,000 or more totaled $1.0 million. The table below presents the maturities for time deposits in denominations of $100,000 or more:

Over 3 months

Over 6 months

(in thousands)

3 months

but within

By Remaining Maturity at December 31, 2006

or less

6 months

12 months

Total

Time certificates of deposit ($100,000 or more)

1,027

—

1,027

Short-term Borrowings. Borrowings with original maturities of one year or less are classified as short-term. The following is a summary of key statistics for the Bank’s short-term borrowings.


	Year ended December 31,
(dollars in thousands)	2006			2005			2004


Federal funds purchased and loans from other FHLBanks:
Outstanding balance at year-end		—			—			—
Weighted average rate at year-end		—			—			—
Daily average outstanding balance for the year	$	5,918		$	91,533		$	226,018
Weighted average rate for the year		5.33	%		3.02	%		1.38	%
Highest outstanding balance at any month-end		—			—			1,466,000
Securities under repurchase agreements:
Outstanding balance at year-end		—			—			—
Weighted average rate at year-end		—			—			—
Daily average outstanding balance for the year		8,644			8,782			3,048
Weighted average rate for the year		5.34	%		3.12	%		1.43	%
Highest outstanding balance at any month-end		97,794			449,471			—
Mandatorily redeemable capital stock
Outstanding balance at year-end		7,892			16,731			18,208
Weighted average rate at year-end		*			3.00	%		2.43	%
Daily average outstanding balance for the year		14,786			19,417			4,577
Weighted average rate for the year		9.50	%		2.86	%		5.43	%
Highest outstanding balance at any month-end		44,980			21,457			18,208
Consolidated obligation discount notes:
Outstanding balance at year-end		17,845,226			14,580,400			15,160,634
Weighted average rate at year-end		5.26	%		4.13	%		2.09	%
Daily average outstanding balance for the year		13,189,561			16,409,649			14,741,227
Weighted average rate for the year		4.97	%		3.23	%		1.31	%
Highest outstanding balance at any month-end		17,845,226			21,715,136			18,650,485
Total short-term borrowings:
Outstanding balance at year-end		17,853,118			14,597,132			15,178,842
Weighted average rate at year-end		5.26	%		4.11	%		2.12	%
Daily average outstanding balance for the year		13,218,910			16,529,381			14,974,870
Weighted average rate for the year		4.97	%		3.23	%		1.33	%


*		No dividends were declared in December 2006; therefore, there is no calculated rate.

Contractual Obligations. The following table summarizes significant contractual obligations for the payment of liabilities by due date or by stated maturity date at December 31, 2006 at par.

Less than

One to three

Four to five

(in thousands)

Total

one year

years

Thereafter

Consolidated obligations:

Bonds⁽¹⁾

53,406,100

14,799,570

17,640,530

7,781,000

13,185,000

Index amortizing notes⁽¹⁾

3,606,483

21,831

548,372

1,498,876

1,537,404

Discount notes

17,933,218

—

Operating leases:

Premises

8,015

2,422

4,633

960

—

Equipment

795

250

381

164

—

Notes:


⁽¹⁾	Specific bonds or notes incorporate features, such as calls or indicies, which could cause redemption at different times than the stated maturity dates.

Commitment and Off-balance Sheet Items. At December 31, 2006, the Bank is obligated to fund approximately $66.5 billion in additional loans to members, $4.3 million of mortgage loans, $969.6 million in outstanding standby letters of credit and $98.0 million in consolidated obligations. The Bank does not have any special purpose entities or any other type of off-balance sheet conduits.

Retained Earnings. The Finance Board has issued regulatory guidance to the FHLBanks relating to capital management and retained earnings. The guidance directs each FHLBank to assess, at least annually, the adequacy of its retained earnings with consideration given to future possible financial and economic scenarios. The guidance also outlines the considerations that each FHLBank should undertake in assessing the adequacy of the Bank’s retained earnings.

At December 31, 2006, Bank retained earnings stood at $254.8 million, representing an increase of $66.3 million, or 35.2%, over December 31, 2005. In 2006, the Bank exceeded its longer-term retained earnings target of $200 million by first quarter 2006. Prior to reaching the retained earnings target, the Bank paid out less than 100% of net income in dividends. Any future dividend payments are subject to the approval of the Board of Directors. The retained earnings target has not been established as a static figure; it is subject to modification as conditions warrant and, as a matter of policy, the Bank’s Board of Directors continues to evaluate this target in light of prevailing conditions. On March 8, 2006, the Finance Board published a proposed rule, “Excess Stock Restrictions and Retained Earnings Requirements for the Federal Home Loan Banks.” On December 22, 2006, a final rule, “Limitations on Issuance of Excess Stock,” was approved, which prohibits the Bank from issuing additional excess stock or paying stock dividends if excess capital stock is greater than one percent of its assets. It also requires that dividends be declared and paid only out of known income, as is the Bank’s current practice. However, this rule did not address the establishment of a required minimum retained earnings balance for the FHLBanks, which was a component of the original proposal. The Finance Board plans to conduct a comprehensive review of the FHLBank System’s risk-based capital requirements and it is expected that the level of retained earnings will be considered in that process. The following table summarizes the change in retained earnings:


(in thousands)	2006			2005			2004


Balance, beginning of the year	$	188,479		$	77,190		$	2,645
Net income		216,462			191,805			118,855
Dividends		(150,164	)		(80,516	)		(44,310	)


Balance, end of the year	$	254,777		$	188,479		$	77,190


Payout ratio (dividends/net income)		69.4	%		42.0	%		37.3	%

Operating Segment Results

The following is management’s discussion and analysis of the Bank’s operating segment results for the years ended December 31, 2006, 2005 and 2004, which should be read in conjunction with Note 22 to the audited financial statements.

The Bank operates two segments differentiated by products. The first segment entitled Traditional Member Finance encompasses a majority of the Bank’s activities, including but not limited to, providing loans to members; investments; and deposit products. The MPF, or Mortgage Finance, segment purchases loans from members and funds and hedges the resulting portfolio.

Results of segments are presented based on management accounting practices and the Bank’s management structure. There is no comprehensive, authoritative body of guidance for management accounting equivalent to Generally Accepted Accounting Principles. Therefore, the financial results of the segments are not necessarily comparable with similar information at other FHLBanks or any other company.

The management accounting process uses various balance sheet and income statement assignments and transfers to measure performance of the segment. Methodologies are refined from time to time as management accounting practices change. Borrowings are allocated to the Mortgage Finance segment based on mortgage loans outstanding. All remaining borrowings and all capital remain in the Traditional Member Finance business. The allowance for credit losses pertaining to mortgage loans held for portfolio is allocated to the Mortgage Finance segment and the allowance for credit losses pertaining to Banking on Business loans is allocated to Traditional Member Finance. Derivatives are allocated to segments consistent with hedging strategies. Cost incurred by support areas not directly aligned with the segment are allocated based on estimated usage of services.

The following tables set forth the Bank’s financial performance by operating segment for the years ended December 31, 2006, 2005 and 2004.


