Derivatives And Hedging Activities

6 Months Ended

Jun. 30, 2011

Derivatives And Hedging Activities

Derivatives And Hedging Activities

NOTE 7 – DERIVATIVES AND HEDGING ACTIVITIES

Nature of Business Activity: The FHLBank is exposed to interest rate risk primarily from the effect of interest rate changes on its interest-earning assets and its funding sources that finance these assets. The goal of the FHLBank's interest-rate risk management strategy is not to eliminate interest-rate risk, but to manage it within appropriate limits. To mitigate the risk of loss, the FHLBank has established policies and procedures, which include guidelines on the amount of exposure to interest rate changes it is willing to accept. In addition, the FHLBank monitors the risk to its revenue, net interest margin and average maturity of interest-earning assets and funding sources.

Consistent with Finance Agency regulation, the FHLBank enters into derivatives only to reduce the interest rate risk exposures inherent in otherwise unhedged assets and funding positions, to achieve risk management objectives and to act as an intermediary between its members and counterparties. Accordingly, the FHLBank may enter into derivatives that do not necessarily qualify for hedge accounting (economic hedges).

Common ways in which the FHLBank uses derivatives are to:

§Reduce funding costs by combining an interest rate swap with a consolidated obligation, as the cost of a combined funding structure can be lower than the cost of a comparable consolidated obligation;

§Reduce the interest rate sensitivity and repricing gaps of assets and liabilities;

§Preserve a favorable interest rate spread between the yield of an asset (e.g., an advance) and the cost of the related liability (e.g., the consolidated obligation used to fund the advance). Without the use of derivatives, this interest rate spread could be reduced or eliminated when a change in the interest rate on the advance does not match a change in the interest rate on the consolidated obligation;

§Mitigate the adverse earnings effects of the shortening or extension of certain assets (e.g., advances or mortgage assets) and liabilities;

§Manage embedded options in assets and liabilities; and

§Manage its overall asset-liability management.

Application of Derivatives: Derivative financial instruments may be used by the FHLBank as follows:

§As a fair value or cash flow hedge of an associated financial instrument, a firm commitment or an anticipated transaction;

§As an economic hedge to manage certain defined risks in the course of its balance sheet. These hedges are primarily used to manage mismatches between the coupon features of its assets and liabilities. For example, the FHLBank may use interest rate exchange agreements in its overall interest rate risk management activities to adjust the interest rate sensitivity of consolidated obligations to approximate more closely the interest rate sensitivity of its assets (both advances and investments), and/or to adjust the interest rate sensitivity of advances or investments to approximate more closely the interest rate sensitivity of its liabilities; and

§As an intermediary hedge to meet the asset/liability management needs of its members. The FHLBank acts as an intermediary by entering into interest-rate exchange agreements with its members and offsetting interest-rate exchange agreements with other counterparties. This intermediation grants smaller members indirect access to the derivatives market. The derivatives used in intermediary activities do not receive hedge accounting treatment and are separately marked-to-market through earnings. The net result of the accounting for these derivatives does not significantly affect the operating results of the FHLBank.

Derivative financial instruments are used by the FHLBank when they are considered to be the most cost-effective alternative to achieve the FHLBank's financial and risk management objectives. The FHLBank reevaluates its hedging strategies from time to time and may change the hedging techniques it uses or adopt new strategies.

Types of Derivatives: The FHLBank commonly enters into interest rate swaps (including callable and putable swaps), swaptions, and interest rate cap and floor agreements (collectively, derivatives) to manage its exposure to changes in interest rates.

Types of Hedged Items: At the inception of every hedge transaction, the FHLBank documents all hedging relationships between derivatives designated as hedging instruments and the hedged items, its risk management objectives and strategies for undertaking various hedge transactions, and its method of assessing effectiveness. This process includes linking all derivatives that are designated as fair value or cash flow hedges to: (1) assets and/or liabilities on the Statements of Condition; (2) firm commitments; or (3) forecasted transactions. The FHLBank formally assesses (both at the hedge's inception and at least quarterly on an ongoing basis) whether the derivatives that are used have been effective in offsetting changes in the fair value or cash flows of hedged items and whether those derivatives may be expected to remain effective in future periods. The FHLBank typically uses regression analyses or similar statistical analyses to assess the effectiveness of its hedging relationships. The types of hedged items are:

§Consolidated obligations;

§Advances;

§Mortgage loans;

§Firm commitment strategies;

§Investments; and

§Anticipated debt issuance.

