10-K 1 fhlb12311110k.htm FORM 10-K FHLB 123111 10K
 
 
 
 
 

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
 
 
 
x
 
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
 
For the fiscal year ended December 31, 2011
OR
 
o
 
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
 
Commission File Number: 000-51999
 

FEDERAL HOME LOAN BANK OF DES MOINES
(Exact name of registrant as specified in its charter)
 
Federally chartered corporation
(State or other jurisdiction of incorporation or organization)
 
42-6000149
(I.R.S. employer identification number)
 
 
 
 
 
 
 
Skywalk Level
801 Walnut Street, Suite 200
Des Moines, IA
(Address of principal executive offices)
 


50309
(Zip code)
 

Registrant's telephone number, including area code: (515) 281-1000
 

Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act: Class B Stock, par value $100
Name of Each Exchange on Which Registered: None

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. o Yes x 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 x 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. x Yes o No
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (section 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). x Yes o No
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (section 229.405 of this chapter) is not contained herein, and will not be contained, to the best of the registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment of this Form 10-K. x
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of large accelerated filer, accelerated filer and smaller reporting company in Rule 12b-2 of the Exchange Act.
Large accelerated filer o
 
Accelerated filer o
 
Non-accelerated filer x
 
Smaller reporting company o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). o Yes x No
Registrant's stock is not publicly traded and is only issued to members of the registrant. Such stock is issued and redeemed at par value, $100 per share, subject to certain regulatory and statutory limits. At June 30, 2011, the aggregate par value of the stock held by current and former members of the registrant was approximately $2,146,317,000. At February 29, 2012, 20,707,458 shares of stock were outstanding.




TABLE OF CONTENTS
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 


2


SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS

Statements contained in this annual report on Form 10-K, including statements describing the objectives, projections, estimates, or future predictions in our operations, may be forward-looking statements. These statements may be identified by the use of forward-looking terminology, such as believes, projects, expects, anticipates, estimates, intends, strategy, plan, could, should, may, and will or their negatives or other variations on these terms. By their nature, forward-looking statements involve risk or uncertainty, and actual results could differ materially from those expressed or implied or could affect the extent to which a particular objective, projection, estimate, or prediction is realized. These risks and uncertainties include, but are not limited to, the following:

political events, including legislative, regulatory, judicial, or other developments that affect us, our members, our counterparties, and/or our investors in the consolidated obligations of the 12 Federal Home Loan Banks (FHLBanks);

competitive forces, including without limitation, other sources of funding available to our borrowers that could impact the demand for our advances, other entities purchasing mortgage loans in the secondary mortgage market, and other entities borrowing funds in the capital markets;

risks related to the other 11 FHLBanks that could trigger our joint and several liability for debt issued on behalf of the other 11 FHLBanks;

changes in the relative attractiveness of consolidated obligations due to actual or perceived changes in the FHLBanks' credit ratings as well as the U.S. Government's long-term credit rating;

the U.S. Government's response to the deficit;

the volatility of credit quality, market prices, interest rates, and other indices that could affect the value of collateral held by us as security for borrower and counterparty obligations;

general economic and market conditions that could impact the volume of business we do with our members, including, but not limited to, the timing and volatility of market activity, inflation/deflation, employment rates, housing prices, the condition of the mortgage and housing markets on our mortgage-related assets, including the level of mortgage prepayments, and the condition of the capital markets on our consolidated obligations;

the availability of derivative instruments in the types and quantities needed for risk management purposes from acceptable counterparties;

increases in delinquency and loss severity on mortgage loans;

member failures, mergers, and consolidations;

the volatility of reported results due to changes in the fair value of certain assets, liabilities, and derivative instruments;

changes in our capital structure and capital requirements;

the ability to develop and support technology and information systems that effectively manage the risks we face; and

the ability to attract and retain key personnel.

We undertake no obligation to update or revise publicly any forward-looking statements, whether as a result of new information, future events, or otherwise. A detailed discussion of the more important risks and uncertainties that could cause actual results and events to differ from such forward-looking statements is included under “Item 1A. Risk Factors."


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PART I

ITEM 1. BUSINESS
OVERVIEW
The Federal Home Loan Bank of Des Moines (the Bank, we, us, or our) is a federally chartered corporation organized on October 31, 1932, that is exempt from all federal, state, and local taxation (except real property taxes) and is one of 12 district FHLBanks. The FHLBanks were created under the authority of the Federal Home Loan Bank Act of 1932 (FHLBank Act). With the passage of the Housing and Economic Recovery Act of 2008 (Housing Act), the Federal Housing Finance Agency (Finance Agency) was established and became the new independent federal regulator of Federal National Mortgage Association (Fannie Mae) and Federal Home Loan Mortgage Corporation (Freddie Mac) (collectively, Enterprises), as well as the FHLBanks and FHLBank's Office of Finance (Office of Finance), effective July 30, 2008. The Finance Agency's mission is to provide effective supervision, regulation, and housing mission oversight of the Enterprises and FHLBanks to promote their safety and soundness, support housing finance and affordable housing, and support a stable and liquid mortgage market. The Finance Agency establishes policies and regulations governing the operations of the Enterprises and FHLBanks. Each FHLBank operates as a separate entity with its own management, employees, and board of directors.
We are a cooperative. This means we are owned by our customers, whom we call members. Our members may include commercial banks, thrifts, credit unions, insurance companies, and community development financial institutions in Iowa, Minnesota, Missouri, North Dakota, and South Dakota. While not considered members, we also do business with state and local housing associates meeting certain statutory criteria.
BUSINESS MODEL
Our mission is to provide funding and liquidity to our members and housing associates so that they can meet the housing, economic development, and business needs of the communities they serve. We strive to achieve our mission within an operating principle that balances the trade-off between attractively priced products, reasonable returns on capital investments, and maintaining adequate capital and retained earnings to support safe and sound business operations.
We are capitalized primarily through the purchase of capital stock by our members. As a condition of membership, all of our members must purchase and maintain membership capital stock based on a percentage of their total assets as of the preceding December 31st subject to a cap of $10.0 million and a floor of $10,000. Each member is also required to purchase and maintain activity-based capital stock to support certain business activities with us. Member demand for our products expands and contracts with economic and market conditions. Our self-capitalizing capital structure, which allows us to repurchase or require additional capital stock based on member activity, provides us with the flexibility to effectively and efficiently meet the changing needs of our membership. While eligible to borrow, housing associates are not members and, as such, are not permitted to purchase capital stock.
Our capital stock is not publicly traded. It is purchased and redeemed by members or repurchased by us at a par value of $100 per share. Our current members own nearly all of our outstanding capital stock. Former members own the remaining capital stock to support business transactions still carried on our Statements of Condition. All stockholders, including current and former members, may receive dividends on their investment to the extent declared by our Board of Directors.
Our primary business activities are providing collateralized loans, known as advances, to members and housing associates, and acquiring residential mortgage loans from or through our members. Our primary source of funding and liquidity is the issuance of debt securities, referred to as consolidated obligations, in the capital markets. Consolidated obligations are the joint and several obligations of all FHLBanks and are backed only by the financial resources of the FHLBanks. A critical component to the success of our operations is the ability to issue consolidated obligations regularly in the capital markets under a wide range of maturities, structures, and amounts, and at relatively favorable spreads to market interest rates.
Our net income is primarily attributable to the difference between the interest income we earn on our advances, mortgage loans, and investments, and the interest expense we pay on our consolidated obligations and member deposits, as well as components of other (loss) income (e.g., gains and losses on derivatives and hedging activities). Because we are a cooperative, we operate with narrow margins and expect to be profitable over the long-term based on our prudent lending standards, conservative investment strategies, and diligent risk management practices. Because we operate with narrow margins, our net income is sensitive to changes in market conditions that can impact the interest we earn and pay and introduce volatility in other (loss) income.

4


A portion of our annual net income is used to fund our Affordable Housing Program (AHP), which provides grants and subsidized advances to members to support housing for very low to moderate income households. By regulation, we are required to contribute ten percent of our net earnings each year to the AHP. For purposes of the AHP assessment, net earnings is defined as net income before assessments, plus interest expense related to mandatorily redeemable capital stock, less the assessment for Resolution Funding Corporation (REFCORP), if applicable. For additional details on our AHP, refer to the "Assessments" section of this Item 1.
We manage our credit risk and establish collateral requirements to support safe and sound business operations. We manage credit risk on our advance products by obtaining and maintaining security interests in eligible collateral, setting restrictions on borrowings, and performing continuous monitoring of borrowings and members’ financial condition. We manage credit risk on our mortgage loan portfolio by monitoring portfolio performance and the creditworthiness of our participating financial institutions (PFIs). All loans we purchase must comply with underwriting guidelines which follow standards generally required in the conventional conforming mortgage market. The Mortgage Partnership Finance (MPF) program (Mortgage Partnership Finance and MPF are registered trademarks of the FHLBank of Chicago) involves several layers of legal loss protection including homeowner equity, mortgage insurance requirements, and credit sharing responsibilities between us and our PFIs. We manage credit risk on derivatives and investments by transacting with highly rated counterparties, using master netting and bilateral collateral agreements for derivative counterparties, establishing collateral delivery requirements, and monitoring counterparty creditworthiness through internal and external analyses.

Due to our conservative collateral practices, counterparty monitoring, and risk mitigation tools, we did not experience any credit losses during 2011 on our advance products, derivatives, or investments, and despite the current mortgage market environment, experienced only minimal credit losses on our mortgage loan portfolio. To the extent we are unable to secure the obligations of borrowers and counterparties in the future, our lending, investing, and hedging activities could decrease, negatively impacting our financial condition and results of operations.

MEMBERSHIP
Our membership is diverse and includes both small and large commercial banks, thrifts, credit unions, insurance companies, and community development financial institutions. The majority of institutions in our five-state district that are eligible for membership are currently members.
The following table summarizes our membership, by type of institution, at December 31, 2011, 2010, and 2009:
Institutional Entity
 
2011
 
2010
 
2009
Commercial banks
 
1,005

 
1,029

 
1,049

Thrifts
 
69

 
73

 
73

Credit unions
 
92

 
71

 
64

Insurance companies
 
48

 
46

 
40

Community development financial institutions
 
1

 

 

Total
 
1,215

 
1,219

 
1,226


The following table summarizes our membership, by asset size, at December 31, 2011, 2010, and 2009:
Membership Asset Size
 
2011
 
2010
 
2009
Depository institutions1
 
 
 
 
 
 
Less than $100 million
 
42.5
%
 
43.3
%
 
44.5
%
$100 million to $500 million
 
42.6

 
42.5

 
41.8

Greater than $500 million
 
10.9

 
10.4

 
10.5

Insurance companies
 

 
 
 
 
Less than $100 million
 
0.4

 
0.4

 
0.2

$100 million to $500 million
 
0.8

 
0.8

 
0.7

Greater than $500 million
 
2.7

 
2.6

 
2.3

Community development financial institutions
 
 
 
 
 
 
Less than $100 million
 
0.1

 

 

Total
 
100.0
%
 
100.0
%
 
100.0
%
1
Depository institutions consist of commercial banks, thrifts, and credit unions.


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Our membership level declined during 2011 primarily due to four bank failures and 29 mergers or consolidations, partially offset by 31 new members. At December 31, 2011, approximately 85 percent of our members were Community Financial Institutions (CFIs). CFIs are defined under the Housing Act to include all Federal Deposit Insurance Corporation (FDIC) insured institutions with average total assets over the previous three-year period of less than $1.040 billion, as adjusted annually for inflation. CFIs are eligible to pledge certain collateral types that non-CFIs cannot pledge, including small business, small agri-business, and small farm loans.

BUSINESS SEGMENTS
We manage our operations as one business segment. Management and our Board of Directors review enterprise-wide financial information in order to make operating decisions and assess performance.
PRODUCTS AND SERVICES
Advances
We carry out our mission primarily through lending funds, which we call advances, to our members and eligible housing associates (collectively, borrowers). Our advance products are designed to help borrowers compete effectively in their markets and meet the credit needs of their communities. Borrowers generally use our advance products as sources of wholesale funding for mortgage lending, affordable housing and other community lending (including economic development), and general asset-liability management. As of December 31, 2011, 2010, and 2009, approximately 62 percent, 68 percent, and 73 percent of our members had outstanding advances.
Our advance products include the following:

Overnight Advances. These advances are used primarily to fund the short-term liquidity needs of our borrowers and are renewed automatically until the borrower pays off the advance. Interest rates are set daily.

Fixed Rate Advances. These advances are used to fund both the short- and long-term liquidity needs of our borrowers and are available over a variety of terms.
 
Variable Rate Advances. These advances have interest rates that reset periodically to a specified interest rate index such as London Interbank Offered Rate (LIBOR) and are used to fund both the short- and long-term liquidity needs of our borrowers. Capped LIBOR advances are a type of variable rate advance in which the interest rate cannot exceed a specified maximum interest rate.

Callable Advances. These advances may be prepaid by borrowers on pertinent dates (call dates) and therefore provide borrowers a source of long-term financing with prepayment flexibility. Amortizing advances are a type of callable advance with fixed rates and amortizing balances. Using an amortizing advance, a borrower may make predetermined principal payments at scheduled intervals throughout the term of the advance to manage the interest rate risk associated with long-term fixed rate amortizing assets. Also included in callable advances are fixed and variable rate member-owned option advances that are non-amortizing.

Putable Advances. These advances may, at our discretion, be terminated on predetermined dates prior to the stated maturity of the advances, requiring the borrower to repay the advance. Should an advance be terminated, replacement funding at the prevailing market rates and terms will be offered, based on our available advance products and subject to our normal credit and collateral requirements. A putable advance carries an interest rate lower than a comparable maturity advance that does not have the putable feature.