	Traditional		MPF^® or
	Member		Mortgage
(in thousands)	Finance		Finance			Total


2006
Net interest income	$	314,544	$	29,786		$	344,330
Provision for credit losses		2,052		196			2,248
Other income (loss)		18,968		(5,336	)		13,632
Other expenses		56,353		4,563			60,916


Income before assessments		275,107		19,691			294,798
Affordable Housing Program		22,611		1,607			24,218
REFCORP		50,501		3,617			54,118


Total assessments		73,112		5,224			78,336


Net income before cumulative effect of change in accounting principle	$	201,995	$	14,467		$	216,462


Total assets	$	70,410,113	$	6,966,345		$	77,376,458


2005
Net interest income	$	236,213	$	73,330		$	309,543
Provision for credit losses		1,211		878			2,089
Other income (loss)		13,092		(5,690	)		7,402
Other expenses		49,852		3,874			53,726


Income before assessments		198,242		62,888			261,130
Affordable Housing Program		16,240		5,134			21,374
REFCORP		36,400		11,551			47,951


Total assessments		52,640		16,685			69,325


Net income before cumulative effect of change in accounting principle	$	145,602	$	46,203		$	191,805


Total assets	$	65,246,297	$	7,651,914		$	72,898,211


2004
Net interest income	$	118,345	$	181,425		$	299,770
Provision for credit losses		142		166			308
Other income (loss)		40,252		(141,901	)		(101,649	)
Other expenses		42,887		2,911			45,798


Income before assessments		115,568		36,447			152,015
Affordable Housing Program		10,259		2,975			13,234
REFCORP		23,020		6,694			29,714


Total assessments		33,279		9,669			42,948


Net income before cumulative effect of change in accounting principle	$	82,289	$	26,778		$	109,067


Total assets	$	52,423,603	$	8,644,995		$	61,068,598

Total net income for full year 2006 increased to $216.5 million, up $24.7 million from $191.8 million in the same year-ago period. This increase was driven by a $56.4 million increase in the net income of the Traditional

Member Finance segment, partially offset by a $31.7 million decrease in the net income of the Mortgage Finance Segment.

For the year ended December 31, 2006, net income in the Traditional Member Finance segment increased $56.4 million, from $145.6 million in the prior year to $202.0 million in the current year. This increase was primarily due to a $78.3 million increase in net interest income, partially offset by a $6.5 million increase in other expenses. The increase in net interest income was due to both growth in total interest-earning assets, primarily short-term investments, and the impact of a rising rate environment. The increase in other income was due in part to fluctuations in the fair value hedge ineffectiveness on the loans to members and consolidated obligations portfolios. The increase in other expenses was driven primarily by higher salaries and benefits.

For the year ended December 31, 2006, net income in the Mortgage Finance segment decreased $31.7 million, from $46.2 million in 2005 to $14.5 million in 2006. This decrease was primarily due to lower net interest income, which decreased from $73.3 million in 2005 to $29.8 million in 2006. The decline in net interest income was attributable in part to the use of index-amortizing swaps in 2005, as discussed below, as well as the continued run-off of the mortgage loan portfolio. In addition, 2006 results for the Mortgage Finance segment reflected a change in the funding of a portion of the segment-related debt. The 2006 debt was funded at higher, long-term rates. In 2005, approximately $2.8 billion of debt was funded at lower, short-term rates.

In 2005, index-amortizing swaps were used to economically hedge the fair value of mortgage loans held for portfolio. Included in other income (loss) was a net increase in fair value of the index-amortizing swaps for 2005 of $44.8 million. In addition, net interest expense on these economic hedges of $44.8 million for 2005 was booked to other income (loss). These swaps were terminated in 2005 and funding of these mortgage loans for 2006 was accomplished primarily via amortizing debt issuances. The interest expense on this debt in 2006 was reflected in net interest income.

Other Financial Information

Selected Quarterly Financial Data

The following is a summary of the Bank’s unaudited quarterly operating results for each quarter for the two years ended December 31, 2006.

2006

First

Second

Third

Fourth

(in thousands)

Quarter

Interest income

823,119

905,237

997,908

1,036,840

Interest expense

744,869

818,263

908,124

947,518

Net interest income before provision

78,250

86,974

89,784

89,322

Provision for credit losses

570

509

1,123

Net interest income after provision

77,680

86,928

89,275

88,199

Other income

6,267

2,059

218

5,088

Other expense

16,303

15,528

14,981

14,104

Assessments

17,957

19,506

19,818

21,055

Net income

49,687

53,953

54,694

58,128

Earnings per share

1.68

1.73


	2005
	First		Second			Third			Fourth
(in thousands)	Quarter		Quarter			Quarter			Quarter


Interest income	$	463,558	$	563,331		$	655,834		$	769,076
Interest expense		386,200		486,162			577,937			691,957


Net interest income before provision		77,358		77,169			77,897			77,119
Provision (benefit) for credit losses		637		297			(102	)		1,257


Net interest income after provision		76,721		76,872			77,999			75,862
Other income		34,948		(53,646	)		24,236			1,864
Other expense		12,488		13,128			13,604			14,506
Assessments		26,324		2,690			23,527			16,784


Net income	$	72,857	$	7,408		$	65,104		$	46,436


Earnings per share	$	2.94	$	0.27		$	2.20		$	1.46

Mortgage Partnership Finance (MPF) Program

Mortgage Loan Portfolio

As of December 31, 2006, the par value of the Bank’s mortgage loan portfolio totaled $6.9 billion, a decrease of $0.7 billion, or 9.2%, from the December 31, 2005 balance of $7.6 billion. These balances were approximately 8.9% and 10.4% of period-end total assets, respectively. The average mortgage loan portfolio balance for 2006 was $7.3 billion, a decrease of $1.0 billion or 11.8% from 2005. These decreases were due primarily to less availability of mortgages to be purchased coupled with the continued run-off of the existing portfolio. The tables below present additional mortgage loan portfolio statistics and portfolio balances categorized by term and product.


(dollars in thousands)	2006			2005			2004


Mortgage loans net interest income	$	372,520		$	401,742		$	405,775
Average mortgage loans portfolio balance	$	7,329,638		$	8,311,338		$	8,576,381
Average yield		5.08	%		4.83	%		4.73	%
Weighted average coupon		5.82	%		5.83	%		5.65	%
Weighted average estimated life		5.8 years			5.1 years			6.2 years


	December 31,			December 31,
(in thousands)	2006			2005


Fixed-rate 15-year single-family mortgages	$	1,314,990		$	1,529,441
Fixed-rate 20 and 30-year single-family mortgages		5,579,605			6,029,531


Subtotal par value of mortgage loans held for portfolio		6,894,595			7,558,972
Unamortized premiums		79,579			97,055
Unamortized discounts		(27,088	)		(27,444	)
SFAS 133 hedging adjustments		20,112			23,988


Total mortgage loans held for portfolio, net		6,967,198			7,652,571
Less: Allowance for credit losses		853			657


Total mortgage loans, net of allowance for credit losses	$	6,966,345		$	7,651,914

December 31,

December 31,

2006

2005

(dollars in thousands)

Balance

Percent

Balance

Percent

Conventional loans:

Original MPF

465,998

6.8

435,744

5.8

MPF Plus

5,805,784

84.2

6,382,921

84.4

Total conventional loans

6,271,782

91.0

6,818,665

90.2

Government-insured loans:

MPF Government

622,813

9.0

740,307

9.8

Total par value

6,894,595

7,558,972

The following table presents a geographic breakdown of the mortgage loans held by the Bank according to participating member loan originations and based on the unpaid principal balance at the end of each period.