Managing Credit Risk on Derivatives: The FHLBank is subject to credit risk due to nonperformance by counterparties to the derivative agreements. The degree of counterparty risk on derivative agreements depends on the extent to which master netting arrangements are included in such contracts to mitigate the risk. The FHLBank manages counterparty credit risk through credit analyses and collateral requirements and by following the requirements set forth in its RMP. The FHLBank requires collateral agreements on all derivatives that establish collateral delivery thresholds. Additionally, collateral related to derivatives with member institutions includes collateral assigned to an FHLBank, as evidenced by a written security agreement and held by the member institution for the benefit of the FHLBank. The maximum credit risk applicable to a single counterparty was $30,094,000 and $29,783,000 as of June 30, 2011 and December 31, 2010, respectively. The counterparty was the same each period.

The following table presents credit risk exposure on derivative instruments, excluding circumstances where the FHLBank's pledged collateral exceeds the FHLBank's net position (in thousands):

	06/30/2011	12/31/2010
Total net exposure at fair value1	$78,429	$90,155
Cash collateral held	(52,284)	(64,090)
Net positive exposure after cash collateral	26,145	26,065
Other collateral2	(1,828)	(2,952)
Net exposure after collateral	$24,317	$23,113

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1	Includes net accrued interest receivable of $9,949,000 and $11,251,000 as of June 30, 2011 and December 31, 2010, respectively.
2	Collateral held with respect to derivatives with members, which represents either collateral physically held by or on behalf of the FHLBank or collateral assigned to the FHLBank as evidenced by a written security agreement and held by the member for the benefit of the FHLBank.

Certain of the FHLBank's derivative instruments contain provisions that require the FHLBank to post additional collateral with its counterparties if there is deterioration in the FHLBank's credit rating. If the FHLBank's credit rating is lowered by an NRSRO, the FHLBank would be required to deliver additional collateral on derivative instruments in which the FHLBank has a net derivative liability recorded on its Statements of Condition. The aggregate fair value of all derivative instruments with derivative counterparties containing credit-risk-related contingent features that were classified as net derivative liabilities as of June 30, 2011 and December 31, 2010 was $364,429,000 and $352,908,000, respectively, for which the FHLBank has posted collateral with a fair value of $132,811,000 and $99,468,000, respectively, in the normal course of business. If the FHLBank's credit rating had been lowered one level (e.g., from AAA to AA), the FHLBank would have been required to deliver an additional $122,820,000 and $133,350,000 of collateral to its derivative counterparties as of June 30, 2011 and December 31, 2010.

The FHLBank transacts a significant portion of its derivatives with major banks and primary broker/dealers. Some of these banks and broker/dealers or their affiliates buy, sell and distribute consolidated obligations. No single entity dominates the FHLBank's derivatives business. The FHLBank is not a derivatives dealer and thus does not trade derivatives for short-term profit.

Financial Statement Impact and Additional Financial Information: The notional amount of derivatives reflects the volume of the FHLBank's hedges, but it does not measure the credit exposure of the FHLBank because there is no principal at risk. The notional amount in derivative contracts serves as a factor in determining periodic interest payments or cash flows received and paid.

The FHLBank considers accrued interest receivables and payables and the legal right to offset derivative assets and liabilities by counterparty. Consequently, derivative assets and liabilities reported on the Statements of Condition include the net cash collateral and accrued interest from counterparties. Therefore, an individual derivative may be in an asset position (counterparty would owe the FHLBank the current fair value, which includes net accrued interest receivable or payable on the derivative, if the derivative was settled as of the Statement of Condition date) but when the derivative fair value and cash collateral fair value (includes accrued interest on the collateral) are netted by counterparty, the derivative may be recorded on the Statements of Condition as a derivative liability. Conversely, a derivative may be in a liability position (FHLBank would owe the counterparty the fair value if settled as of the Statement of Condition date) but may be recorded on the Statements of Condition as a derivative asset after netting.