Community Investment Advances. These advances are below-market rate funds used by borrowers in both affordable housing projects and community development. Interest rates on these advances represent our cost of funds plus a mark-up to cover our administrative expenses. This mark-up is determined by our Asset-Liability Committee. On an annual basis, our Board of Directors establishes limits on the total amount of funds available for community investment advances.
For additional information on our advances, including our top five borrowers, see “Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations — Statements of Condition — Advances.”

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COLLATERAL
We are required by regulation to obtain and maintain a security interest in eligible collateral at the time we originate or renew an advance and throughout the life of the advance to ensure a fully collateralized position. Eligible collateral includes (i) whole first mortgages on improved residential real property or securities representing a whole interest in such mortgages, (ii) loans and securities issued, insured, or guaranteed by the U.S. Government or any agency thereof, including mortgage-backed securities (MBS) issued or guaranteed by Fannie Mae, Freddie Mac, or Government National Mortgage Association (Ginnie Mae) and Federal Family Education Loan Program guaranteed student loans, (iii) cash deposited with us, and (iv) other real estate-related collateral acceptable to us provided such collateral has a readily ascertainable value and we can perfect a security interest in such property. CFIs may also pledge collateral consisting of secured small business, small agri-business, or small farm loans. As additional security, the FHLBank Act provides that we have a lien on each member's capital stock investment; however, capital stock cannot be pledged as collateral to secure credit exposures.
Our hierarchy of pledged assets is to have the borrower execute a blanket lien, specifically assign the collateral, or place physical possession of the collateral with us or our safekeeping agent. We perfect our security interest in all pledged collateral by filing Uniform Commercial Code financing statements or taking physical possession of the collateral. Under the FHLBank Act, any security interest granted to us by our members, or any affiliates of our members, has priority over the claims and rights of any party (including any receiver, conservator, trustee, or similar party having rights of a lien creditor), unless those claims and rights would be entitled to priority under otherwise applicable law and are held by actual purchasers or by parties that have perfected security interests.
Under a blanket lien, we are granted a security interest in all financial assets of the borrower to fully secure the borrower's indebtedness to us. Other than securities and cash deposits, we do not initially take delivery of collateral pledged by blanket lien borrowers. In the event of deterioration in the financial condition of a blanket lien borrower, we have the ability to require delivery of pledged collateral sufficient to secure the borrower's indebtedness to us. With respect to non-blanket lien borrowers (typically insurance companies and housing associates), we generally take control of collateral through the delivery of cash, securities, or mortgages to us or our safekeeping agent.
For additional information on our collateral requirements, refer to “Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations — Risk Management — Credit Risk — Advances.”
HOUSING ASSOCIATES
The FHLBank Act permits us to make advances to eligible housing associates. Housing associates are approved mortgagees under Title II of the National Housing Act that meet certain criteria, including: (i) chartered under law and have succession, (ii) subject to inspection and supervision by some governmental agency, and (iii) lend their own funds as their principal activity in the mortgage field. The same regulatory lending requirements that apply to our members generally apply to housing associates. Because housing associates are not members, they are not subject to certain provisions of the FHLBank Act applicable to members and cannot own our capital stock. In addition, they may only pledge certain types of collateral including: (i) Federal Housing Administration (FHA) mortgages, (ii) Ginnie Mae securities backed by FHA mortgages, (iii) certain residential mortgage loans, and (iv) cash deposited with us.
PREPAYMENT FEES
Advances are subject to a prepayment fee if terminated prior to their stated maturity or outside of a predetermined call or put date. The fees charged are priced to make us financially indifferent to the prepayment of the advance.
Standby Letters of Credit
We issue standby letters of credit on behalf of our members, certain other FHLBank members (through a master participation agreement), and housing associates to facilitate business transactions with third parties. Letters of credit may be used to facilitate residential housing finance and community lending, assist with asset-liability management, and provide liquidity or other funding. Standby letters of credit must be fully collateralized with eligible collateral.
Mortgage Loans
We invest in mortgage loans through the MPF program, a secondary mortgage market structure developed by the FHLBank of Chicago to help fulfill the housing mission of the FHLBanks. Under the MPF program, we purchase or fund eligible mortgage loans (MPF loans) from or through PFIs. We may also acquire MPF loans through participations with other FHLBanks. MPF loans are conforming conventional or government-insured fixed rate mortgage loans secured by one-to-four family residential properties with maturities ranging from five to 30 years.

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MPF PROVIDER
The FHLBank of Chicago serves as the MPF Provider for the MPF program. In its role as MPF Provider, the FHLBank of Chicago provides the infrastructure and operational support for the MPF program and is responsible for publishing and maintaining the MPF Guides, which detail the requirements PFIs must follow in originating, selling, and servicing MPF loans. The MPF Provider is also responsible for establishing the base price of MPF loan products utilizing the agreed upon methodologies determined by the participating MPF FHLBanks. In exchange for providing these services, the MPF Provider receives a fee from each of the FHLBanks participating in the MPF program. The MPF Provider has engaged Wells Fargo Bank N.A. (Wells Fargo) as the master servicer for the MPF program.
MPF GOVERNANCE COMMITTEE
The MPF program Governance Committee, which is comprised of representatives from each of the FHLBanks participating in the MPF program, is responsible for implementing strategic MPF program decisions, including, but not limited to, pricing methodology changes.

Effective March 28, 2011, based on a decision of the MPF Governance Committee, participating MPF FHLBanks are now allowed to adjust the base price of MPF loan products established by the FHLBank of Chicago. As a result, beginning in the second quarter of 2011, we began to monitor daily market conditions and make price adjustments to our MPF loan products when necessary.
PARTICIPATING FINANCIAL INSTITUTIONS
Our members and eligible housing associates must apply to become a PFI. In order to do MPF business with us, each member or eligible housing associate must meet certain eligibility standards and sign a PFI Agreement. The PFI Agreement provides the terms and conditions for the sale or funding of MPF loans, including the servicing of MPF loans.
PFIs may either retain the servicing of MPF loans or sell the servicing to an approved third-party provider. If a PFI chooses to retain the servicing, it receives a servicing fee to manage the servicing activities. If a PFI chooses to sell the servicing rights to an approved third-party provider, the servicing is transferred concurrently with the sale of the MPF loans and a servicing fee is paid to the third-party provider. Throughout the servicing process, the master servicer monitors the PFI's compliance with MPF program requirements and makes periodic reports to the MPF Provider.
MPF LOAN TYPES
There are six MPF loan products under the MPF program: Original MPF, MPF 100, MPF 125, MPF Plus, MPF Government and MPF Xtra (MPF Xtra is a trademark of the FHLBank of Chicago). While still held in our Statements of Condition, we currently do not offer the MPF 100 or MPF Plus loan products. The discussion below outlines characteristics of our MPF loans products.
Original MPF, MPF 125, MPF Plus, and MPF Government are closed loan products in which we purchase loans acquired or closed by the PFI. MPF 100 is a loan product in which we "table fund" MPF loans; that is, we provide the funds through the PFI as our agent to make the MPF loan to the borrower. MPF Xtra is an off-balance sheet loan product in which we assign 100 percent of our interest in PFI master commitments to the FHLBank of Chicago. The FHLBank of Chicago then purchases mortgage loans from our PFIs and sells those loans to Fannie Mae. We receive a small fee for our continued management of the PFI relationship under MPF Xtra.
The PFI performs all traditional retail loan origination functions on our MPF loan products. With respect to the MPF 100 loan product, we are considered the originator of the MPF loan for accounting purposes since the PFI is acting as our agent when originating the MPF loan; however, we do not collect any origination fees.
We are responsible for managing the interest rate risk, including prepayment risk, and liquidity risk associated with the MPF loans we purchase and carry on our Statements of Condition. In order to limit our credit risk exposure to that of an investor in an MBS that is rated the equivalent of AA by a nationally recognized statistical rating organization (NRSRO), we require a credit risk sharing arrangement with the PFI on all MPF loans at the time of purchase.
For additional discussion on our mortgage loans and their related credit risk, refer to “Item 8. Financial Statements and Supplementary Data — Note 11 — Allowance for Credit Losses” and “Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations — Risk Management — Credit Risk — Mortgage Assets.”

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LOAN MODIFICATIONS
Effective August 1, 2009, we introduced a temporary loan payment modification plan for participating PFIs, with a scheduled expiration date of December 31, 2011. Homeowners in default or imminent danger of default with conventional loans secured by their primary residence and originated prior to January 1, 2009 were eligible for the plan. On December 13, 2011, we extended the modification plan until December 31, 2013. Homeowners in default or imminent danger of default with conventional loans secured by their primary residence, regardless of loan origination date, are now eligible for the plan. At December 31, 2011, seven modified loans totaling $1.3 million were outstanding in our Statements of Condition.
Investments
We maintain an investment portfolio to provide investment income and liquidity, support the business needs of our members, and support the housing market through the purchase of mortgage-related assets. Our investment portfolio is comprised of both short- and long-term investments. Our short-term investments may include, but are not limited to, interest-bearing deposits, Federal funds sold, securities purchased under agreements to resell, negotiable certificates of deposit, and commercial paper. Our long-term investments may include, but are not limited to, other U.S. obligations, government-sponsored enterprise (GSE) obligations, state or local housing agency obligations, Temporary Liquidity Guarantee Program (TLGP) debentures, taxable municipal bonds, and MBS. Our long-term investments generally provide higher returns than our short-term investments.
We do not have any subsidiaries. With the exception of a limited partnership interest in a Small Business Investment Company (SBIC), we have no equity position in any partnerships, corporations, or off-balance sheet special purpose entities. We limit new investments in MBS to those guaranteed by the U.S. Government, issued by a GSE, or that carry the highest investment grade rating by an NRSRO at the time of purchase. Our Enterprise Risk Management Policy (ERMP) prohibits new purchases of private-label MBS.
The Finance Agency also prohibits us from investing in certain types of securities, including:

instruments that provide an ownership interest in an entity, other than stock in an SBIC and certain investments targeted at low-income persons or communities;

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

non-investment grade debt instruments, other than certain investments targeted at low-income persons or communities and instruments that were downgraded to a below investment grade after acquisition;

whole mortgages or other whole loans, or interests in mortgages or loans, other than: (i) those acquired under the FHLBank mortgage purchase programs; (ii) certain investments targeted at low-income persons or communities; (iii) certain marketable direct obligations of state, local, or tribal government units or agencies, having at least the second highest credit rating from an NRSRO; (iv) MBS or asset-backed securities collateralized by manufactured housing loans or home equity loans; and (v) certain foreign housing loans authorized under the FHLBank Act;

non-U.S. dollar denominated securities;

interest-only or principal-only stripped MBS;

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

fixed or variable rate MBS that, on 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 Finance Agency further limits our investments in MBS by requiring that the total book value of our MBS not exceed three times regulatory capital at the time of purchase. On March 24, 2008, the Finance Agency gave temporary authorization for the FHLBanks to increase their purchases of MBS from three times regulatory capital to six times regulatory capital through March 31, 2010. After March 31, 2010, our purchase limit for MBS returned to three times regulatory capital. For details on our compliance with this regulatory requirement, refer to “Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations — Statements of Condition — Investments.”

9


Standby Bond Purchase Agreements
We enter into standby bond purchase agreements with housing associates within our district whereby, for a fee, we agree to serve as a liquidity provider if required, to purchase and hold the housing associate's bonds until the designated marketing agent can find a suitable investor or the housing associate repurchases the bonds according to a schedule established by the agreement. Each standby bond purchase agreement dictates the specific terms that would require us to purchase the bonds. If purchased, the bonds would be classified as available-for-sale (AFS) securities in our Statements of Condition. For additional details on our standby bond purchase agreements, refer to “Item 8. Financial Statements and Supplementary Data — Note 20 — Commitments and Contingencies.”
Deposits
We accept deposits from our members and eligible housing associates. We offer several types of deposit programs, including demand, overnight, and term deposits. Deposit programs provide us funding while providing members a low-risk interest-earning asset.
Consolidated Obligations
Our primary source of funding and liquidity is the issuance of debt securities, referred to as consolidated obligations, in the capital markets. Consolidated obligations (bonds and discount notes) are the joint and several obligations of all 12 FHLBanks and are backed only by the financial resources of the 12 FHLBanks. They are not obligations of the U.S. Government, and the U.S. Government does not guarantee them. At February 29, 2012, Standard & Poor's Ratings Services (S&P) and Moody's Investors Service, Inc. (Moody's) rated the consolidated obligations AA+/A-1+ and Aaa/P-1.
The Office of Finance issues all consolidated obligations on behalf of the 12 FHLBanks. It is also responsible for servicing all outstanding debt, coordinating transfers of debt between the FHLBanks, serving as a source of information for the FHLBanks on capital market developments, managing the FHLBank System's relationship with the rating agencies with respect to consolidated obligations, and preparing and making available the FHLBank System's Combined Financial Reports.
Although we are primarily responsible for the portion of consolidated obligations issued on our behalf, we are also jointly and severally liable with the other 11 FHLBanks for the payment of principal and interest on all consolidated obligations. The Finance Agency, at its discretion, may require any FHLBank to make principal and/or interest payments due on any consolidated obligation, whether or not the primary obligor FHLBank has defaulted on the payment of that consolidated obligation. The Finance Agency has never exercised this discretionary authority.
To the extent that an FHLBank makes any payment on a consolidated obligation on behalf of another FHLBank, the paying FHLBank is entitled to reimbursement from the FHLBank otherwise responsible for the payment. However, if the Finance Agency determines that an FHLBank is unable to satisfy its obligations, then it may allocate the outstanding liability among the remaining FHLBanks on a pro-rata basis in proportion to each FHLBank’s participation in all consolidated obligations outstanding, or on any other basis that it may determine.