	December 31,			December 31,
	2006			2005


Midwest (IA, IL, IN, MI, MN, ND, NE, OH, SD and WI)		20.3	%		20.0	%
Northeast (CT, DE, MA, ME, NH, NJ, NY, PA, PR, RI, VI and VT)		21.3			20.8
Southeast (AL, DC, FL, GA, KY, MD, MS, NC, SC, TN, VA and WV)		27.2			27.3
Southwest (AR, AZ, CO, KS, LA, MO, NM, OK, TX and UT)		16.6			16.9
West (AK, CA, GU, HI, ID, MT, NV, OR, WA and WY)		14.6			15.0


Total		100.0	%		100.0	%

Participating Financial Institution (PFI) Agreement. Members must specifically apply to become a PFI. The Bank reviews the general eligibility of the member including servicing qualifications and ability to supply documents, data and reports required to be delivered under the MPF Program. The member and the Bank enter into an MPF Program Participating Financial Institution Agreement (PFI Agreement). The purpose of the PFI Agreement is to: (1) establish the member as an approved seller of mortgages to the Bank and an approved servicer of mortgages held by the Bank; and (2) to provide the terms and conditions for the origination or purchase, including required credit enhancement, and servicing of the mortgages to be purchased by the Bank. Under the terms of the PFI Agreement, the Bank has no obligation to enter into any commitment to purchase loans. However, once the Bank and the PFI enter into a delivery commitment, it is binding on both the PFI and the Bank.

As of December 31, 2006, 58 members were approved participants in the MPF Program. Of the Bank’s 10 largest members, 4 members have executed PFI agreements: PNC Bank, NA; Sovereign Bank; Chase Manhattan Bank, USA, NA; and Citicorp Trust Bank, FSB.

Mortgage Loan Purchases. The Bank and the PFI enter into a Master Commitment which provides the general terms under which the PFI will deliver mortgage loans, including a maximum loan delivery amount, maximum credit enhancement amount and expiration date. Mortgage loans are purchased by the Bank directly from a PFI pursuant to a delivery commitment, which is a binding agreement between the PFI and the Bank. Each MPF loan delivered must conform to specified ranges of interest rates and maturity terms for delivery specified in the delivery commitment. Prior to requesting funding for a mortgage loan, the PFI must designate under which delivery commitment the loan will be funded and must submit certain data concerning the loan so that a credit enhancement analysis and calculation can be completed. Typically, except for a minimal tolerance, the amount of the mortgage loans funded under a delivery commitment may not exceed the amount of the delivery commitment. Delivery commitments that exceed the minimal tolerance or are not fully funded by their expiration date are subject to pair-off fees or extension fees which protect the Bank against changes in market prices.

Mortgage Loan Participations. The Bank may sell participation interests in purchased mortgage loans to other FHLBanks, institutional third party investors approved in writing by the FHLBank of Chicago, the member that provided the credit enhancement, and as of April 30, 2006, other members of the FHLBank System. Prior to April 30, 2006, the Bank regularly sold 25% participation interests in purchased mortgage loans to the FHLBank of Chicago as compensation for the transaction processing services provided by the FHLBank of Chicago. For the year ended December 31, 2006, the volume of participation interests sold to the FHLBank of Chicago was $88.0 million. The Bank has not sold any interests in mortgage loans to any FHLBank, other than the FHLBank of Chicago, since fiscal year 2000. The outstanding principal balance of participation interests sold prior to fiscal year 2000 to other FHLBanks as of December 31, 2006, was $21.8 million (comprised of $19.3 million to the FHLBank of Atlanta and $2.5 million to the FHLBank of Dallas). The Bank has not purchased any participation interests in mortgage loans from other FHLBanks since 1999 and currently holds no participations in other FHLBank mortgage loans. The Bank is responsible for monitoring the creditworthiness of each relevant member PFI and ensuring adequate collateral to secure each PFI’s obligations, including its credit enhancement obligation. The Bank must provide participants with an annual credit report on the credit condition of each PFI. The Bank is responsible for enforcing any obligations under the PFI Agreement with each member PFI. The volume of mortgage loan purchases by product is shown in the table below.


	December 31, 2006				December 31, 2005				December 31, 2004

(in thousands, except percentages)	Balance		Percent		Balance		Percent		Balance		Percent


Conventional loans:
Original MPF	$	77,297		16.3	$	130,638		10.7	$	159,937		4.2
MPF Plus		351,625		74.3		1,091,683		89.3		3,564,973		94.6


Total conventional loans		428,922		90.6		1,222,321		100.0		3,724,910		98.8
Government-insured loans:
MPF Government		44,217		9.4		—				43,902		1.2


Total volume of mortgage loan purchases, at par value		473,139		100.0		1,222,321		100.0		3,768,812		100.0
Less: volume participated to the FHLBank of Chicago		88,031				288,694				925,997


Volume retained by the Bank, at par	$	385,108			$	933,627			$	2,842,815

The Bank has several available options to limit growth in its mortgage balances. First, the Bank’s PFI Agreement does not obligate the Bank to purchase mortgage loans from PFIs. In addition, in select instances, the Bank has imposed monthly delivery limits on certain PFIs, and would work with PFIs to adjust volume limits, as necessary. Finally, if the Bank was faced with volume expectations that exceeded its acquisition plans, the Bank could offer to sell mortgage loans to other FHLBanks.

Restricted Securities. The Bank does not package any mortgage loan production into mortgage-backed securities. However, the Bank, along with several other FHLBanks, participated in the MPF Shared Funding^® Program, which was administered by an unrelated third party. This program allows mortgage loans originated through the MPF Program and the related credit enhancements to be sold to a third party sponsored trust and pooled into securities. The FHLBank of Chicago purchased the pooled securities, which are rated at least double-A, and either retained or partially sold them to other FHLBanks. The collateral underlying these investments is the mortgages sold by PFIs to the trust. These securities are not publicly traded, are not guaranteed by any of the FHLBanks, and have certain sale restrictions. The amortized cost of the Bank’s share of these securities was $60.4 million and $69.4 million as of December 31, 2006 and 2005, respectively.