The following table represents outstanding notional balances and fair values (includes net accrued interest receivable or payable on the derivatives) of the derivatives outstanding by type of derivative and by hedge designation as of June 30, 2011 (in thousands):

	06/30/2011
	Gross Asset Positions		Gross Liability Positions		Net Derivative Assets		Net Derivative Liabilities
	Notional	Fair Value	Notional	Fair Value	Notional	Fair Value	Notional	Fair Value
Fair value hedges:
Interest rate swaps	$7,534,500	$296,276	$8,903,462	$(506,487)	$6,778,570	$84,797	$9,659,392	$(295,008)
Interest rate caps/floors	30,000	44	217,000	(3,415)	97,000	(1,485)	150,000	(1,886)
Total fair value hedges	7,564,500	296,320	9,120,462	(509,902)	6,875,570	83,312	9,809,392	(296,894)
Economic hedges:
Interest rate swaps	1,660,000	3,129	1,719,820	(176,241)	1,080,000	(43,583)	2,299,820	(129,529)
Interest rate caps/floors	7,080,533	100,560	362,000	(852)	3,759,300	38,566	3,683,233	61,142
Mortgage delivery commitments	35,124	134	69,458	(440)	35,124	134	69,458	(440)
Total economic hedges	8,775,657	103,823	2,151,278	(177,533)	4,874,424	(4,883)	6,052,511	(68,827)
TOTAL	$16,340,157	$400,143	$11,271,740	$(687,435)	$11,749,994	$78,429	$15,861,903	$(365,721)
Total derivative fair value						$78,429		$(365,721)
Fair value of cash collateral delivered to counterparties						0		132,811
Fair value of cash collateral received from counterparties						(52,284)		0
NET DERIVATIVE FAIR VALUE						$26,145		$(232,910)

The following table represents outstanding notional balances and fair values (includes net accrued interest receivable or payable on the derivatives) of the derivatives outstanding by type of derivative and by hedge designation as of December 31, 2010 (in thousands):

	12/31/2010
	Gross Asset Positions		Gross Liability Positions		Net Derivative Assets		Net Derivative Liabilities
	Notional	Fair Value	Notional	Fair Value	Notional	Fair Value	Notional	Fair Value
Fair value hedges:
Interest rate swaps	$8,626,899	$315,969	$9,084,209	$(518,805)	$7,528,867	$96,142	$10,182,241	$(298,978)
Interest rate caps/floors	30,000	369	159,000	(1,855)	97,000	(1,038)	92,000	(448)
Total fair value hedges	8,656,899	316,338	9,243,209	(520,660)	7,625,867	95,104	10,274,241	(299,426)
Economic hedges:
Interest rate swaps	1,425,000	7,167	2,224,820	(190,531)	1,330,000	(55,629)	2,319,820	(127,735)
Interest rate caps/floors	7,257,533	124,642	332,000	(743)	3,819,300	50,389	3,770,233	73,510
Mortgage delivery commitments	54,737	291	88,602	(1,524)	54,737	291	88,602	(1,524)
Total economic hedges	8,737,270	132,100	2,645,422	(192,798)	5,204,037	(4,949)	6,178,655	(55,749)
TOTAL	$17,394,169	$448,438	$11,888,631	$(713,458)	$12,829,904	$90,155	$16,452,896	$(355,175)
Total derivative fair value						$90,155		$(355,175)
Fair value of cash collateral delivered to counterparties						0		99,468
Fair value of cash collateral received from counterparties						(64,090)		0
NET DERIVATIVE FAIR VALUE						$26,065		$(255,707)

The following tables provide information regarding gains and losses on derivatives and hedging activities by type of hedge and type of derivative and gains and losses by hedged item for fair value hedges.