The Finance Agency also requires each FHLBank to maintain unpledged qualifying assets, as defined by regulation, in an amount at least equal to the amount of that FHLBank’s participation in the total consolidated obligations outstanding. For details on our compliance with this regulatory requirement, refer to “Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations — Liquidity and Capital Resources — Liquidity Requirements.”

BONDS
Bonds are generally issued to satisfy our intermediate- and long-term funding needs. Typically, they have maturities ranging up to 30 years, although there is no statutory or regulatory limitation as to their maturity. Periodically, index amortizing notes may be issued that pay down consistent with a specified reference pool of mortgages determined at issuance and have a final stated maturity of up to 15 years. Bonds are issued with either fixed or variable rate payment terms that use a variety of indices for interest rate resets including, but not limited to, LIBOR, Constant Maturity Treasury, and the Federal funds rate. To meet the specific needs of certain investors, both fixed and variable rate bonds may also contain certain embedded features, which result in complex coupon payment terms and call features. When bonds are issued on our behalf, we may concurrently enter into a derivative agreement to effectively convert the fixed rate payment stream to variable or to offset the embedded features in the bond.
Depending on the amount and type of funding needed, bonds may be issued through negotiated or competitively bid transactions with approved underwriters or selling group members (i.e., TAP Issue Program, callable auction, and Global Debt Program), or through debt transfers between FHLBanks.

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The TAP Issue Program is used to issue fixed rate, noncallable bonds with standard maturities of two, three, five, seven, or ten years. The goal of the TAP Issue Program is to aggregate frequent smaller bond issues into a larger bond issue that may have greater market liquidity.
A callable auction process is used to issue fixed rate, callable bonds. Auction structures are determined by the FHLBanks in consultation with the Office of Finance and the securities dealer community. We may receive zero to 100 percent of the proceeds of the bonds issued via the callable auction depending on (i) the amounts and costs for the bonds bid by underwriters, (ii) the maximum costs we or other FHLBanks participating in the same issue, if any, are willing to pay for the obligations, and (iii) the guidelines for allocation of bond proceeds among multiple participating FHLBanks administered by the Office of Finance.
The Global Debt Program allows the FHLBanks to diversify their funding sources to include overseas investors. Global Debt Program bonds may be issued in maturities ranging up to 30 years and can be customized with different terms and currencies. FHLBanks participating in the Global Debt Program approve the terms of the individual issues.
For additional information on our bonds, see “Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations — Statements of Condition — Consolidated Obligations” and “Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations — Liquidity and Capital Resources — Sources of Liquidity.”
DISCOUNT NOTES
Discount notes are generally issued to satisfy our short-term funding needs. They have maturities of up to 365/366 days and are offered daily through a discount note selling group and other authorized underwriters. Discount notes are sold at a discount and mature at par.
On a daily basis, we may request that specific amounts of discount notes with specific maturity dates be offered by the Office of Finance for sale through certain securities dealers. We may receive zero to 100 percent of the proceeds of the discount notes issued via this sales process depending on (i) the time of the request, (ii) the maximum costs we or other FHLBanks participating in the same issue, if any, are willing to pay for the discount notes, and (iii) the amount of orders for the discount notes submitted by dealers.
Twice weekly, we may request that specific amounts of discount notes with fixed maturities of four to 26 weeks be offered by the Office of Finance through competitive auctions conducted with securities dealers in the discount note selling group. One or more of the FHLBanks may also request that amounts of those same discount notes be offered for sale for their benefit through the same auction. The discount notes offered for sale through competitive auction are not subject to a limit on the maximum costs the FHLBanks are willing to pay. We may receive zero to 100 percent of the proceeds of the discount notes issued through a competitive auction depending on the amounts of the discount notes bid by underwriters and the guidelines for allocation of discount note proceeds among multiple participating FHLBanks administered by the Office of Finance.
For additional information on our discount notes, see “Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations — Statements of Condition — Consolidated Obligations” and “Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations — Liquidity and Capital Resources — Sources of Liquidity.”
Derivatives
We use derivatives to manage interest rate risk, including mortgage prepayment risk, in our Statements of Condition and to achieve our risk management objectives. Finance Agency regulations and our ERMP establish guidelines for derivatives, prohibit trading in or the speculative use of derivatives, and limit credit risk arising from derivatives.
The goal of our interest rate risk management strategy is not to eliminate interest rate risk, but to manage it within appropriate limits. One key way we manage interest rate risk is to acquire and maintain a portfolio of assets and liabilities which, together with their associated derivatives, are conservatively matched with respect to the expected repricings.
We can use interest rate swaps, swaptions, interest rate caps and floors, options, and future/forward contracts as part of our interest rate risk management strategies. These derivatives can be used as either a fair value hedge of a financial instrument or firm commitment or an economic hedge to manage certain defined risks in our Statements of Condition.
Additional information on our derivatives can be found in "Item 8. Financial Statements and Supplementary Data — Note 12 — Derivatives and Hedging Activities” and “Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations — Statements of Condition — Derivatives.”

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CAPITAL AND DIVIDENDS
Capital
We issue a single class of capital stock (Class B capital stock). Our capital stock has a par value of $100 per share, and all shares are issued, redeemed, or repurchased by us at the stated par value. We have two subclasses of capital stock: membership and activity-based. Each member must purchase and maintain membership capital stock in an amount equal to 0.12 percent of its total assets as of the preceding December 31st subject to a cap of $10.0 million and a floor of $10,000. Each member must also maintain activity-based capital stock in an amount equal to 4.45 percent of its total advances and mortgage loans outstanding in our Statements of Condition.
The investment requirements established in our Capital Plan are designed so that we remain adequately capitalized as member activity changes. To ensure we remain adequately capitalized, our Board of Directors may make adjustments to the investment requirements within ranges established in our Capital Plan. All capital stock issued is subject to a five year notice of redemption period.
Capital stock owned by members in excess of their investment requirement is known as excess capital stock. Under our Capital Plan, we, at our discretion and upon 15 days' written notice, may repurchase excess capital stock. In addition, we, at our discretion, may repurchase excess activity-based capital stock to the extent that (i) the excess capital stock balance exceeds an operational threshold set forth in the Capital Plan or (ii) a member submits a notice to redeem all or a portion of the excess activity based capital stock.
For additional information on our capital, see “Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations — Liquidity and Capital Resources — Capital.”
Retained Earnings
Our ERMP requires a minimum retained earnings level based on the level of market risk, credit risk, and operational risk within the Bank. If realized financial performance results in actual retained earnings below the minimum level, we, as determined by our Board of Directors, will establish an action plan to enable us to return to our targeted level of retained earnings within twelve months. At December 31, 2011, our actual retained earnings were above the minimum level, and therefore no action plan was necessary.
Dividends
Our Board of Directors may declare and pay different dividends for each subclass of capital stock. Dividend payments may be made in the form of cash and/or additional shares of capital stock. Historically, we have only paid cash dividends. By regulation, we may pay dividends from current earnings or retained earnings, but we may not declare a dividend based on projected or anticipated earnings. We are prohibited from paying a dividend in the form of additional shares of capital stock if, after the issuance, the outstanding excess capital stock would be greater than one percent of our total assets. In addition, we may not declare or pay a dividend if the par value of our capital stock is impaired or is projected to become impaired after paying such dividend. Our Board of Directors may not declare or pay dividends if it would result in our non-compliance with regulatory capital requirements.
Historically, our dividend philosophy for both membership and activity-based capital stock has been to pay a dividend equal to or above the average three-month LIBOR rate for the covered period. Beginning in the first quarter of 2012, we plan to differentiate dividend payments between membership and activity-based capital stock. Our Board of Directors believe that any excess returns on capital stock above an appropriate benchmark rate which are not retained for capital growth should be returned to members that utilize our product and service offerings. Our dividend philosophy will be to pay a membership capital stock dividend similar to a benchmark rate of interest, such as average-three month LIBOR, and an activity-based capital stock dividend, when possible, at least 50 basis points in excess of the membership capital stock dividend. Our actual dividend payout will continue to be determined quarterly by our Board of Directors, based on policies, regulatory requirements, financial projections, and actual performance.
For additional information on our dividends, refer to “Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations — Liquidity and Capital Resources — Capital — Dividends.”

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Joint Capital Enhancement Agreement
The 12 FHLBanks have entered into a Joint Capital Enhancement Agreement (JCE Agreement). The JCE Agreement became effective on February 28, 2011 and was amended by the FHLBanks on August 5, 2011. The intent of the JCE Agreement is to enhance the capital position of each FHLBank by allocating that portion of each FHLBank's earnings historically paid to satisfy the REFCORP obligation to a separate retained earnings account.

The JCE Agreement provides that, upon full satisfaction of the REFCORP obligation, each FHLBank will contribute 20 percent of its net income each quarter to a restricted retained earnings account (RREA) until the balance of that account equals at least one percent of its average balance of outstanding consolidated obligations for the previous quarter. The restricted retained earnings will not be available to pay dividends. To review the JCE Agreement, as amended, see Exhibit 99.1 of our Form 8-K filed with the Securities and Exchange Commission (SEC) on August 5, 2011.

On August 5, 2011, the Finance Agency certified that the FHLBanks had fully satisfied their REFCORP obligation with their payments made on July 15, 2011 and approved amendments to their Capital Plans, including ours, designed to implement the provisions of the JCE Agreement. As a result, beginning in the third quarter of 2011, we began allocating 20 percent of our net income to a separate RREA. At December 31, 2011, our RREA amounted to $6.5 million.

COMPETITION
In general, the current competitive environment, as it has historically, presents a challenge to achieving our financial goals. We continuously reassess the potential for success in attracting and retaining customers for our products and services.
Advances
Our primary business is making advances to our members and eligible housing associates. Demand for our advances is affected by, among other things, the cost of other available sources of funding for our borrowers. We compete with other suppliers of secured and unsecured wholesale funding including, but not limited to, investment banks, commercial banks, other GSEs, and U.S. Government agencies. We may also compete with other FHLBanks to the extent that member institutions have affiliated institutions located outside of our district. Furthermore, our members typically have access to brokered deposits and resale agreements, each of which represent competitive alternatives to our advances. Many of our competitors are not subject to the same body of regulation that we are, which enables those competitors to offer products and terms that we may not be able to offer. Efforts to effectively compete with other suppliers of wholesale funding by changing the pricing of our advances may result in a decrease in the profitability of our advance business.
Mortgage Loans
The purchase of mortgage loans through the MPF program is subject to competition on the basis of prices paid for mortgage loans, customer service, and ancillary services, such as automated underwriting and loan servicing options. We compete primarily with other GSEs, such as Fannie Mae, Freddie Mac, and other financial institutions and private investors for acquisition of conventional fixed rate mortgage loans.
Consolidated Obligations
Our primary source of funding is through the issuance of consolidated obligations. We compete with the U.S. Government, Fannie Mae, Freddie Mac, and other GSEs as well as corporate, sovereign, and supranational entities for funds raised through the issuance of debt in the national and global debt markets. In the absence of increased demand, increased supply of competing debt products may result in higher debt costs or lesser amounts of debt issued at the same cost. Although our debt issuances have kept pace with the funding needs of our members, there can be no assurance that this will continue.
TAXATION
We are exempt from all federal, state, and local taxation except real property taxes.

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ASSESSMENTS
Affordable Housing Program
The FHLBank Act requires each FHLBank to establish and fund an AHP. Each FHLBank utilizes its AHP to provide grants and subsidized advances to members to support housing for very low to moderate income households. Annually, the FHLBanks must set aside for the AHP the greater of ten percent of their current year net earnings or their pro-rata share of an aggregate $100 million to be contributed in total by the FHLBanks. For purposes of the AHP assessment, net earnings is defined as net income before assessments, plus interest expense related to mandatorily redeemable capital stock, less the assessment for REFCORP, if applicable. The exclusion of interest expense related to mandatorily redeemable capital stock is a regulatory interpretation of the Finance Agency. We accrue the AHP assessment on a monthly basis and reduce our AHP liability as program funds are distributed.
As discussed in the following section, we satisfied our REFCORP obligation during the third quarter of 2011 and began allocating a portion of our net income to a separate RREA. Because the REFCORP assessment reduced the amount of net earnings used to calculate the AHP assessment, it had the effect of reducing the total amount of funds allocated to the AHP. The amounts allocated to the new RREA, however, will not be treated as an assessment and will not reduce our net earnings. As a result, our AHP contributions as a percentage of pre-assessment earnings will increase because the REFCORP obligation has been fully satisfied.
For additional information on the AHP, refer to “Item 8. Financial Statements and Supplementary Data — Note 15 — Affordable Housing Program.”
Resolution Funding Corporation
On August 5, 2011, the Finance Agency certified that the FHLBanks had fully satisfied their REFCORP obligation with their payments made on July 15, 2011. The 12 FHLBanks entered into a JCE Agreement, as amended, which requires each FHLBank to allocate 20 percent of its net income to a separate RREA, beginning in the third quarter of 2011. For additional details on the JCE Agreement, refer to the "Capital and Dividends" section of this Item 1.
Prior to the satisfaction of the REFCORP obligation, each FHLBank was required to pay 20 percent of its net income (before the REFCORP assessment and after the AHP assessment) to REFCORP until the total amount of payments actually made was equivalent to a $300 million annual annuity whose final maturity date was April 15, 2030.
AVAILABLE INFORMATION
We are required to file with the SEC an annual report on Form 10-K, quarterly reports on Form 10-Q, and current reports on Form 8-K. The SEC maintains a website containing these reports and other information regarding our electronic filings located at www.sec.gov. These reports may also be read and copied at the SEC's Public Reference Room at 100 F Street, NE, Washington, DC 20549. Further information about the operation of the SEC's Public Reference Room may be obtained by calling 1-800-SEC-0330.
We also make our annual reports, quarterly reports, current reports, and amendments to all such reports filed with or furnished to the SEC available, free of charge, on our internet website at www.fhlbdm.com as soon as reasonably practicable after such reports are available. Annual and quarterly reports for the FHLBanks on a combined basis are also available, free of charge, at the website of the Office of Finance as soon as reasonably practicable after such reports are available. The internet website address to obtain these reports is www.fhlb-of.com.
Information contained in the previously mentioned websites, or that can be accessed through those websites, is not incorporated by reference into this annual report on Form 10-K and does not constitute a part of this or any report filed with the SEC.
PERSONNEL
As of February 29, 2012, we had 221 full-time equivalent employees. Our employees are not covered by a collective bargaining agreement.