Services Agreement with the FHLBank of Chicago. In April 1999, the Bank and the FHLBank of Chicago entered into a services agreement, which set forth the terms and conditions of the Bank’s participation in the MPF Program. The Bank and the FHLBank of Chicago agreed that the Bank would compensate the FHLBank of Chicago for its transaction processing services by selling to the FHLBank of Chicago at least a 25% participation interest in the mortgage loans funded by the Bank. The percentage in individual mortgage loans could vary from transaction to transaction by agreement between the Bank and the FHLBank of Chicago. In the event of losses on participated

loans, losses after certain adjustments are first applied to each participant’s first loss account on a pro rata basis. Additional losses are then applied to the credit enhancement obligation of the PFI or supplemental mortgage insurance as indicated by the particular MPF product. Further losses are shared based on the participation interests of the Bank and the FHLBank of Chicago. Under the services agreement, there were no minimum sales levels or transaction fees.

The MPF Program services agreement with the FHLBank of Chicago was renegotiated effective April 30, 2006. The significant changes resulting from this renegotiation are summarized as follows: (1) the contract has no set term and is cancelable by either party with 180 days’ prior notice; and (2) the Bank no longer sells a minimum 25% participation interest in mortgage loans funded by the Bank to the FHLBank of Chicago, but instead pays an annual transaction services fee, paid monthly, to the FHLBank of Chicago which is subject to change annually, ranging from 0.05% to 0.035% based on current volume.

The Bank continues to have options to limit growth in its mortgage balances by limiting its purchases of mortgage loans funded by the Bank on any day, or by selling participations to other FHLBanks or any member of the FHLB System. Sales of participations in mortgage loans purchased by the Bank may be made to other FHLBanks or members of the FHLB System contemporaneously with the purchase of such loans or at any time subsequent to the purchase. Generally, participations in mortgage loans sold contemporaneously will be sold at the same price as purchased by the Bank. Participations that are sold subsequent to the purchase of the mortgage loans by the Bank generally will be sold at current market prices. The credit enhancement obligations of the PFI and the credit enhancement fees paid by the Bank are integral to the MPF mortgage loans and cannot be stripped off or otherwise separated from the underlying mortgage loans. Thus, the credit enhancement will be conveyed with a sale of a 100% participation in a mortgage loan; if the participation is for less than 100% of the loan, the credit enhancement fee will be shared by the Bank and the participant, in accordance with the terms of the applicable MPF Program product.

Mortgage loans are purchased directly from PFIs through the transactional services provided by the FHLBank of Chicago. As part of the services provided, the FHLBank of Chicago establishes daily pricing for mortgage loans and provides reporting for both the PFI and Bank. The FHLBank of Chicago also acts as the master custodian and master servicer for the Bank and provides the necessary quality control services on purchased mortgage loans. See Exhibit 10.7 for more information about the services agreement.

Servicing

Mortgage Loan Servicing. Under the MPF program, PFIs may retain or sell servicing to third parties. The Bank does not service loans or own any servicing rights. The Bank must approve any transfers of servicing to third parties. The FHLBank of Chicago acts as the master servicer for the Bank and has contracted with Wells Fargo Bank, N.A. to fulfill the master servicing duties. The Bank pays the PFI or third party servicer a servicing fee to perform these duties; the fee is generally 25 basis points for conventional loans.

The PFI is responsible for collecting the borrower’s monthly payments and otherwise dealing with the borrower with respect to the MPF loan and the mortgaged property. Monthly principal and interest payments are withdrawn from the PFI’s deposit account on the 18th day (or prior business day) of each month based on reports the PFI is required to provide to the master servicer.

If an MPF loan becomes delinquent, the PFI is required to contact the borrower to determine the cause of the delinquency and whether the borrower will be able to cure the default. If the PFI determines that an MPF loan that has become 90 days delinquent is not likely to be brought current, the PFI is required to commence foreclosure activities in accordance with the MPF Guides.

The risks to the Bank include improper servicing and/or default by the PFI or third party servicer. The Bank has in place several controls or contractual terms to mitigate these risks. As master servicer, the FHLBank of Chicago must bring any material concerns to the attention of the Bank. Major deficiencies in satisfying servicing requirements could result in a PFI’s servicing rights being terminated for cause and the servicing of the particular mortgage loans being transferred to a new servicer.

Credit Exposure

Underwriting Standards. Purchased mortgage loans must meet certain underwriting standards established in the MPF Program guidelines. Key standards and/or eligibility guidelines include the following loan criteria:


	•	Conforming loan size, established annually; may not exceed the loan limits permitted, to be set by the Office of Federal Housing Enterprise Oversight (OFHEO);

	•	Fixed-rate, fully-amortizing loans with terms from 5 to 30 years;

	•	Secured by first lien mortgages on owner-occupied residential properties and second homes;

	•	95% maximum loan-to-value; all loan-to-value ratios are based on the loan purpose, occupancy and borrower citizenship status; all loans with loan-to-value ratios above 80% require primary mortgage insurance coverage; and

	•	Unseasoned or current production with up to 5 payments made by the borrowers.

Under the MPF Program, the FHLBank of Chicago and the PFI both conduct quality assurance reviews on a sample of the conventional mortgage loans to ensure compliance with MPF Program requirements. Under the MPF Program, individual loans which fail these reviews are required to be repurchased by the PFI at par. Additionally, MPF Government residential mortgage loans which are 90 days or more past due are permitted to be repurchased by the PFI. While the repurchase of these government mortgage loans is not required, PFIs have historically exercised their option to repurchase these loans. For the years 2006 and 2005, the total funded amount of repurchased mortgage loans was $13.9 million and $30.7 million, or 3.6% and 3.3% of total funded loans, respectively.

Layers of Loss Protection. The Bank is required to put a credit enhancement structure in place that assures that the Bank’s exposure to credit risk on mortgage loans is no greater than that of a mortgage asset rated at least double-A. The PFI must bear a specified portion of the direct economic consequences of actual loan losses on the individual mortgage loans or pool of loans, which may be provided by a credit enhancement obligation or SMI. Each MPF product structure has various layers of loss protections which are described below. The first layer of protection with all products is the borrower’s equity in the real property securing the loan. As is customary for conventional mortgage loans, the next layer of loss protection comes from primary mortgage insurance issued by qualified mortgage insurance companies. Such coverage is required for mortgage loans with a loan-to-value ratios greater than 80%.


Layer	Original MPF	MPF Plus


First	Borrower’s equity in the property	Borrower’s equity in the property
Second	Primary mortgage insurance (if applicable)	Primary mortgage insurance (if applicable)
Third	Bank first loss account (allocated amount)	Bank first loss account (upfront amount)
Fourth	PFI credit enhancement amount	Supplemental mortgage insurance and/or PFI credit enhancement amount, if applicable
Final	Bank loss	Bank loss

First Loss Account and Credit Enhancement. The risk of loss in mortgage loans sold to the Bank by a PFI is shared between the Bank and the PFI by structuring potential losses on conventional mortgage loans into layers with respect to each pool of mortgage loans purchased or funded by the Bank. Losses for each loan pool that are not paid by primary mortgage insurance are recorded in the financial statements up to an agreed upon amount, called a first loss account (“FLA”), which represents the third layer of loss protection shown above. The FLA is a memo account which either builds over time or an amount equal to an agreed-upon percentage of the aggregate balance of the mortgage loans purchased. The type of FLA is established by MPF product. The Bank does not receive fees in connection with the FLA.