For the three- and six-month periods ended June 30, 2011 and 2010, the FHLBank recorded net gain (loss) on derivatives and hedging activities as follows (in thousands):

	Three-month Period Ended		Six-month Period Ended
	06/30/2011	06/30/2010	06/30/2011	06/30/2010
Derivatives and hedge items in fair value hedging relationships:
Interest rate swaps	$2,192	$(3,025)	$5,142	$(2,112)
Interest rate caps/floors	0	(13)	(57)	(45)
Total net gain (loss) related to fair value hedge ineffectiveness	2,192	(3,038)	5,085	(2,157)
Derivatives not designated as hedging instruments:
Economic hedges:
Interest rate swaps	(10,606)	(40,943)	8,302	(53,478)
Interest rate caps/floors	(16,586)	(37,153)	(24,179)	(95,247)
Net interest settlements	(9,980)	(17,091)	(21,350)	(33,927)
Mortgage delivery commitments	1,754	4,081	1,902	5,289
Intermediary transactions:
Interest rate swaps	(8)	(13)	(17)	(23)
Interest rate caps/floors	11	0	11	3
Total net gain (loss) related to derivatives not designated as hedging instruments	(35,415)	(91,119)	(35,331)	(177,383)
Net gain (loss) on derivatives and hedging activities	$(33,223)	$(94,157)	$(30,246)	$(179,540)

The FHLBank carries derivative instruments at fair value on its Statements of Condition. Any change in the fair value of derivatives designated under a fair value hedging relationship is recorded each period in current period earnings. Fair value hedge accounting allows for the offsetting fair value of the hedged risk in the hedged item to also be recorded in current period earnings. For the three-month periods ended June 30, 2011 and 2010, the FHLBank recorded net gain (loss) on derivatives and the related hedged items in fair value hedging relationships and the impact of those derivatives on the FHLBank's net interest income as follows (in thousands):

	Three-month Period Ended
	06/30/2011				06/30/2010
	Gain (Loss) on Derivatives	Gain (Loss) on Hedged Items	Net Fair Value Hedge Ineffectiveness	Effect of Derivatives on Net Interest Income1	Gain (Loss) on Derivatives	Gain (Loss) on Hedged Items	Net Fair Value Hedge Ineffectiveness	Effect of Derivatives on Net Interest Income1
Advances	$(77,541)	$76,545	$(996)	$(57,517)	$(138,994)	$137,750	$(1,244)	$(77,575)
Consolidated obligation bonds	42,465	(39,054)	3,411	59,400	72,589	(74,733)	(2,144)	83,138
Consolidated obligation discount notes	(391)	168	(223)	380	(193)	543	350	221
TOTAL	$(35,467)	$37,659	$2,192	$2,263	$(66,598)	$63,560	$(3,038)	$5,784

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¹ The differentials between accruals of interest receivables and payables on derivatives designated as fair value hedges as well as the amortization/accretion of hedging activities are recognized as adjustments to the interest income or expense of the designated underlying hedged item.

For the six-month periods ended June 30, 2011 and 2010, the FHLBank recorded net gain (loss) on derivatives and the related hedged items in fair value hedging relationships and the impact of those derivatives on the FHLBank's net interest income as follows (in thousands):

	Six-month Period Ended
	06/30/2011				06/30/2010
	Gain (Loss) on Derivatives	Gain (Loss) on Hedged Items	Net Fair Value Hedge Ineffectiveness	Effect of Derivatives on Net Interest Income1	Gain (Loss) on Derivatives	Gain (Loss) on Hedged Items	Net Fair Value Hedge Ineffectiveness	Effect of Derivatives on Net Interest Income1
Advances	$(1,325)	$938	$(387)	$(124,953)	$(167,103)	$165,360	$(1,743)	$(158,931)
Consolidated obligation bonds	(13,093)	18,901	5,808	112,962	129,147	(129,876)	(729)	171,868
Consolidated obligation discount notes	(1,073)	737	(336)	1,219	(235)	550	315	263
TOTAL	$(15,491)	$20,576	$5,085	$(10,772)	$(38,191)	$36,034	$(2,157)	$13,200

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¹ The differentials between accruals of interest receivables and payables on derivatives designated as fair value hedges as well as the amortization/accretion of hedging activities are recognized as adjustments to the interest income or expense of the designated underlying hedged item.

There were no amounts for the three- and six-month periods ended June 30, 2011 and 2010 that were reclassified into earnings as a result of the discontinuance of cash flow hedges because it became probable that the original forecasted transactions would not occur by the end of the originally specified time period or within a two-month period thereafter. As of June 30, 2011, no amounts relating to hedging activities remain in accumulated OCI.