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ITEM 1A. RISK FACTORS

The following discussion summarizes some of the more important risks we face. This discussion is not exhaustive, and there may be other risks we face, which are not described below. The risks described below, if realized, could negatively affect our business operations, financial condition, and future results of operations and, among other things, could result in our inability to pay dividends on our capital stock or repurchase capital stock.
WE ARE SUBJECT TO A COMPLEX BODY OF LAWS AND REGULATIONS THAT COULD CHANGE IN A MANNER DETRIMENTAL TO OUR BUSINESS OPERATIONS
The FHLBanks are GSEs, organized under the authority of the FHLBank Act, and as such, are governed by federal laws and regulations adopted and applied by the Finance Agency. From time to time, Congress may amend the FHLBank Act or other statutes in ways that affect the rights and obligations of the FHLBanks and the manner in which the FHLBanks carry out their housing finance mission and business operations. New or modified legislation enacted by Congress or regulations adopted by the Finance Agency or other financial services regulators could adversely impact our ability to conduct business or the cost of doing business.
We cannot predict when new regulations will be promulgated by the Finance Agency or whether Congress will enact new legislation, and we cannot predict the effect of any new regulations or legislation on our business operations. Changes in regulatory or statutory requirements could result in, among other things, changes to the eligibility criteria of our membership, changes to the types of business activities that we are permitted to engage in, an increase in our cost of funding, or a decrease in the size, scope, or nature of our lending, investment, or MPF program activities, which could negatively affect our financial condition and results of operations.

Our legislative and regulatory environment continues to change as financial regulators issue proposed and/or final rules to implement the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act) and Congress continues to debate proposals for housing finance and GSE reform. For a discussion of recent legislative and regulatory activity that could affect us, refer to “Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations — Legislative and Regulatory Developments.”

WE FACE COMPETITION FOR ADVANCES, MORTGAGE LOANS, AND FUNDING
Our primary business activities are providing advances to members and housing associates and acquiring residential mortgage loans from or through our members. Demand for our advances is affected by, among other things, the cost of other available sources of funding for our borrowers. We compete with other suppliers of secured and unsecured wholesale funding including, but not limited to, investment banks, commercial banks, other GSEs, and U.S. Government agencies. In addition, our members typically have access to brokered deposits and resale agreements, each of which represent competitive alternatives to our advances. Many of our competitors are not subject to the same body of regulation that we are, which enables those competitors to offer products and terms that we may not be able to offer. Efforts to effectively compete with other suppliers of wholesale funding by changing the pricing of our advances may result in a decrease in the profitability of our advance business. A decrease in the demand for advances or a decrease in the profitability on advances would negatively affect our financial condition and results of operations.
The purchase of mortgage loans through the MPF program is subject to competition on the basis of prices paid for mortgage loans, customer service, and ancillary services, such as automated underwriting and loan servicing options. We compete primarily with other GSEs, such as Fannie Mae, Freddie Mac, and other financial institutions and private investors for acquisition of conventional fixed rate mortgage loans. Increased competition could result in a reduction in the amount of mortgage loans we are able to purchase, which could negatively affect our financial condition and results of operations.
We also compete with the U.S. Government, Fannie Mae, Freddie Mac, and other GSEs as well as corporate, sovereign, and supranational entities for funds raised through the issuance of debt in the national and global markets. In the absence of increased demand, increased supply of competing debt products may result in higher debt costs or lesser amounts of debt issued at the same cost. An increase in funding costs would negatively affect our financial condition and results of operations.

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WE ARE JOINTLY AND SEVERALLY LIABLE FOR THE CONSOLIDATED OBLIGATIONS OF OTHER FHLBANKS AND MAY BE REQUIRED TO PROVIDE FINANCIAL ASSISTANCE TO 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 the 12 FHLBanks and are backed only by the financial resources of the FHLBanks. They are not obligations of the U.S. Government, and the U.S. Government does not guarantee them. The Finance Agency, at its discretion, may require any FHLBank to make principal and/or interest payments due on any consolidated obligation, whether or not the primary obligor FHLBank has defaulted on the payment of that consolidated obligation. Furthermore, if the Finance Agency determines that an FHLBank is unable to satisfy its obligations, it may allocate the outstanding liability among the remaining FHLBanks on a pro-rata basis in proportion to each FHLBank’s participation in all consolidated obligations outstanding, or on any other basis that it may determine. Accordingly, we could incur liability beyond our primary obligation under consolidated obligations, which could negatively affect our financial condition and results of operations. Moreover, we may not pay dividends to, or redeem or repurchase capital stock from, any of our members if timely payment of principal and interest on all FHLBank consolidated obligations has not been made. Accordingly, our ability to pay dividends or to redeem or repurchase capital stock may be affected not only by our financial condition, but by the financial condition of the other FHLBanks.
Due to our relationship with other FHLBanks, we could also be impacted by events other than the default on a consolidated obligation. Events that impact other FHLBanks include, but are not limited to, member failures, capital deficiencies, and other-than-temporary impairment charges. These events may cause the Finance Agency, at its discretion, to require any FHLBank to either provide capital to or buy assets of any other FHLBank. If we were called upon by the Finance Agency to do either of these items, it may impact our financial condition.
Additionally, the FHLBank Act requires each FHLBank to establish and fund an AHP. Annually, the FHLBanks are required to set aside, in the aggregate, the greater of $100 million or ten percent of their current year net earnings. If the FHLBanks do not make the minimum $100 million AHP contribution in a given year, we could be required to contribute more than ten percent of our current year net earnings. An increase in our AHP contributions could adversely impact our financial condition and results of operations.
ACTUAL OR PERCEIVED CHANGES IN THE FHLBANK'S CREDIT RATINGS AS WELL AS THE U.S. GOVERNMENT'S CREDIT RATING COULD ADVERSELY AFFECT OUR BUSINESS
Our consolidated obligations are currently rated AA+/A-1+ by S&P and Aaa/P-1 by Moody's. These ratings are subject to reduction or withdrawal at any time by an NRSRO, and the FHLBank System may not be able to maintain these credit ratings. Adverse rating agency actions on the FHLBank System or U.S. Government may reduce investor confidence and negatively affect our cost of funds and ability to issue consolidated obligations on acceptable terms, which could adversely impact our financial condition and results of operations.
A reduction in our credit rating would also trigger additional collateral posting requirements under our derivative agreements. At December 31, 2011, if our credit rating had been lowered from its current rating of AA+ to the next lower rating, we would have been required to deliver up to an additional $69.2 million of collateral to our derivative counterparties. Further, demand for certain Bank products, including, but not limited to, standby letters of credit and standby bond purchase agreements, is influenced by our credit rating. A reduction in our credit rating could weaken or eliminate demand for such products.

We cannot predict future impacts on our financial condition, results of operations, and business model resulting from actions taken by the rating agencies and/or the U.S. Government's fiscal health. To the extent we cannot access funding and derivatives when needed on acceptable terms or demand for our products declines, our financial condition and results of operations could be adversely affected.

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WE COULD BE ADVERSELY AFFECTED BY OUR EXPOSURE TO CREDIT RISK
We are exposed to credit risk if the market value of an obligation declines as a result of deterioration in the creditworthiness of the obligor or the credit quality of a security instrument. We assume unsecured and secured credit risk exposure in that a borrower or counterparty could default and we may suffer a loss if we are not able to fully recover amounts owed to us in a timely manner.
We attempt to mitigate unsecured credit risk by limiting the terms of unsecured investments and the borrowing capacity of our counterparties. We attempt to mitigate secured credit risk through collateral requirements and credit analysis of our borrowers and counterparties. We require collateral on advances, letters of credit, mortgage loan credit enhancements provided by PFIs, certain investments, and derivatives. All advances, letters of credit, and mortgage loan credit enhancements are required to be fully collateralized. We evaluate the types of collateral pledged by our borrowers and counterparties and assign a borrowing capacity to the collateral, generally based on a percentage of its estimated market value. We generally have the ability to call for additional or substitute collateral during the life of an obligation to ensure we are fully collateralized.
If a borrower or counterparty fails, we have the right to take ownership of the collateral covering the obligation. However, if the liquidation value of the collateral is less than the value of the outstanding obligation, we may incur losses that could adversely affect our financial condition and results of operations. If we are unable to secure the obligations of borrowers and counterparties, our lending, investing, and hedging activities could decrease, which would negatively impact our financial condition and results of operations.
CHANGES IN ECONOMIC CONDITIONS OR FEDERAL FISCAL AND MONETARY POLICY COULD ADVERSELY IMPACT OUR BUSINESS
As a cooperative, we operate with narrow margins and expect to be profitable over the long-term based on our prudent lending standards, conservative investment strategies, and diligent risk management practices. Because we operate with narrow margins, our net income is sensitive to changes in market conditions that can impact the interest we earn and pay and introduce volatility in other (loss) income. These conditions include, but are not limited to, changes in interest rates and the money supply, inflation, fluctuations in both debt and equity capital markets, and the strength of the U.S. economy and the local economies in which we conduct business. Our financial condition, results of operations, and ability to pay dividends could be negatively affected by changes in economic conditions.
Additionally, our business and results of operations may be affected by the fiscal and monetary policies of the federal government and its agencies, including the Federal Reserve, which regulates the supply of money and credit in the U.S. The Federal Reserve's policies directly and indirectly influence the yield on interest-earning assets and the cost of interest-bearing liabilities, which could adversely affect our financial condition, results of operations, and ability to pay dividends.
WE COULD BE ADVERSELY AFFECTED BY OUR INABILITY TO ENTER INTO DERIVATIVE INSTRUMENTS ON ACCEPTABLE TERMS
We use derivatives to manage interest rate risk, including prepayment risk, in our Statements of Condition and to achieve our risk management objectives. Our effective use of derivative instruments depends upon management's ability to determine the appropriate hedging positions in light of our assets and liabilities as well as prevailing and anticipated market conditions. In addition, the effectiveness of our hedging strategies depends upon our ability to enter into derivatives with acceptable counterparties, on terms desirable to us, and in quantities necessary to hedge our corresponding assets and liabilities. If we are unable to manage our hedging positions properly, or are unable to enter into derivative instruments on desirable terms, we may incur higher funding costs and be unable to effectively manage our interest rate risk and other risks, which could negatively affect our financial condition and results of operations.
One factor that could impact our ability to manage our hedging positions properly or enter into derivative instruments on desirable terms is the Dodd-Frank Act. The Dodd-Frank Act provides for new statutory and regulatory requirements for derivative transactions, including those utilized by us to hedge our interest rate and other risks. As a result of these requirements, certain derivative transactions will be required to be cleared through a third-party central clearinghouse and traded on regulated exchanges or new swap execution facilities. These new requirements could materially affect our ability or cost to hedge our risk exposures and achieve our risk management objectives.
For additional discussion on how the Dodd-Frank Act could affect our derivative and hedging activities, refer to “Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations — Legislative and Regulatory Developments.”