Losses for each loan pool in excess of the FLA up to an agreed upon amount, called the credit enhancement amount, are covered by the PFI and/or supplemental mortgage insurance and represent the fourth layer of loss

protection. The PFI’s credit enhancement amount for each pool of loans, together with any primary mortgage insurance or supplemental mortgage insurance coverage, is sized to equal the amount of losses in excess of the FLA to the equivalent of a double-A rated mortgage investment. The financial model used by the FHLBank of Chicago provides an analysis of each pool of loans that is comparable to a methodology that a NRSRO would use in determining credit enhancement levels when conducting a rating review of the asset or pool of assets in a securitization transaction. By undertaking to credit enhance each loan pool, the PFI maintains an interest in the performance of the mortgage loans it originates or sells to and may service for the Bank. For managing this risk, the PFI is paid a monthly credit enhancement fee by the Bank. Credit enhancement fees are recorded as an offset to mortgage loan net interest income in the statement of operations. For the years ended December 31, 2006, 2005 and 2004, the credit enhancement fees were $8.5 million, $9.4 million, and $9.2 million, respectively. Performance based credit enhancement fees paid are reduced by losses absorbed through the FLA, where applicable.

The differences between the Original MPF and MPF Plus products, other than the use of supplemental mortgage insurance coverage, are contained in the FLA and the ability to recapture the performance based credit enhancement fees paid to the PFIs when loan losses occur. The FLAs for both products are recorded in a memo account for the Bank, and therefore, there are no cash flows associated with recording first loss accounts. The product differences are described in more detail below.

Original MPF. In Original MPF, the FLA starts out at zero on the day the first loan is purchased and generally increases steadily over the life of the Master Commitment based on the month-end outstanding aggregate principal balance of the Master Commitment. Loan losses not covered by primary mortgage insurance, but not to exceed the FLA, are deducted from the FLA and recorded as losses by the Bank for financial reporting purposes. Any loan loss in excess of the FLA is paid by the PFI up to the aggregate credit enhancement amount. The PFI is paid a monthly credit enhancement fee, typically 10 basis points annually, based on the aggregate outstanding principal balance of the mortgage loans in the Master Commitment. Over time, the FLA is expected to cover normal and expected losses on a pool of loans, although early losses could exceed the FLA and be charged to the PFI’s credit enhancement amount. Loan losses in excess of both the FLA and the credit enhancement amount are unlikely, but if any such losses should occur, they would be recorded as losses by the Bank based on the Bank’s participation interest.

MPF Plus. In MPF Plus, the FLA is generally an amount equal to the agreed-upon percentage of the aggregate principal balance of the mortgage loans purchased in the pool. Loan losses not covered by primary mortgage insurance, but not to exceed the FLA established for each Master Commitment, are incurred by the Bank. The PFI is required to provide a supplemental mortgage insurance policy covering the mortgage loans with a deductible equal to the FLA. Any loan losses in excess of the FLA are normally covered by the SMI; however, special hazard losses are not covered by SMI. Losses not covered by the FLA or supplemental mortgage insurance are charged against the PFI’s credit enhancement amount, if any. The PFI may or may not have a direct credit enhancement amount. Credit enhancement fees are generally 13 or 14 basis points annually and apportioned about equally between two components: a fixed component and a performance based component. The performance based component is available as a recapture to any loan losses recorded by the Bank up to the amount of the FLA. The Bank holds twelve months of the performance based credit enhancement fees as a reserve payable to the PFI to recover losses against the FLA. Beginning in the thirteenth month the performance based credit enhancement fees are paid to the PFI monthly. The amount of this payable was $4.3 million and $4.8 million as of December 31, 2006 and 2005, respectively. Losses in excess of the FLA, supplemental mortgage insurance coverage and PFI’s credit enhancement amount are unlikely, but if any such final losses should occur, they would be recorded as losses by the Bank based on the Bank’s participation interest.

The following are outstanding balances in the FLAs for the Original MPF and MPF Plus products:


(in millions)	Original MPF		MPF Plus		Total


December 31, 2006	$	2.0	$	42.7	$	44.7
December 31, 2005	$	0.4	$	44.5	$	44.9
December 31, 2004	$	0.3	$	41.5	$	41.8

MPF Government. Effective February 1, 2007, the name “Original MPF for FHA/VA” was changed to “MPF Government” and has been expanded from FHA and VA to also include HUD 184 and RHS loan programs.

Only government-insured or government-guaranteed mortgage loans are eligible for sale under this product. The PFI provides and maintains FHA insurance or a VA, HUD or RHS guaranty for the government-insured or government-guaranteed mortgage loans. The PFI is responsible for compliance with all FHA, VA, HUD and RHS requirements and for obtaining the benefit of the FHA insurance or the VA, HUD or RHS guaranty with respect to defaulted government mortgage loans. The PFI’s servicing obligations are essentially identical to those undertaken for servicing loans of a Ginnie Mae security. Since the PFI servicing these mortgage loans takes the risk with respect to amounts not reimbursed by the FHA, VA, HUD or RHS, the product results in the Bank having mortgage loans that are expected to perform the same as Ginnie Mae securities. Only PFIs that are licensed or qualified to originate and service FHA, VA, HUD and RHS loans are eligible to sell and service government-insured or government-guaranteed mortgage loans under the MPF Program. In addition, PFIs must maintain a mortgage loan delinquency ratio that is comparable to the national average and/or regional delinquency rates as published by the Mortgage Bankers Association.

Other Real Estate Owned. When a PFI forecloses on a delinquent mortgage loan, the Bank reclassifies the carrying value of the loan to other assets as real estate owned (REO) at the lower of cost or fair value less estimated selling expenses. If the value of the REO property is lower than the carrying value of the loan then the difference to the extent such amount is not expected to be recovered through recapture of performance-based credit enhancement fees, is recorded as a charge-off to the allowance for credit losses. If the fair value of the REO property is higher than the carrying value of the loan, then the REO property is recorded in other assets at the carrying value of the loan. If a charge-off is required, the fair value less estimated costs to sell the property becomes the new cost basis for subsequent accounting. A PFI is charged with the responsibility for disposing of real estate on defaulted mortgage loans on behalf of the Bank. Once a property has been sold, the PFI presents a summary of the gain or loss for the individual mortgage loan to the master servicer for reimbursement of any loss. Gains on the sale of REO property are held and offset by future losses in the pool of loans, ahead of any remaining balances in the first loss account. Losses are deducted from the first loss account, if it has not been fully used. As of December 31, 2006 and 2005, the Bank held $2.7 million and $2.0 million, respectively, of REO.

Capital Resources

The following is management’s discussion and analysis of the Bank’s capital resources as of December 31, 2006, which should be read in conjunction with Note 15 to the audited financial statements.

Liquidity and Funding. Please refer to the presentation of the Bank’s liquidity and funding risk analysis in the “Risk Management” section.