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EXPOSURE TO OPTION RISK IN OUR FINANCIAL ASSETS AND LIABILITIES COULD HAVE AN ADVERSE EFFECT ON OUR BUSINESS
Our mortgage assets provide homeowners the option to prepay their mortgages prior to maturity. The effect of changes in interest rates can exacerbate prepayment or extension risk, which is the risk that mortgage assets will be refinanced by the mortgagor in low interest rate environments or will remain outstanding longer than expected at below-market yields when interest rates increase. Our advances, consolidated obligations, and derivatives may provide us, the borrower, the issuer, or the counterparty with the option to call or put the asset or liability. These options leave us susceptible to unpredictable cash flows associated with our financial assets and liabilities. The exercise of the option and the prepayment or extension risk is dependent on general market conditions and if not managed appropriately, could have a material adverse effect on our financial condition and results of operations.
A DELAY IN THE INITIATION OR COMPLETION OF FORECLOSURE PROCEEDINGS ON OUR MPF LOANS COUPLED WITH INCREASING DELINQUENCY AND LOSS SEVERITY RATES MAY HAVE AN ADVERSE IMPACT ON OUR FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The housing market experienced a significant slowdown in foreclosure activity throughout 2011 due primarily to delays in processing foreclosure paperwork. A continued delay in the initiation or completion of foreclosure proceedings could impact the amount of losses we incur on our mortgage loans. Additionally, as a result of the prolonged deterioration in the U.S. housing market, we continue to experience increased loan loss severity on our mortgage loan portfolio. We increased our allowance for credit losses on mortgage loans to $19.0 million at December 31, 2011 from $13.0 million at December 31, 2010. To the extent that economic conditions further weaken and home prices continue to decline, we could see an increase in delinquency or loss severity and decide to further increase our allowance for credit losses on mortgage loans. In addition, to the extent that mortgage insurance providers fail to fulfill their obligations to pay us for claims, we could bear additional losses on certain mortgage loans with outstanding mortgage insurance coverage. As a result, our financial condition and results of operations could be adversely impacted.
MEMBER FAILURES, MERGERS, AND CONSOLIDATIONS COULD ADVERSELY AFFECT OUR BUSINESS
Over the last several years, the financial services industry has experienced increasing defaults on, among other things, home mortgages, commercial real estate, and credit card loans, which caused increased regulatory scrutiny and required capital to cover non-performing loans. These factors have led to an increase in the number of financial institution failures, mergers, and consolidations. During 2011, our membership level declined primarily as a result of four bank failures and 29 mergers or consolidations, three of which were outside our district. The number of current and potential members in our district may decline further if these trends continue. The resulting loss of business could negatively impact our business operations, financial condition, and results of operations.
WE COULD BE ADVERSELY AFFECTED BY OUR INABILITY TO ACCESS THE CAPITAL MARKETS
Our primary source of funds is through the issuance of consolidated obligations in the capital markets. Our ability to obtain funds through the issuance of consolidated obligations depends in part on prevailing market conditions in the capital markets and rating agency actions, both of which are beyond our control. We cannot make any assurance that we will be able to obtain funding on terms acceptable to us, if at all. If we cannot access funding when needed, our ability to support and continue business operations, including our compliance with regulatory liquidity requirements, could be adversely impacted, which would thereby adversely impact our financial condition and results of operations. Although our debt issuances have kept pace with the funding needs of our members and eligible housing associates, there can be no assurance that this will continue.


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THE IMPACT OF FINANCIAL MODELS AND THE UNDERLYING ASSUMPTIONS USED TO VALUE FINANCIAL INSTRUMENTS AND COLLATERAL MAY HAVE AN ADVERSE IMPACT ON OUR FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The degree of management judgment involved in determining the fair value of financial instruments or collateral is dependent upon the availability of quoted market prices or observable market parameters. For financial instruments and collateral that are actively traded and have quoted market prices or parameters readily available, there is little to no subjectivity in determining fair value. 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 or prices of similar instruments. We utilize external and internal pricing models to determine the fair value of certain financial instruments and collateral. For external pricing models, we review the vendors' pricing processes, methodologies, and control procedures for reasonableness. For internal pricing models, the underlying assumptions are based on management's best estimates for discount rates, prepayments, market volatility, and other factors. The assumptions used in both external and internal pricing models could have a significant effect on the reported fair values of assets and liabilities or collateral, the related income and expense, and the expected future behavior of assets and liabilities or collateral. While models used by us to value financial instruments and collateral are subject to periodic validation by independent parties, rapid changes in market conditions could impact the value of our financial instruments and collateral. The use of different models and assumptions, as well as changes in market conditions, could impact our financial condition and results of operations as well as the amount of collateral we require from borrowers and counterparties.
The information provided by our internal financial models is also used in making business decisions relating to strategies, initiatives, transactions, and products. We have adopted controls, procedures, and policies to monitor and manage assumptions used in our internal models. However, models are inherently imperfect predictors of actual results because they are based on assumptions about future performance or activities. Changes in any models or in any of the assumptions, judgments or estimates used in the models may cause the results generated by the model to be materially different. If the results are not reliable due to inaccurate assumptions, we could make poor business decisions, including asset and liability management, or other decisions, which could result in an adverse financial impact.
FAILURE TO MEET MINIMUM REGULATORY CAPITAL REQUIREMENTS COULD ADVERSELY AFFECT OUR ABILITY TO REDEEM OR REPURCHASE CAPITAL STOCK, PAY DIVIDENDS, AND ATTRACT NEW MEMBERS
We are required to maintain capital to meet specific minimum requirements, as defined by the Finance Agency. Historically, our capital has exceeded all capital requirements and we have maintained adequate capital and leverage ratios. If we fail to meet any of these requirements or if our Board of Directors or the Finance Agency determines that we have incurred, or are likely to incur, losses resulting in, or losses that are expected to result, in a charge against capital, we would not be able to redeem or repurchase any capital stock while such charges are continuing or expected to continue. In addition, failure to meet our capital requirements could result in the Finance Agency's imposition of restrictions pertaining to dividend payments, lending, investing, or other business activities. Additionally, the Finance Agency could require that we call upon our members to purchase additional capital stock to meet our minimum regulatory capital requirements. Members may be unable or unwilling to satisfy such calls for additional capital, thereby affecting their desire to continue business with us.
OUR RELIANCE ON INFORMATION SYSTEMS AND OTHER TECHNOLOGY COULD HAVE A NEGATIVE IMPACT ON OUR BUSINESS
We rely heavily upon information systems and other technology to conduct and manage our business. To the extent that we experience a technical failure or interruption in any of these systems or other technology, including those caused by a breach of our information systems, we may be unable to conduct and manage our business effectively. During the third quarter of 2011, we began the process of replacing our core banking system. This implementation, which is expected to take several years, could subject us to a higher level of operational risk or risk of technical failure or interruption. Although we have implemented a disaster recovery and business continuity plan, we can make no assurance that it will be able to prevent, timely and adequately address, or mitigate the negative effects of any technical failure or interruption. Any technical failure or interruption could harm our customer relations, risk management, and profitability, and could adversely impact our financial condition and results of operations.
THE INABILITY TO ATTRACT AND RETAIN KEY PERSONNEL COULD ADVERSELY IMPACT OUR BUSINESS
We rely heavily upon our employees in order to successfully execute our business and strategies. The success of our business mission depends, in large part, on our ability to attract and retain certain key personnel with required talents and skills. Should we be unable to hire or retain effective key personnel with the needed talents or skills, our business operations could be adversely impacted.

19


RELIANCE ON THE FHLBANK OF CHICAGO, AS MPF PROVIDER, AND FANNIE MAE, AS THE ULTIMATE INVESTOR IN THE MPF XTRA PRODUCT, COULD HAVE A NEGATIVE IMPACT ON OUR BUSINESS
As part of our business, we participate in the MPF program with the FHLBank of Chicago. In its role as MPF Provider, the FHLBank of Chicago provides the infrastructure and operational support for the MPF program and is responsible for publishing and maintaining the MPF Guides, which detail the requirements PFIs must follow in originating, selling, and servicing MPF loans. If the FHLBank of Chicago changes its MPF Provider role, ceases to operate the MPF program, or experiences a failure or interruption in its information systems and other technology, our mortgage purchase business could be adversely affected, and we could experience a related decrease in our net interest margin and profitability. In the same way, we could be adversely affected if any of the FHLBank of Chicago's third-party vendors supporting the operation of the MPF program were to experience operational or technical difficulties.
Additionally, under the MPF Xtra loan product, we assign 100 percent of our interest in PFI master commitments to the FHLBank of Chicago, who then purchases mortgage loans from our PFIs and sells those loans to Fannie Mae. Should the FHLBank of Chicago or Fannie Mae experience any operational difficulties or inability to continue to do business, those difficulties could have a negative impact on the value of the Bank to our membership.

ITEM 1B. UNRESOLVED STAFF COMMENTS

None.

ITEM 2. PROPERTIES
On January 2, 2007, we executed a 20 year lease with an affiliate of our member, Wells Fargo, for approximately 43,000 square feet of office space. The office space is located at 801 Walnut Street, Suite 200, Des Moines, Iowa and used for all primary business functions.
On June 10, 2011, we executed a three year lease with Tomorrow 30 Des Moines, Limited Partnership, for approximately 6,000 square feet of office space. The office space is located at 666 Walnut Street, Suite 1910, Des Moines, Iowa and is used for general business functions.

We also maintain a leased, off-site back-up facility with approximately 4,100 square feet in Urbandale, Iowa.

ITEM 3. LEGAL PROCEEDINGS

We are not currently aware of any material pending or threatened legal proceedings against us, other than ordinary routine litigation incidental to our business, that could have an adverse effect on our financial condition, results of operations, or cash flows.

ITEM 4. MINE SAFETY DISCLOSURES

Not applicable.


20


PART II

ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
We are a cooperative. This means we are owned by our customers, whom we call members. Our current and former members own all of our outstanding capital stock. Our capital stock is not publicly traded. It is purchased and redeemed by members or repurchased by us at a par value of $100 per share. Our capital stock may be redeemed with a five year notice from the member or voluntarily repurchased by us at par value, subject to certain limitations set forth in our Capital Plan. The par value of each share of capital stock is $100. At February 29, 2012, we had 1221 current members that held 20.6 million shares of capital stock and 10 former members that held 0.1 million shares of mandatorily redeemable capital stock.
We paid the following cash dividends in 2011 and 2010 (dollars in millions):
 
 
2011
 
2010
Quarter Declared and Paid
 
Amount1
 
Annualized Rate3
 
Amount2
 
Annualized Rate3
First Quarter
 
$
16.9

 
3.00
%
 
$
14.6

 
2.00
%
Second Quarter
 
15.8

 
3.00

 
11.9

 
2.00

Third Quarter
 
16.0

 
3.00

 
11.5

 
2.00

Fourth Quarter
 
16.2

 
3.00

 
23.1

 
4.00

1 
Amounts exclude $40,000, $50,000, $48,000, and $49,000 of cash dividends paid on mandatorily redeemable capital stock for the first, second, third, and fourth quarters of 2011. For financial reporting purposes, these dividends were classified as interest expense.
2 
Amounts exclude $85,000, $40,000, $34,000, and $63,000 of cash dividends paid on mandatorily redeemable capital stock for the first, second, third, and fourth quarters of 2010. For financial reporting purposes, these dividends were classified as interest expense.
3 
Reflects the annualized rate paid on our average capital stock outstanding during the prior quarter regardless of its classification for financial reporting purposes as either capital stock or mandatorily redeemable capital stock.
For additional information regarding our dividends, see “Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations — Liquidity and Capital Resources — Capital — Dividends.”


21


ITEM 6. SELECTED FINANCIAL DATA

The following tables present selected financial data for the periods indicated (dollars in millions):
 
December 31,
Statements of Condition
2011
 
2010
 
2009
 
2008
 
2007
Investments1
$
14,637

 
$
18,639

 
$
20,790

 
$
15,369

 
$
9,244

Advances
26,591

 
29,253

 
35,720

 
41,897

 
40,412

Mortgage loans held for portfolio, gross
7,157

 
7,434

 
7,719

 
10,685

 
10,802

Allowance for credit losses
(19
)
 
(13
)
 
(2
)
 

 

Total assets
48,733

 
55,569

 
64,657

 
68,129

 
60,736

Consolidated obligations
 
 
 
 
 
 
 
 
 
Discount notes
6,810

 
7,208

 
9,417

 
20,061

 
21,501

Bonds
38,012

 
43,791

 
50,495

 
42,723

 
34,564

Total consolidated obligations2
44,822

 
50,999

 
59,912

 
62,784

 
56,065

Mandatorily redeemable capital stock
6

 
7

 
8

 
11

 
46

Capital stock — Class B putable3
2,109

 
2,183

 
2,461

 
2,781

 
2,717

Retained earnings
569

 
556

 
484

 
382

 
361

Accumulated other comprehensive income (loss)
134

 
91

 
(34
)
 
(146
)
 
(26
)
Total capital
2,812

 
2,830

 
2,911

 
3,017

 
3,052

 
Years Ended December 31,
Statements of Income
2011
 
2010
 
2009
 
2008
 
2007
Net interest income4
$
235.6

 
$
414.9

 
$
197.4

 
$
245.6

 
$
171.1

Provision for credit losses on mortgage loans
9.2

 
12.1

 
1.5

 
0.3

 

Other (loss) income5
(71.9
)
 
(161.5
)
 
55.8

 
(27.8
)
 
10.3

Other expense
56.9

 
60.2

 
53.1

 
44.1

 
42.4

Net income
77.8

 
133.0

 
145.9

 
127.4

 
101.4

 
Years Ended December 31,
Selected Financial Ratios6
2011
 
2010
 
2009
 
2008
 
2007
Net interest spread7
0.36
%
 
0.59
%
 
0.17
%
 
0.18
%
 
0.07
%
Net interest margin8
0.44

 
0.67

 
0.28

 
0.35

 
0.37

Return on average equity
2.78

 
4.57

 
4.46

 
3.88

 
4.25

Return on average capital stock
3.66

 
5.76

 
5.05

 
4.27

 
4.97

Return on average assets
0.15

 
0.22

 
0.21

 
0.18

 
0.21

Average equity to average assets
5.27

 
4.70

 
4.63

 
4.71

 
5.04

Regulatory capital ratio9
5.51

 
4.94

 
4.57

 
4.66

 
5.14

Dividend payout ratio10
83.34

 
45.92

 
30.05

 
83.81

 
83.13

1
Investments include: interest-bearing deposits, securities purchased under agreements to resell, Federal funds sold, trading securities, AFS securities, and held-to-maturity (HTM) securities.
2
The total par value of outstanding consolidated obligations of the 12 FHLBanks was $691.8 billion, $796.3 billion, $930.5 billion, $1,251.5 billion, and $1,189.6 billion at December 31, 2011, 2010, 2009, 2008, and 2007.
3
Total capital stock includes excess capital stock of $80.7 million, $57.7 million, $61.8 million, $61.1 million, and $95.1 million at December 31, 2011, 2010, 2009, 2008, and 2007.
4
Represents net interest income before the provision for credit losses on mortgage loans.
5
Other (loss) income includes, among other things, net gains on trading securities, net (losses) gains on derivatives and hedging activities, and net (losses) gains on the extinguishment of debt.
6
Amounts used to calculate selected financial ratios are based on numbers in thousands. Accordingly, recalculations using numbers in millions may not produce the same results.
7
Represents yield on total interest-earning assets minus cost of total interest-bearing liabilities.
8
Represents net interest income expressed as a percentage of average interest-earning assets.
9
Represents period end regulatory capital expressed as a percentage of period-end total assets. Regulatory capital includes all capital stock, including mandatorily redeemable capital stock, and retained earnings.
10
Represents dividends declared and paid in the stated period expressed as a percentage of net income in the stated period.


22


ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Our Management's Discussion and Analysis (MD&A) is designed to provide information that will help the reader develop a better understanding of our financial statements, changes in our financial statements from year to year, and the primary factors driving those changes. Our MD&A is organized as follows:
CONTENTS
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 

23


FORWARD-LOOKING INFORMATION

Statements contained in this annual report on Form 10-K, including statements describing objectives, projections, estimates, or future predictions in our operations, may be forward-looking statements. These statements may be identified by the use of forward-looking terminology, such as believes, projects, expects, anticipates, estimates, intends, strategy, plan, could, should, may, and will or their negatives or other variations on these terms. By their nature, forward-looking statements involve risk or uncertainty, and actual results could differ materially from those expressed or implied or could affect the extent to which a particular objective, projection, estimate, or prediction is realized. We undertake no obligation to update or revise publicly any forward-looking statements, whether as a result of new information, future events, or otherwise. A detailed discussion of risks and uncertainties is included under “Item 1A. Risk Factors.”

EXECUTIVE OVERVIEW

Our Bank is a member-owned cooperative serving shareholder members in a five-state region (Iowa, Minnesota, Missouri, North Dakota, and South Dakota). Our mission is to provide funding and liquidity to our members and housing associates so that they can meet the housing, economic development, and business needs of the communities they serve. We fulfill our mission by providing liquidity to our members and housing associates through advances, supporting residential mortgage lending through the MPF program, and providing affordable housing programs that create housing opportunities for low and moderate income families. Our members may include commercial banks, thrifts, credit unions, insurance companies, and community development financial institutions.

We reported net income of $77.8 million in 2011 compared to $133.0 million in 2010. Our 2011 net income, calculated in accordance with accounting principles generally accepted in the U.S. (GAAP), was primarily impacted by a decline in advance interest income, improved funding costs, and losses on derivatives and hedging activities.

Throughout 2011, we experienced a continued decline in our advance balances resulting from reduced member demand, scheduled maturities, and prepayments. Advance demand remained weak primarily due to high deposit levels at member institutions, which serve as a liquidity alternative to advances, and low demand for loans at member institutions. Our advance interest income declined $290.8 million in 2011 when compared to 2010. A large portion of this decline was due to a decrease in advance prepayment fee income. When a member decides to prepay an advance, we are required by regulation to charge a prepayment fee to make ourself financially indifferent. Our advance prepayment fee income decreased $163.3 million in 2011 when compared to 2010 as a result of fewer advance prepayments.

Throughout 2011, our interest expense on consolidated obligations decreased $204.9 million when compared to 2010. The decrease was primarily due to a reduction in funding needs resulting from a declining balance sheet. In addition, as a result of the low interest rate environment, we took advantage of calling certain higher-costing debt in order to reduce our future interest costs and reposition our balance sheet. We called $28.9 billion and $25.5 billion of debt during 2011 and 2010. As advances were prepaid during 2010, we also extinguished $1.3 billion of bonds funding the prepaid advances and recorded losses on these debt extinguishments of $163.7 million.

The decline in advance interest income, specifically advance prepayment fee income, partially offset by improved funding costs, decreased our net interest income to $235.6 million in 2011 from $414.9 million in 2010. Excluding the impact of advance prepayment fees, our net interest income in 2011 and 2010 was $224.9 million and $240.9 million, resulting in a net interest margin of 0.42 and 0.39 percent. Refer to “Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations — Results of Operations — Net Interest Income” for additional discussion on our net interest income.

Our net income during 2011 was also impacted by our use of derivatives and hedging activities. We utilize derivative instruments to manage our interest rate risk, including mortgage prepayment risk, and to achieve our risk management objectives. Because derivative accounting rules affect the timing and recognition of income or expense, we may be subject to income statement volatility. During 2011, as a result of market volatility, we recorded net losses of $110.8 million on our derivatives and hedging activities compared to net losses of $52.6 million in 2010. The net losses were recorded as a component of other (loss) income and were due to economic derivatives, which do not qualify for fair value hedge accounting. During 2011, we recorded net losses of $121.7 million on economic derivatives compared to net losses of $57.3 million in 2010. These losses were primarily due to the effect of changes in interest rates on interest rate caps economically hedging our mortgage asset portfolio and interest rate swaps economically hedging our trading securities portfolio. The net losses on derivatives and hedging activities during 2011 and 2010 were partially offset by gains on fair value derivatives. Refer to “Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations — Results of Operations — Hedging Activities” for additional discussion on our derivatives and hedging activities.


24


Our total assets decreased to $48.7 billion at December 31, 2011 from $55.6 billion at December 31, 2010 due primarily to a decline in investment securities and advances. Investment securities declined due primarily to principal paydowns on MBS and a reduction in short-term investments. Advances declined due to reduced member demand, scheduled maturities, and prepayments. Our total liabilities decreased to $45.9 billion at December 31, 2011 from $52.7 billion at December 31, 2010 due to a decline in consolidated obligations resulting from a decline in total assets. At December 31, 2011 and 2010, our total capital was $2.8 billion. Refer to “Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations — Statements of Condition” for additional discussion on our financial condition.

Adjusted Earnings

As part of evaluating financial performance, we adjust GAAP net income before assessments (GAAP net income) and GAAP net interest income before provision for credit losses (GAAP net interest income) for the impact of (i) market adjustments relating to derivative and hedging activities and instruments held at fair value, (ii) realized gains (losses) on the sale of investment securities, (iii) holding gains on trading securities, and (iv) other unpredictable items, including asset prepayment fee income and debt extinguishment losses. The resulting non-GAAP measure, referred to as our adjusted earnings, reflects both adjusted net interest income before provision for credit losses (adjusted net interest income) and adjusted net income before assessments (adjusted net income).

Because our business model is primarily one of holding assets and liabilities to maturity, management believes that the adjusted earnings measure is helpful in understanding our operating results and provides a meaningful period-to-period comparison in contrast to GAAP income, which can be impacted by fair value changes driven by market volatility or transactions that are considered to be unpredictable. Market volatility in our Statements of Income is primarily driven by derivatives and hedging activities and investments classified as trading in our Statements of Condition. We use derivatives to manage interest rate risk, including mortgage prepayment risk, in our Statements of Condition and to achieve our risk management objectives. The use of derivative instruments requires that, on a GAAP basis, we record the changes in fair value of our derivatives instruments and related hedged items (if applicable) in earnings, which can create volatility. We also acquire and classify certain investments as trading securities generally for liquidity purposes. The trading classification requires that, on a GAAP basis, we record these securities at fair value with changes in fair value reported through earnings.

For the reasons discussed above, management believes that adjusted earnings represents a longer-term view of our value and performance. As a result, management uses the adjusted earnings measure to assess performance under our incentive compensation plans and to ensure management remains focused on our long-term value and performance. Non-GAAP financial measures have inherent limitations, are not required to be uniformly applied, and are not audited. While this non-GAAP measure can be used to assist in understanding the components of our earnings, it should not be considered a substitute for results reported under GAAP.

The following table summarizes the reconciliation between GAAP net interest income and adjusted net interest income for the years ended December 31, 2011, 2010, and 2009 (dollars in millions):
 
2011
 
2010
 
2009
Net interest income before provision for credit losses (GAAP)
$
235.6

 
$
414.9

 
$
197.4

Excludes:
 
 
 
 
 
Prepayment fees on advances, net
10.7

 
174.0

 
10.3

Prepayment fees on investments
14.6

 

 

Fair value hedging adjustments
1.6

 
1.3

 
(15.9
)
Total adjustments
26.9

 
175.3

 
(5.6
)
Includes items reclassified from other (loss) income:
 
 
 
 
 
Net interest income on economic hedges
0.8

 
6.7

 
5.2

Adjusted net interest income before provision for credit losses
$
209.5

 
$
246.3

 
$
208.2

Adjusted net interest margin
0.39
%
 
0.40
%
 
0.30
%


25


Our adjusted net interest income decreased $36.8 million during 2011 when compared to 2010. The decrease was mainly due to lower interest income on advances and investments, partially offset by lower interest expense on consolidated obligations. Our advance interest income declined as a result of the low interest rate environment and continued decline in advance balances resulting from reduced member demand, scheduled maturities, and prepayments. Our investment interest income declined due primarily to MBS principal paydowns and limited investment opportunities. Our consolidated obligation interest expense improved due to a reduction in funding needs resulting from a declining balance sheet and the low interest rate environment. In addition, as a result of the low interest rate environment, we called certain higher-costing debt in order to reduce our future interest costs and reposition our balance sheet. Despite a decline in adjusted net interest income, our adjusted net interest margin was 0.39 percent and 0.40 percent during 2011 and 2010. During 2010, our adjusted net interest income increased $38.1 million when compared to 2009 due primarily to lower interest expense on consolidated obligations resulting from the low interest rate environment.

The following table summarizes the reconciliation between GAAP net income and adjusted net income for the years ended December 31, 2011, 2010, and 2009 (dollars in millions):
 
2011
 
2010
 
2009
Net income before assessments (GAAP)
$
97.6

 
$
181.1

 
$
198.6

Excludes:
 
 
 
 
 
Adjustments to net interest income
26.9

 
175.3

 
(5.6
)
Net gain on trading securities
38.7

 
37.4

 
19.1

Net loss on sale of available-for-sale securities

 

 
(10.9
)
Net gain on sale of held-to-maturity securities
7.2

 

 

Net (loss) gain on consolidated obligations held at fair value
(6.5
)
 
5.7

 
(4.4
)
Net gain on mortgage loans held for sale

 

 
1.3

Net (loss) gain on derivatives and hedging activities
(110.8
)
 
(52.6
)
 
133.8

Net loss on extinguishment of debt
(4.6
)
 
(163.7
)
 
(89.9
)
Includes:
 
 
 
 
 
Net interest income on economic hedges
0.8

 
6.7

 
5.2

Amortization of hedging costs1
(6.1
)
 

 

Adjusted net income before assessments
$
141.4

 
$
185.7

 
$
160.4

1
Beginning in the first quarter of 2011 and on a go forward basis, we have adjusted our GAAP net income to reflect the amortization of upfront payments and any gains or losses on the sale of derivative instruments with an upfront payment over the life of the instrument.

Our adjusted net income decreased $44.3 million during 2011 when compared to 2010. The decrease was primarily due to a decline in adjusted net interest income and losses on real estate owned (REO). Due to continued deterioration in real estate values, we recorded losses of $1.6 million on REO during 2011 compared to gains of $5.8 million in 2010. Our adjusted net income increased $25.3 million during 2010 when compared to 2009 due to an increase in adjusted net interest income.

For additional discussion on items impacting our GAAP earnings, refer to “Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations — Results of Operations.”

CONDITIONS IN THE FINANCIAL MARKETS

Economy and Capital Markets

During the first half of 2011, the U.S. domestic economy continued its slow recovery from the recent financial crisis. Exports of U.S. manufactured goods, growth in equipment and software, strong corporate profits, and the availability of credit to larger non-financial corporations supported the recovery. However, the pace of the economic expansion reflected the dampening effect of slow growth in consumer spending, continued pressure on housing prices, and limited access to credit by small businesses. Economic growth was negatively affected by high unemployment rates and weaker than expected long-term labor market indicators. Concerns about the financial stability of Europe, as well as the slower than expected domestic economic recovery, triggered a continued flight to quality in the capital markets during the first half of 2011 as investors moved assets into short-term U.S. Treasuries and agency securities.


26


During the second half of 2011, challenges surrounding U.S. fiscal policy and strains in the global financial markets continued to pose significant downside risks to the economic outlook. In mid-July, the U.S. debt ceiling debate took center stage with an ultimate agreement signed in early August. On August 5, 2011, for the first time in U.S. history, S&P downgraded the long-term sovereign rating of the U.S. Government from AAA to AA+ with a negative outlook. In its announcement of the downgrade, S&P stated the following: "The downgrade reflects our opinion that the fiscal consolidation plan that Congress and the Administration recently agreed to falls short of what, in our view, would be necessary to stabilize the government's medium-term debt dynamics."

Economic conditions showed signs of stabilization during the fourth quarter of 2011. Late in the quarter, economic data, including a decline in the unemployment rate, produced positive sentiment amongst market participants. This positive sentiment was somewhat offset by continued concerns surrounding the European debt crisis. In its December 13, 2011 statement, the Federal Open Market Committee (FOMC) noted that it continues to expect a moderate pace of economic growth over coming quarters and consequently anticipates that the unemployment rate will decline only gradually toward levels that it judges to be consistent with its long-term goal for monetary policy. The FOMC also anticipates that inflation will settle over coming quarters to levels at or below those consistent with its long-term goal for monetary policy.