Capital Plan. Under Finance Board implementation of the GLB Act, the Bank was required to adopt and maintain a plan (capital plan) subject to Finance Board approval. The Finance Board approved the Bank’s capital plan on May 8, 2002, and it was implemented on December 16, 2002. Under the capital plan, the Bank replaced its previous capital stock subscription structure. All outstanding capital stock was replaced with shares of new capital stock at a one-for-one exchange rate. Only one existing member declined to participate in the exchange. As intended, the implementation of the Bank’s capital plan resulted in a net reduction in the Bank’s capital of $48.1 million. No member has voluntarily withdrawn from membership since the Bank converted its stock under its capital plan; however, two members have notified the Bank to voluntarily redeem their capital stock and withdraw from membership. The redemption was not complete as of December 31, 2006. The total amount of this pending stock redemption is $3.9 million. In 2006 and 2005, the Bank repurchased $40.7 million and $29.6 million, respectively, of capital stock related to out-of-district mergers. See Note 15 to the audited financial statements for additional information.

Under the capital plan, member institutions are required to maintain capital stock in an amount equal to no less than the sum of three amounts: (1) a specified percentage of their outstanding loans from the Bank; (2) a specified percentage of their unused borrowing capacity (defined generally as the remaining collateral value that can be borrowed against) with the Bank; and (3) a specified percentage of the principal balance of residential mortgage loans previously sold to the Bank and still held by the Bank (any increase in this percentage will be applied on a prospective basis only). These specified percentages may be adjusted by the Bank’s Board of Directors within pre-established ranges as contained in the capital plan.

These specified percentage ranges and established rates are as follows:


				Percentages in Effect as of
	Specified			December 31,
	Percentage Ranges			2006


Outstanding member loans		4.5 to 6.0	%		4.65	%
Unused borrowing capacity		0.0 to 1.5	%		0.65	%
Outstanding residential mortgages previously sold to and held by the Bank		0.0 to 4.0	%		0.0	%

The stock purchase requirement for unused borrowing capacity is referred to as the membership capital stock purchase requirement because it applies to all members. The other two stock purchase requirements are referred to as activity-based requirements. The Bank determines membership capital stock purchase requirements by considering the aggregate amount of capital necessary to prudently capitalize the Bank’s business activities. The amount of capital is dependent upon the size of the current balance sheet, expected members’ borrowing requirements and other forecasted balance sheet changes. As required by Finance Board regulation, the Bank’s Board of Directors is required to evaluate its capital requirements periodically and to make adjustments as warranted and as permitted under the Bank’s capital plan. The Bank’s Board utilizes the flexibility designed into the capital plan to provide what it deems to be the best overall capitalization profile to enhance stockholder value, consistent with the safe and sound operation of the Bank.

Prior to the implementation date of the Bank’s capital plan, the Bank operated under a “subscription” capital structure. Under that structure, a single class of capital stock was issued to members pursuant to a statutory formula. In accordance with that formula, each member was required to purchase stock in an amount equal to the greater of: (1) $500; (2) one percent of the mortgage loan principal on the member’s balance sheet; or (3) five percent of the Bank loans outstanding to the member. The stock was redeemable by members that sought to withdraw from Bank membership upon six months’ prior written notice to the Bank. Upon redemption, a member was entitled to receive the amount it originally paid for the stock.

The subscription capital structure did not prescribe specific minimum levels for the Banks. However, the Finance Board, by regulation, had required the Banks to comply with a leverage limit based on a ratio of each Bank’s assets to its capital. This requirement generally provided that a Bank’s total assets could not exceed 21 times total capital. A Bank whose non-mortgage assets, after deducting deposits and capital, did not exceed eleven percent of its total assets was permitted to operate under a higher leverage limit such that its total assets may be up to 25 times its total capital. This leverage limit ceased to apply to the Bank upon the implementation of its capital plan and the new capital requirements described below now apply to the Bank.

Dividends. Until the Bank’s registration statement with the SEC became effective on August 8, 2006, a dividend could be declared only following consultation with and approval by the Finance Board’s Office of Supervision. Beginning with the third quarter of 2006, all dividends declared need to be approved only by the Board of Directors. Dividends may be paid in either capital stock or cash; the Bank has historically paid cash dividends only.

Risk-Based Capital (RBC)

The Bank became subject to the Finance Board’s Risk-Based Capital (RBC) regulations upon implementation of its capital plan on December 16, 2002. This regulatory framework requires the Bank to maintain sufficient permanent capital, defined as retained earnings plus capital stock, to meet its combined credit risk, market risk and operational risk. Each of these components is computed as specified in directives issued by the Finance Board.


	December 31,		December 31,
(in thousands)	2006		2005


Permanent capital:
Capital stock⁽¹⁾	$	3,392,250	$	3,095,314
Retained earnings		254,777		188,479


Total permanent capital	$	3,647,027	$	3,283,793


Risk-based capital requirement:
Credit risk capital	$	191,810	$	179,986
Market risk capital		199,848		204,080
Operations risk capital		117,497		115,220


Total risk-based capital	$	509,155	$	499,286

Note:


⁽¹⁾		Capital stock includes mandatorily redeemable capital stock

The Bank held excess permanent capital over RBC requirements of $3.1 billion and $2.8 billion at December 31, 2006 and 2005, respectively.

Credit Risk Capital. The Bank’s credit risk capital requirement is determined by adding together the credit risk capital charges computed for assets, off-balance-sheet items, and derivative contracts based on the credit risk percentages assigned to each item as determined by the Finance Board.

Market Risk Capital. The Bank’s market risk capital requirement is determined by adding together the market value of the Bank’s portfolio at risk from movements in interest rates and the amount, if any, by which the Bank’s current market value of total capital is less than 85% of the Bank’s book value of total capital as of the measurement calculation date. The market value of the Bank’s capital has not declined below 85% of its book value since the inception of the RBC regulations. The Bank calculates the market value of its portfolio at risk and the current market value of its total capital by using an internal market risk model that has been examined and approved by the Finance Board and is also subject to annual independent validation.

The market risk component of the overall RBC framework is designed around a “stress test” approach. Simulations of several hundred historical market interest rate scenarios are generated and, under each scenario, the hypothetical beneficial/adverse effects on the Bank’s current market value of equity are determined. The hypothetical beneficial/adverse effect associated with each historical scenario is calculated by simulating the effect of each set of market conditions upon the Bank’s current risk position, which reflects current assets, liabilities, derivatives and off-balance-sheet commitment positions as of the measurement date.

From the resulting simulated scenarios, the most severe deterioration in market value of capital is identified as that scenario associated with a probability of occurrence of not more than 1% (i.e., a 99% confidence interval). The hypothetical deterioration in market value of equity in this scenario, derived under the methodology described above, represents the market value risk component of the Bank’s regulatory RBC requirement which, in conjunction with the credit risk and operations risk components, determines the Bank’s overall RBC requirement.

Operational Risk Capital. The Bank’s operational risk capital requirement is equal to 30% of the sum of its credit risk capital requirement and its market risk capital requirement, unless the Finance Board were to approve a request for a percentage reduction by the Bank. The Bank has not requested a reduction.

Capital and Leverage Ratios

In addition to the requirements for RBC, the Bank must maintain total regulatory capital and leverage ratios of at least 4.0% and 5.0% of total assets, respectively. Management has an ongoing program to measure and monitor compliance with the ratio requirements. As a matter of policy, the Board of Directors has established an operating range for capitalization that calls for the capital ratio to be maintained between 4.08% and 5.0%. To enhance overall returns, it has been the Bank’s practice to utilize as much leverage as permitted within this operating range when market conditions permit, while maintaining compliance with statutory, regulatory and Bank policy limits.


	December 31,			December 31,
(dollars in thousands)	2006			2005


Capital Ratio
Minimum capital (4.0% of total assets)	$	3,095,058		$	2,915,928
Actual capital (permanent capital plus loan loss reserves)		3,654,615			3,289,318
Total assets		77,376,458			72,898,211
Capital ratio (actual capital as a percent of total assets)		4.7	%		4.5	%
Leverage Ratio
Minimum leverage capital (5.0% of total assets)	$	3,868,823		$	3,644,911
Leverage capital (permanent capital multiplied by a 1.5 weighting factor plus loan loss reserves)		5,478,130			4,931,216
Leverage ratio (leverage capital as a percent of total assets)		7.1	%		6.8	%

The Bank’s capital ratio increased modestly from 4.5% at December 31, 2005, to 4.7% at December 31, 2006. Under the Bank’s capital plan, overall capital stock levels are tied to both the level of member borrowings and unused borrowing capacity as described above. Therefore, the Bank’s capital ratios often fluctuate in response to changes in member borrowing activity and unused capacity.

Management reviews, on a routine basis, projections of capital leverage that incorporate anticipated changes in assets, liabilities, and capital stock levels as a tool to manage overall balance sheet leverage within the Board’s operating range. In connection with this review, when management believes that adjustments to the current member stock purchase requirements within the ranges established in the capital plan are warranted, a recommendation is presented for Board consideration. The member stock purchase requirements have been adjusted several times since the implementation of the capital plan in December 2002, and management expects that future adjustments are likely in response to future changes in borrowing activity.

As of December 31, 2006 and 2005, excess capital stock available for repurchase at a member’s request and at the Bank’s discretion totaled $33.4 million and $85.0 million, respectively. It is the Bank’s current practice to promptly repurchase the excess capital stock of its members upon their request, except with respect to directors’ institutions during standard blackout periods. The Bank does not honor other repurchase requests which are capital stock required to meet a member’s minimum capital stock purchase requirement. Assuming the above amounts of excess stock had been repurchased as of the respective year ends, the resulting decrease in the capital and leverage ratios would have been immaterial.

Management believes that based on the Bank’s business profile, balance sheet composition and various potential economic scenarios, the current capital and leverage ratios are adequate to ensure the safe and sound operation of the Bank.

Critical Accounting Policies

The Bank’s consolidated financial statements are prepared in accordance with U.S. Generally Accepted Accounting Principles (GAAP). Application of these principles requires management to make estimates, assumptions or judgments that affect the amounts reported in the financial statements and accompanying notes. The use of estimates, assumptions and judgments is necessary when financial assets and liabilities are required to be recorded at, or adjusted to reflect, fair value. Assets and liabilities carried at fair value inherently result in more financial statement volatility. The fair values and the information used to record valuation adjustments for certain assets and

liabilities are based either on quoted market prices or are provided by other third-party sources, when available. When such information is not available, valuation adjustments are estimated in good faith by management, primarily through the use of internal cash flow and other financial modeling techniques.

The most significant accounting policies followed by the Bank are presented in Note 3 to the audited financial statements. These policies, along with the disclosures presented in the other financial statement notes and in this financial review, provide information on how significant assets and liabilities are valued in the financial statements and how those values are determined. Management views critical accounting policies to be those which are highly dependent on subjective or complex judgments, estimates or assumptions, and those for which changes in those estimates or assumptions could have a significant impact on the financial statements.

Loans to Members and Related Allowance for Credit Losses. At December 31, 2006, loans to members represented 63.8% of total assets. The Statement of Condition presents loans to members, net of unearned commitment fees and discounts. Amortization of such fees and discounts is calculated using the interest method and is reflected as a component of interest income. Since its establishment in 1932, the Bank has never experienced a loan loss on loans to members. Further, management does not anticipate loan losses on any loans currently outstanding to members. The Bank is required by statute to obtain sufficient collateral on member loans to protect against losses and to accept as collateral on member loans only certain United States government, Federal agency or GSE securities, residential mortgage loans, deposits in the Bank, and other real estate-related and Community Financial Institution assets. The Bank has historically had rights to collateral loans or securities on a member-by-member basis with an estimated fair value in excess of the outstanding loans of each individual borrower. Accordingly, there are no credit loss reserves for member loans.

Allowance for Credit Losses on Mortgage Loans Held for Portfolio. The Bank bases the allowance for credit losses on management’s estimate of loan losses inherent in the Bank’s mortgage loan portfolio as of the balance sheet date taking into consideration, among other things, the Bank’s exposure within the first loss account. The Bank performs periodic reviews of its portfolio to identify the losses inherent within the portfolio and to determine the likelihood of collection of the portfolio. The overall allowance is determined based on historical default rates and/or loss percentages for similar loans in the MPF program, loan portfolio characteristics, collateral valuations, industry data, and prevailing economic conditions. During 2005 the Bank changed its method of estimating the allowance for credit losses on its mortgage loans and separated the reserve for off-balance sheet credit exposures to an other liability account. The new method uses a probability and timing of loss analysis from market data on comparable loans. Refer to further discussion regarding the allowance for credit losses in Note 11 to the audited financial statements.

Allowance for Credit Losses on Banking on Business Loans. The allowance for credit losses for the Banking on Business (BOB) program is based on Small Business Administration (SBA) loan loss statistics, which provide a reasonable estimate of losses inherent in the BOB portfolio based on the portfolio’s characteristics. Both probability of default and loss given default are determined and used to estimate the allowance for credit losses. Loss given default is considered to be 100% due to the fact that the BOB program has no collateral or credit enhancement requirements. Refer to further discussion regarding the allowance for credit losses in Note 11 to the audited financial statements.

Accounting for Premiums and Discounts on Mortgage Loans and Mortgage-backed Securities. Typically, the Bank purchases mortgage loans and mortgage-backed securities (MBS) at amounts that are different than the contractual note amount. The difference between the purchase price and the contractual note amount establishes a premium or discount. The Bank also receives or incurs various mortgage related fees. Mortgage loans and MBS are reported on the Statement of Condition at their principal amount outstanding net of deferred loan fees and premiums or discounts. Bank policy requires the amortization or accretion of these premiums or discounts to interest income occur using the contractual method, which produces a constant effective yield over the contractual life, which represents the stated maturity. Management prefers the contractual method to maturity because the income effects of the amortization or accretion are recognized in a manner that reflects the actual behavior of the underlying assets during the period in which the behavior occurs. Also, this method tracks the contractual terms of the assets without regard to changes in estimates based on assumptions about future borrower behavior.