Mortgage Markets

The sluggish economic recovery resulted in minimal growth for new consumer, mortgage, and commercial loans during 2011. Despite low mortgage interest rates, access to mortgage credit remained limited as a result of tight credit policies, lower home prices, and high unemployment levels. The imbalance between housing supply and demand, the substantial backlog of vacant properties for sale, and the significant proportion of distressed property sales kept downward pressure on housing prices throughout 2011. To help bolster conditions in the mortgage markets, the FOMC continued to reinvest principal payments from its holdings of agency debt and agency MBS into agency MBS.

Interest Rates

The following table summarizes key average market interest rates for 2011 and 2010 as well as key market interest rates at December 31, 2011 and 2010:
 
2011
Average
 
2010
Average
 
2011
Ending Rate
 
2010
Ending Rate
Federal funds1
0.10
%
 
0.18
%
 
0.04
%
 
0.13
%
Three-month LIBOR1
0.33

 
0.34

 
0.58

 
0.30

2-year U.S. Treasury1
0.44

 
0.69

 
0.28

 
0.60

10-year U.S. Treasury1
2.77

 
3.19

 
2.02

 
3.30

30-year residential mortgage note1
4.47

 
4.69

 
3.95

 
4.86

1
Source is Bloomberg.
    
The Federal Reserve's key targeted interest rate, the Federal funds rate, maintained at a range of 0.00 to 0.25 percent throughout the end of 2011. In its January 25, 2012 statement, the FOMC noted that it currently anticipates that economic conditions are likely to warrant exceptionally low levels for the Federal funds rate at least through late 2014, which was a change from its prior stance of mid-2013. Average three-month LIBOR remained historically low throughout the first half of 2011. During the second half of 2011, average three-month LIBOR began to steadily increase as a result of the European sovereign risk crisis. Because a considerable portion of our assets and liabilities are directly tied to short-term interest rates, our interest income and interest expense were affected by changes in short-term interest rates throughout 2011. Average U.S. Treasury yields were generally lower throughout 2011 when compared to 2010. Mortgage rates generally moved in tandem with the U.S. Treasury market during 2011.

To support a stronger economic recovery and to help ensure that inflation, over time, is at levels consistent with the Federal Reserve's long-term goal for monetary policy, the FOMC decided to extend the average maturity of its holdings of securities in September of 2011. As announced, the FOMC intends to purchase, by the end of June 2012, $400 billion of U.S. Treasury securities with remaining maturities of 6 to 30 years and to sell an equal amount of U.S. Treasury securities with remaining maturities of 3 years or less. This program, known as "Operation Twist", was implemented by the Federal Reserve to help make broader financial conditions more accommodative.


27


Funding Spreads

The following table summarizes our average funding spreads to LIBOR for 2011 and 2010 as well as our funding spreads to LIBOR at December 31, 2011 and 2010:
 
2011
3-Month
Average
 
2010
3-Month
Average
 
2011
12-Month
Average
 
2010
12-Month
Average
 
2011
Ending Spread
 
2010
Ending Spread
FHLB spreads to LIBOR
 
 
 
 
 
 
 
 
 
 
 
(basis points)1
 
 
 
 
 
 
 
 
 
 
 
3-month
(41.9
)
 
(9.9
)
 
(13.5
)
 
(14.8
)
 
(53.0
)
 
(11.3
)
2-year
(20.9
)
 
(6.8
)
 
(10.3
)
 
(6.8
)
 
(31.4
)
 
(5.6
)
5-year
(0.8
)
 
3.7

 
3.5

 
6.1

 
(8.7
)
 
9.9

10-year
44.1

 
32.8

 
41.9

 
40.6

 
36.5

 
39.9

1
Source is the Office of Finance.
    
As a result of our credit quality, we generally have ready access to funding at relatively competitive interest rates. Throughout 2011, our shorter-term funding spreads relative to LIBOR generally improved when compared to the same periods in 2010, despite a downgrade of our long-term credit rating by S&P on August 8, 2011 following the downgrade of the U.S. Government's long-term sovereign rating. The improvement was primarily due to a rally in U.S. Treasuries, a widening of short-term swap levels, and continued investor interest in high-quality, low-risk investments. Our longer-term (10-year) funding spreads relative to LIBOR were generally less favorable throughout 2011 as a result of decreased investor appetite resulting from ongoing uncertainty in the financial markets. Due to the current funding environment, we utilized swapped fixed rate debt, callable debt, structured debt, and discount notes throughout 2011 to manage our risk profile and restructure our debt profile to more closely match the projected cash flows of our assets.

RESULTS OF OPERATIONS

Net Income

The following table presents comparative highlights of our net income for the years ended December 31, 2011, 2010, and 2009 (dollars in millions). These items are further described in the sections that follow.
 
 
 
 
 
2011 vs. 2010
 
 
 
2010 vs. 2009
 
2011
 
2010
 
$ Change
 
% Change
 
2009
 
$ Change
 
% Change
Net interest income before provision for credit losses
$
235.6

 
$
414.9

 
$
(179.3
)
 
(43.2
)%
 
$
197.4

 
$
217.5

 
110.2
 %
Provision for credit losses on mortgage loans
9.2

 
12.1

 
(2.9
)
 
(24.0
)
 
1.5

 
10.6

 
706.7

Other (loss) income
(71.9
)
 
(161.5
)
 
89.6

 
(55.5
)
 
55.8

 
(217.3
)
 
389.4

Other expense
56.9

 
60.2

 
(3.3
)
 
(5.5
)
 
53.1

 
7.1

 
13.4

Assessments
19.8

 
48.1

 
(28.3
)
 
(58.8
)
 
52.7

 
(4.6
)
 
(8.7
)
Net income
$
77.8

 
$
133.0

 
$
(55.2
)
 
(41.5
)%
 
$
145.9

 
$
(12.9
)
 
(8.8
)%


28


Net Interest Income

Our net interest income is impacted by changes in average asset and liability balances, and the related yields and costs, as well as returns on invested capital. Net interest income is managed within the context of tradeoff between market risk and return.

The following table presents average balances and rates of major interest rate sensitive asset and liability categories for the years ended December 31, 2011, 2010, and 2009 (dollars in millions):
 
 
2011
 
2010
 
2009
 
 
Average Balance1
 
Yield/Cost
 
Interest Income/Expense
 
Average Balance1
 
Yield/Cost
 
Interest Income/Expense
 
Average Balance1
 
Yield/Cost
 
Interest Income/Expense
 
 
 
 
 
 
 
 
 
 
Interest-earning assets
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Interest-bearing deposits
 
$
353

 
0.12
%
 
$
0.4

 
$
125

 
0.29
%
 
$
0.4

 
$
113

 
0.37
%
 
$
0.4

Securities purchased under agreements to resell
 
1,533

 
0.08

 
1.3

 
1,345

 
0.18

 
2.4

 
1,165

 
0.16

 
1.8

Federal funds sold
 
2,552

 
0.10

 
2.5

 
3,021

 
0.16

 
4.8

 
6,007

 
0.29

 
17.4

Short-term investments2
 
146

 
0.13

 
0.2

 
456

 
0.41

 
1.9

 
683

 
0.53

 
3.6

Mortgage-backed securities2,3
 
9,802

 
2.34

 
229.8

 
12,635

 
2.18

 
275.8

 
9,584

 
2.12

 
203.0

Other investments2,4
 
3,215

 
2.25

 
72.3

 
3,826

 
2.17

 
82.9

 
6,028

 
1.59

 
95.6

Advances5,6
 
27,773

 
0.98

 
271.0

 
32,476

 
1.73

 
561.8

 
37,766

 
1.77

 
668.2

Mortgage loans7
 
7,256

 
4.48

 
325.0

 
7,557

 
4.73

 
357.3

 
9,190

 
4.83

 
443.6

Loans to other FHLBanks
 
3

 
0.04

 

 

 

 

 

 

 

Total interest-earning assets
 
52,633

 
1.71

 
902.5

 
61,441

 
2.10

 
1,287.3

 
70,536

 
2.03

 
1,433.6

Non-interest-earning assets
 
477

 

 

 
415

 

 

 
165

 

 

Total assets
 
$
53,110

 
1.70
%
 
$
902.5

 
$
61,856

 
2.08
%
 
$
1,287.3

 
$
70,701

 
2.03
%
 
$
1,433.6

Interest-bearing liabilities
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Deposits
 
$
988

 
0.05
%
 
$
0.5

 
$
1,370

 
0.09
%
 
$
1.2

 
$
1,296

 
0.18
%
 
$
2.4

Consolidated obligations
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Discount notes6
 
7,104

 
0.09

 
6.1

 
7,146

 
0.15

 
10.4

 
20,736

 
0.64

 
132.2

Bonds6
 
41,256

 
1.60

 
660.1

 
49,283

 
1.75

 
860.7

 
44,218

 
2.49

 
1,101.3

Other interest-bearing liabilities8
 
8

 
2.65

 
0.2

 
8

 
2.10

 
0.1

 
38

 
0.80

 
0.3

Total interest-bearing liabilities
 
49,356

 
1.35

 
666.9

 
57,807

 
1.51

 
872.4

 
66,288

 
1.86

 
1,236.2

Non-interest-bearing liabilities
 
956

 

 

 
1,139

 

 

 
1,142

 

 

Total liabilities
 
50,312

 
1.33

 
666.9

 
58,946

 
1.48

 
872.4

 
67,430

 
1.83

 
1,236.2

Capital
 
2,798

 

 

 
2,910

 

 

 
3,271

 

 

Total liabilities and capital
 
$
53,110

 
1.26
%
 
$
666.9

 
$
61,856

 
1.41
%
 
$
872.4

 
$
70,701

 
1.75
%
 
$
1,236.2

Net interest income and spread
 
 
 
0.36
%
 
$
235.6

 
 
 
0.59
%
 
$
414.9

 
 
 
0.17
%
 
$
197.4

Net interest margin9
 
 
 
0.44
%
 
 
 
 
 
0.67
%
 
 
 
 
 
0.28
%
 
 
Average interest-earning assets to interest-bearing liabilities
 
 
 
106.64
%
 
 
 
 
 
106.29
%
 
 
 
 
 
106.41
%
 
 
Composition of net interest income
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Asset-liability spread
 
 
 
0.37
%
 
$
198.5

 
 
 
0.60
%
 
$
371.8

 
 
 
0.20
%
 
$
137.4

Earnings on capital
 
 
 
1.33
%
 
37.1

 
 
 
1.48
%
 
43.1

 
 
 
1.83
%
 
60.0

Net interest income
 
 
 
 
 
$
235.6

 
 
 
 
 
$
414.9

 
 
 
 
 
$
197.4

1
Average balances are calculated on a daily weighted average basis and do not reflect the effect of derivative master netting arrangements with counterparties.
2
The average balance of AFS securities is reflected at amortized cost; therefore the resulting yields do not give effect to changes in fair value.
3
MBS interest income includes a $14.6 million prepayment fee during the year ended December 31, 2011 as a result of an AFS MBS prepayment.
4
Other investments include: TLGP debentures, taxable municipal bonds, other U.S. obligations, GSE obligations, state or local housing agency obligations, a Private Export Funding Corporation bond, and an equity investment in a SBIC.
5
Advance interest income includes advance prepayment fee income of $10.7 million, $174.0 million, and $10.3 million for the years ended December 31, 2011, 2010, and 2009.
6
Average balances reflect the impact of fair value hedging adjustments and/or fair value option adjustments.
7
Non-accrual loans and loans held for sale are included in average balances used to determine the average rate.
8
Other interest-bearing liabilities consist of mandatorily redeemable capital stock and borrowings from other FHLBanks.
9
Represents net interest income expressed as a percentage of average interest-earning assets.

29


The following table presents changes in interest income and interest expense. Changes in interest income and interest expense that are not identifiable as either volume-related or rate-related, but rather equally attributable to both volume and rate changes, are allocated to the volume and rate categories based on the proportion of the absolute value of the volume and rate changes (dollars in millions).
 
2011 vs. 2010
 
2010 vs. 2009
 
Total Increase
(Decrease) Due to
 
Total Increase
(Decrease)
 
Total Increase
(Decrease) Due to
 
Total Increase
(Decrease)
 
Volume
 
Rate
 
 
Volume
 
Rate
 
Interest income
 
 
 
 
 
 
 
 
 
 
 
Interest-bearing deposits
$
0.3

 
$
(0.3
)
 
$

 
$
0.1

 
$
(0.1
)
 
$

Securities purchased under agreements to resell
0.3

 
(1.4
)
 
(1.1
)
 
0.3

 
0.3

 
0.6

Federal funds sold
(0.7
)
 
(1.6
)
 
(2.3
)
 
(6.6
)
 
(6.0
)
 
(12.6
)
Short-term investments
(0.8
)
 
(0.9
)
 
(1.7
)
 
(1.0
)
 
(0.7
)
 
(1.7
)
Mortgage-backed securities
(65.1
)
 
19.1

 
(46.0
)
 
66.8

 
6.0

 
72.8

Other investments
(13.6
)
 
3.0

 
(10.6
)
 
(41.3
)
 
28.6

 
(12.7
)
Advances
(72.8
)
 
(218.0
)
 
(290.8
)
 
(91.6
)
 
(14.8
)
 
(106.4
)
Mortgage loans
(13.9
)
 
(18.4
)
 
(32.3
)
 
(77.3
)
 
(9.0
)
 
(86.3
)
Loans to other FHLBanks

 

 

 

 

 

Total interest income
(166.3
)
 
(218.5
)
 
(384.8
)
 
(150.6
)
 
4.3

 
(146.3
)
Interest expense
 
 
 
 
 
 
 
 
 
 
 
Deposits
(0.3
)
 
(0.4
)
 
(0.7
)
 
0.1

 
(1.3
)
 
(1.2
)
Consolidated obligations
 
 
 
 
 
 
 
 
 
 
 
Discount notes
(0.1
)
 
(4.2
)
 
(4.3
)
 
(56.2
)
 
(65.6
)
 
(121.8
)
Bonds
(131.4
)
 
(69.2
)
 
(200.6
)
 
115.2

 
(355.8
)
 
(240.6
)
Other interest-bearing liabilities

 
0.1

 
0.1

 
(0.4
)
 
0.2

 
(0.2
)
Total interest expense
(131.8
)
 
(73.7
)
 
(205.5
)
 
58.7

 
(422.5
)
 
(363.8
)
Net interest income
$
(34.5
)
 
$
(144.8
)
 
$
(179.3
)
 
$
(209.3
)
 
$
426.8

 
$
217.5

    
Our net interest income is made up of two components: asset-liability spread and earnings on capital.

ASSET-LIABILITY SPREAD

Asset-liability spread equals the yield on total assets minus the cost of total liabilities. During 2011, our asset-liability spread was 37 basis points compared to 60 and 20 basis points in 2010 and 2009. The majority of our asset-liability spread is driven by our net interest spread. During 2011, our net interest spread was 36 basis points compared to 59 and 17 basis points in 2010 and 2009. Our 2011 net interest spread was primarily impacted by lower advance prepayment fee income, decreased average interest-earning asset and interest-bearing liability volumes, and lower interest rates. The composition of our interest income and interest expense is discussed below.

Advances

Interest income on advances (including prepayment fees on advances, net) decreased 52 percent during 2011 when compared to 2010 and 16 percent during 2010 when compared to 2009. The decrease in 2011 was due to lower advance prepayment fee income, lower average advance volumes, and lower interest rates. Advance prepayment fee income declined $163.3 million during 2011 due to fewer advance prepayments by members. Average advance volumes declined $4.7 billion during 2011 due to reduced member demand, scheduled maturities, and prepayments. Because the majority of our advance originations during 2011 were short-term in nature, the low interest rate environment also contributed to a decline in our advance interest income. The decrease in 2010 was due to lower average advance volumes and lower interest rates, partially offset by increased advance prepayment fee income. Average advance volumes declined $5.3 billion during 2010 due to the high level of liquidity in the market and the low loan demand experienced by our members. Given the low interest rate environment and steady decline in our advance balances, we anticipate that advance interest income will continue to decrease in the near future.


30


Bonds

Interest expense on bonds decreased 23 percent during 2011 when compared to 2010 and 22 percent during 2010 when compared to 2009. The decrease in 2011 was due to lower average bond volumes and lower interest rates. Average bond volumes declined during 2011 due to a reduction in advance demand and limited investment opportunities. In addition, as a result of the low interest rate environment, we took advantage of calling certain higher-costing debt in order to reduce our future interest costs and reposition our balance sheet. We called $28.9 billion and $25.5 billion of debt during 2011 and 2010. The decrease in 2010 was due to lower interest rates, partially offset by increased average bond volumes. Average bond volumes increased during 2010 due to us replacing maturing discount notes with bonds in an effort to better match fund our longer-term assets with longer-term debt.

Investments

Interest income on investments decreased 17 percent during 2011 when compared to 2010. The decrease was primarily due to lower average volumes resulting from MBS principal paydowns and limited investment opportunities. The decrease in investment income during 2011 was partially offset by our receipt of a $14.6 million prepayment fee for the prepayment of an AFS MBS during the first quarter of 2011.

Interest income on investments increased 14 percent during 2010 when compared to 2009. The increase was primarily due to higher average MBS volumes. During the first quarter of 2010, we purchased GSE MBS up to five times regulatory capital as a result of temporary authorization from the Finance Agency to increase our purchases of MBS from three times regulatory capital to six times regulatory capital through March 31, 2010. After March 31, 2010, our purchase limit for MBS returned to three times regulatory capital.

Mortgage Loans

Interest income on mortgage loans decreased 9 percent during 2011 when compared to 2010 and 19 percent during 2010 when compared to 2009. The decrease during both periods was due to lower interest rates and lower average mortgage loan volumes. Average mortgage loan volumes declined due primarily to principal paydowns exceeding mortgage loan purchases. The decline in average mortgage loan volumes during 2010 was also due to us selling approximately $2.1 billion of mortgage loans to Fannie Mae through the FHLBank of Chicago in 2009.

Discount Notes

Interest expense on discount notes decreased 42 percent during 2011 when compared to 2010 and 92 percent during 2010 when compared to 2009. The decrease during both periods was due primarily to lower interest rates and lower average discount note volumes. Average discount note volumes declined as a result of decreased short-term funding needs and us replacing maturing discount notes with bonds in an effort to better match fund our longer-term assets with longer-term debt.

EARNINGS ON CAPITAL

Our earnings on capital decreased during 2011 when compared to 2010 and 2009 due primarily to lower interest rates. During 2011, earnings on invested capital amounted to $37.1 million compared to $43.1 million and $60.0 million in 2010 and 2009.

Provision for Credit Losses on Mortgage Loans

During 2011, we recorded a provision for credit losses of $9.2 million, bringing our allowance for credit losses to $19.0 million at December 31, 2011. The provision recorded was primarily driven by increased loss severities, management's expectation that loans migrating to REO and loss severities will likely increase in the future, and decreased availability of performance-based credit enhancement fees resulting from an increase in charge-off activity and a decline in master commitment balances. In addition, we made certain refinements to our allowance for credit losses model during 2011 to better estimate loss severities, future delinquencies, and loans migrating to REO status. During 2010 and 2009, we recorded a provision for credit losses of $12.1 million and $1.5 million.

See additional discussion regarding our mortgage loan credit risk in “Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations — Risk Management — Credit Risk — Mortgage Assets.”



31


Other (Loss) Income

The following table summarizes the components of other (loss) income for the years ended December 31, 2011, 2010, and 2009 (dollars in millions):
 
2011
 
2010
 
2009
Service fees
$
1.2

 
$
1.6

 
$
2.1

Net gain on trading securities
38.7

 
37.4

 
19.1

Net loss on sale of available-for-sale securities

 

 
(10.9
)
Net gain on sale of held-to-maturity securities
7.2

 

 

Net (loss) gain on consolidated obligations held at fair value
(6.5
)
 
5.7

 
(4.4
)
Net gain on mortgage loans held for sale

 

 
1.3

Net (loss) gain on derivatives and hedging activities
(110.8
)
 
(52.6
)
 
133.8

Net loss on extinguishment of debt
(4.6
)
 
(163.7
)
 
(89.9
)
Other, net
2.9

 
10.1

 
4.7

Total other (loss) income
$
(71.9
)
 
$
(161.5
)
 
$
55.8

    
Other (loss) income can be volatile from period to period depending on the type of financial activity recorded. During 2011, 2010, and 2009, other (loss) income was primarily impacted by derivatives and hedging activities, debt extinguishments, fair value adjustments on trading securities, and fair value adjustments on consolidated obligations held at fair value.
 
We use derivatives to manage interest rate risk, including mortgage prepayment risk, in our Statements of Condition and to achieve our risk management objectives. Derivatives are recorded at fair value with changes in fair value reflected through other (loss) income. During 2011, we recorded net losses of $110.8 million on our derivatives and hedging activities compared to net losses of $52.6 million in 2010 and net gains of $133.8 million in 2009. The net losses during 2011 and 2010 were due to economic derivatives. During 2011, we recorded net losses of $121.7 million on economic derivatives compared to losses of $57.3 million in 2010. These losses were primarily due to the effect of changes in interest rates on interest rate caps economically hedging our mortgage asset portfolio and interest rate swaps economically hedging our trading securities portfolio. The net gains during 2009 were primarily due to the effect of changes in interest rates on interest rate swaps hedging certain AFS securities. Refer to “Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations — Results of Operations — Hedging Activities” for a more detailed discussion of our hedging activities.

In an effort to reduce future interest costs and reposition our balance sheet, we may extinguish certain higher-costing bonds from time to time. During 2011, we extinguished bonds with a total par value of $33.0 million and recorded net losses of $4.6 million. During 2010, we extinguished bonds with a total par value of $1.3 billion and recorded net losses of $163.7 million. The primary driver for extinguishing such a large amount of debt in 2010 was advance prepayments. As advances were prepaid, we extinguished certain bonds funding the prepaid advances and utilized the advance prepayment fee income to offset the losses on the debt extinguishments. During 2009, we extinguished bonds with a total par value of $0.9 billion and recorded losses of $89.9 million.

We generally hold trading securities in our Statements of Condition for liquidity purposes. Trading securities are recorded at fair value with changes in fair value reflected through other (loss) income. During 2011, 2010, and 2009, we recorded net gains on trading securities of $38.7 million, $37.4 million, and $19.1 million. Net gains on trading securities include both realized gains from the sale of trading securities and holding gains. Realized gains on trading securities amounted to $1.0 million, $28.6 million, and $14.5 million during 2011, 2010, and 2009. The decrease in realized gains during 2011 when compared to 2010 was due to fewer investment sales. Holding gains on trading securities amounted to $37.7 million, $8.8 million, and $4.6 million during 2011, 2010, and 2009. The increase in holding gains during 2011 when compared to 2010 was primarily due to the effect of changes in interest rates.

During 2011, 2010, and 2009, we elected the fair value option on certain consolidated obligations that did not qualify for hedge accounting. We recorded fair value adjustment losses of $6.5 million on these consolidated obligations during 2011 compared to gains of $5.7 million in 2010 and losses of $4.4 million in 2009. The change between periods was primarily due to the effect of changes in interest rates. In order to achieve some offset to the fair value adjustment recorded on the fair value option consolidated obligations, we executed interest rate swaps accounted for as economic derivatives. Refer to “Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations — Results of Operations — Hedging Activities” for the impact of these economic derivatives.

32


Hedging Activities

We use derivatives to manage interest rate risk, including mortgage prepayment risk, in our Statements of Condition and to achieve our risk management objectives. Accounting rules affect the timing and recognition of income or expense on derivatives and therefore we may be subject to income statement volatility.
  
If a hedging activity qualifies for hedge accounting treatment (fair value hedge), we include the periodic cash flow components of the hedging instrument related to interest income or expense in the relevant income statement caption consistent with the hedged asset or liability. We also record the amortization of basis adjustments from terminated hedges in interest income or expense or other (loss) income. Changes in the fair value of both the hedging instrument and the hedged item are recorded as a component of other (loss) income in “Net (loss) gain on derivatives and hedging activities."

If a hedging activity does not qualify for hedge accounting treatment (economic hedge), we record the hedging instrument's components of interest income and expense, together with the effect of changes in fair value as a component of other (loss) income in “Net (loss) gain on derivatives and hedging activities”; however, there is no fair value adjustment for the corresponding asset or liability unless changes in the fair value of the asset or liability are normally marked to fair value through earnings (e.g., trading securities and fair value option instruments).

The following table categorizes the net effect of hedging activities on net income by product for the year ended December 31, 2011 (dollars in millions):
 
 
2011
Net Effect of
Hedging Activities
 
Advances
 
Investments
 
Mortgage
Loans
 
Bonds
 
Discount Notes
 
Balance
Sheet
 
Total
Net Interest Income:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Net (amortization) accretion1
 
$
(33.0
)
 
$

 
$
(3.2
)
 
$
43.2

 
$

 
$

 
$
7.0

Net interest settlements
 
(313.9
)
 
(11.8
)
 

 
265.2

 

 

 
(60.5
)
Total net interest income
 
(346.9
)
 
(11.8
)
 
(3.2
)
 
308.4

 

 

 
(53.5
)
Net Gain (Loss) on Derivatives and Hedging Activities:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Gains (losses) on fair value hedges
 
8.5

 
(2.7
)
 

 
5.1

 

 

 
10.9

(Losses) gains on economic hedges
 
(0.3
)
 
(59.9
)
 
(0.8
)
 
7.3

 
(0.9
)
 
(67.1
)
 
(121.7
)
Total net gain (loss) on derivatives and hedging activities
 
8.2

 
(62.6
)
 
(0.8
)
 
12.4

 
(0.9
)
 
(67.1
)
 
(110.8
)
Subtotal
 
(338.7
)
 
(74.4
)
 
(4.0
)
 
320.8

 
(0.9
)
 
(67.1
)
 
(164.3
)
Net gain on trading securities2
 

 
40.2

 

 

 

 

 
40.2

Net loss on consolidated obligations held at fair value
 

 

 

 
(5.1
)
 
(1.4
)
 

 
(6.5
)
Net amortization3
 

 

 

 
(0.5
)
 

 

 
(0.5
)
Total net effect of hedging activities
 
$
(338.7
)
 
$
(34.2
)
 
$
(4.0
)
 
$
315.2

 
$
(2.3
)
 
$
(67.1
)
 
$
(131.1
)
1
Represents the amortization/accretion of basis adjustments on closed hedge relationships included in net interest income.
2
Represents the net gains on those trading securities in which we have entered into a corresponding economic derivative to hedge the risk of changing market prices. As a result, this line item may not agree to the Statements of Income.
3
Represents the amortization of basis adjustments on closed bond hedge relationships included in other (loss) income as a result of debt extinguishments.

33


The following table categorizes the net effect of hedging activities on net income by product for the year ended December 31, 2010 (dollars in millions):
 
 
2010
Net Effect of
Hedging Activities
 
Advances
 
Investments
 
Mortgage
Loans
 
Bonds