Guarantees and Consolidated Obligations. The Bank is jointly and severally liable for the payment of all the consolidated obligations of the entire FHLBank System. Accordingly, if one or more of the FHLBanks were unable to repay its direct participation in the consolidated obligations, each of the other FHLBanks could be called upon to repay all or part of those obligations, as approved or directed by the Finance Board. The Bank does not recognize a liability for its joint and several obligations related to consolidated obligations issued for other FHLBanks. The Bank records on its Statement of Condition a liability for consolidated obligations associated only with the proceeds it receives from the issuance of those consolidated obligations.

The Bank recognizes at the inception of a guarantee, a liability for the fair value of the obligations it has undertaken in issuing the guarantee, namely the ongoing obligation to stand ready to perform over the term of the guarantee. No liability is recorded, however, for the joint and several obligation related to the other FHLBanks’ consolidated obligations due to the high-credit quality of each FHLBank and the remote possibility that the other FHLBanks would be unable to repay their respective participations.

Accounting for Derivatives. The Bank regularly uses derivative instruments as part of its risk management activities to protect the value of certain assets, liabilities and future cash flows against adverse interest rate movements. The valuation and accounting assumptions related to derivatives are considered critical because management must make estimates based on judgments and assumptions that can significantly affect financial statement presentation.

Derivative instruments are presented on the Statement of Condition at fair value. Any change in the fair value of a derivative is required to be reflected in current period earnings or other comprehensive income, regardless of how fair value changes in the assets or liabilities being hedged may be treated. This accounting treatment can cause significant volatility in reported net income from period to period.

Generally, the Bank strives to use derivatives when doing so is likely to provide a cost-effective means to mitigate the interest rate risk inherent in its business. The most common objectives of hedging with derivatives include: (1) preserving an interest spread between the yield of an asset and the cost of a supporting liability of mismatched maturity; (2) mitigating the adverse earnings effects resulting from the potential prepayment or extension of certain assets and liabilities; and (3) protecting the value of existing asset or liability positions or of anticipated transactions. Much of the Bank’s hedging activity is directed toward reducing interest rate risk and basis risk from loans and supporting debt. Through the use of structured debt, low-cost funding is created, which is used primarily to provide more attractively priced loans to the Bank’s members. Derivatives are also used to create loans with specialized embedded pricing features, customized to meet individual member funding needs and/or to reduce member borrowing costs.

The Bank’s policy remains consistent with Finance Board regulation which is to use derivative instruments only to reduce the market risk exposures inherent in the otherwise unhedged asset and funding positions of the Bank. When doing so represents the most cost-efficient strategy and can be achieved while minimizing adverse earnings effects, management intends to continue utilizing derivative instruments as a means to reduce the Bank’s exposure to changes in market interest rates. See Notes 3 and 16 to the audited financial statements for further discussion.

Future REFCORP Payments. The Bank’s financial statements do not include a liability for the Bank’s statutorily mandated future REFCORP payments. In the aggregate, the FHLBanks are required to fund a $300 million annual annuity whose final maturity date is April 15, 2030. The ultimate liability of the Bank is dependent on its own profitability and that of the other FHLBanks. The Bank pays 20% of its net earnings (after its AHP obligation) to support the payment of part of the interest on the bonds issued by REFCORP and, as such, the Bank is unable to estimate reasonably its future payments as would be required to recognize this future obligation as a liability on its Statement of Condition. Accordingly, the Bank discloses the REFCORP obligation as a long-term statutory payment requirement and treats it in a manner similar to the typical treatment of income tax expense for accounting purposes under GAAP, by recording it as an expense in the period in which the related net earnings are accrued. Further discussion is provided in Note 18 to the audited financial statements.

Fair Value Calculations and Methodologies. Certain of the Bank’s assets and liabilities, including all derivatives, are presented in the Statement of Condition at fair value. Under GAAP, the fair value of an asset or

liability is the price at which that asset could be bought or sold in a current transaction between willing parties, other than in liquidation. Fair values play an important role in the valuation of certain of the Bank’s assets, liabilities and hedging strategies. Fair values are based on market prices when they are available. If market quotes are not available, fair values are based on discounted cash flows using market estimates of interest rates and volatility, or on dealer prices and prices of similar instruments or observed prices in actual transactions. Generally, pricing models and their underlying assumptions are based on estimates obtained from qualified independent sources for discount rates, prepayment estimates, market volatility and other factors. These assumptions may have a significant effect on the reported fair values of assets and liabilities, including derivatives, and the related income and expense. The use of different models and assumptions, as well as changes in market conditions, can result in materially different amounts of net income and retained earnings.

There are no available market prices for the Bank’s loans to members, which currently have a carrying value of $49,335 million and an overall calculated fair value of $49,310 million. The Bank’s loans to members cannot be openly traded in the market place, since they are strictly an agreement between the Bank and its members. The Bank therefore uses its own internal modeling system to value these loans for accounting purposes.

Recently Issued Accounting Standards and Interpretations. See Note 4 to the audited financial statements for a discussion of recent accounting pronouncements that are relevant to the Bank’s businesses.

Risk Management

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Risk Governance

The Bank’s lending, investment, and funding activities and use of derivative hedging instruments expose the Bank to a number of risks, including the following: market and interest rate risk, credit risk, liquidity and funding risk and operating and business risk.

The Bank’s Board of Directors and its committees have adopted a comprehensive risk governance structure to oversee the risk management process and manage the Bank’s risk exposures. The Finance and Risk Management Committee of the Board has responsibility to focus on balance sheet management and all risk management issues. The Audit Committee has responsibility for monitoring certain operating and business risks. The Finance and Risk Management Committee is informed by regular and comprehensive reports covering all significant risk types. The Audit Committee receives regular reports on control issues of significance and quarterly allowance for credit loss reports. Both Committees also receive reports and training dealing in more depth with specific risk issues relevant at the time. Additionally, the Bank conducts an annual bank-wide risk self-assessment which is reviewed and approved by the full Board of Directors.

The Board of Directors sets the risk appetite and risk limits for the Bank, which are reviewed and approved at least annually. The size of the risk limits reflects the Bank’s risk appetite given the market environment, the business strategy and the financial resources available to absorb losses. Risk limit breaches are reported in a timely manner to the Board and senior management and the affected business unit must take appropriate action to reduce affected positions.

The risk governance structure also includes a body of risk management policies approved by the Board of Directors. These policies together with subordinate risk management Bank policies and procedures are reviewed on an ongoing basis to ensure that they provide effective and superior governance of the Bank’s risk-taking activities. Further, Internal Audit provides an internal assessment of the Bank’s management and internal control systems. Internal Audit activities are designed to provide reasonable assurance that resources are adequately protected; significant financial, managerial and operating information is materially complete, accurate and reliable; and employees’ actions are in compliance with Bank policies, procedures and applicable laws and regulations. Additionally, the Finance Board conducts an annual onsite examination of the Bank, as well as periodic offsite evaluations, and also requires the Bank to submit periodic compliance reports.

In order to provide effective oversight for risk management strategies, policies and action plans, the Bank has created a formal review and reporting structure implemented by three ri