10-K 1 form_10k.htm 12/31/2011 FORM 10-K form_10k.htm


 
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
 
 
¨  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from ________ to ________
 
 
Commission File Number 000-52004
 
 
FEDERAL HOME LOAN BANK OF TOPEKA
(Exact name of registrant as specified in its charter)
 
 
Federally chartered corporation
 
48-0561319
(State or other jurisdiction of
incorporation or organization)
 
(I.R.S. Employer
Identification No.)
 
One Security Benefit Pl. Suite 100
Topeka, KS
 
 
66606
(Address of principal executive offices)
 
(Zip Code)
 
 
Registrant’s telephone number, including area code: 785.233.0507
 
Securities registered pursuant to Section 12(b) of the Act: None
 
Securities registered pursuant to Section 12(g) of the Act:
Class A Common Stock, $100 per share par value
 
 
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  ¨ 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.  ¨ 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  ¨ 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 (§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 (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  x
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.  ¨ Large accelerated filer          ¨ Accelerated filer          x Non-accelerated filer          ¨ Smaller reporting company
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).  ¨ Yes  x No
 
Indicate the number of shares outstanding of each of the registrant’s classes of common stock, as of the latest practicable date.
 
 
 
Shares outstanding as of March 9, 2012
Class A Stock, par value $100
5,956,011
Class B Stock, par value $100
7,541,606
 
 
Registrant’s common stock is not publicly traded and is only issued to members of the registrant. Such stock is issued, redeemed and repurchased at par value, $100 per share, with all issuances, redemptions and repurchases subject to the registrant’s capital plan as well as certain statutory and regulatory requirements.
 
Documents incorporated by reference:  None
 



 
 

 

 
FEDERAL HOME LOAN BANK OF TOPEKA
 
 
TABLE OF CONTENTS
 
 
PART I
   
  4
  20
  25
  25
  26
  26
    26
  26
  28
  29
  80
  86
  86
  87
    87
  87
  92
 103
 104
 105
PART IV
   
 106
 
 
 
 
 
 
Exhibit 101
XBRL Documents
 
 
 

 
2

 


 
Important Notice about Information in this Annual Report
 
 
In this annual report, unless the context suggests otherwise, references to the “FHLBank,” “FHLBank Topeka,” “we,” “us” and “our” mean the Federal Home Loan Bank of Topeka, and “FHLBanks” mean the 12 Federal Home Loan Banks, including the FHLBank Topeka.
 
The information contained in this annual report is accurate only as of the date of this annual report and as of the dates specified herein.
 
The product and service names used in this annual report are the property of the FHLBank, and in some cases, the other FHLBanks. Where the context suggests otherwise, the products, services and company names mentioned in this annual report are the property of their respective owners.
 
Special Cautionary Notice Regarding Forward-looking Statements
 
 
The information contained in this Form 10-K contains forward-looking statements within the meaning of the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements include statements describing the objectives, projections, estimates or future predictions of the FHLBank’s operations. These statements may be identified by the use of forward-looking terminology such as “anticipates,” “believes,” “may,” “is likely,” “could,” “estimate,” “expect,” “will,” “intend,” “probable,” “project,” “should,” or their negatives or other variations of these terms. The FHLBank cautions that by their nature forward-looking statements involve risk or uncertainty and that actual results may differ materially from those expressed in any forward-looking statements as a result of such risks and uncertainties, including but not limited to:
§  
Governmental actions, including legislative, regulatory, judicial or other developments that affect the FHLBank; its members, counterparties or investors; housing government sponsored enterprises (GSE); or the FHLBank System in general;
§  
Regulatory actions and determinations, including those resulting from the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act);
§  
Changes in the FHLBank’s capital structure;
§  
Changes in economic and market conditions, including conditions in the mortgage, housing and capital markets;
§  
Changes in demand for advances or consolidated obligations of the FHLBank and/or of the FHLBank System;
§  
Effects of derivative accounting treatment, other-than-temporary impairment (OTTI) accounting treatment and other accounting rule requirements;
§  
The effects of amortization/accretion;
§  
Gains/losses on derivatives or on trading investments and the ability to enter into effective derivative instruments on acceptable terms;
§  
Volatility of market prices, interest rates and indices and the timing and volume of market activity;
§  
Membership changes, including changes resulting from member failures or mergers, changes in the principal place of business of members or changes in the Federal Housing Finance Agency (Finance Agency) regulations on membership standards;
§  
Our ability to declare dividends or to pay dividends at rates consistent with past practices;
§  
Soundness of other financial institutions, including FHLBank members, nonmember borrowers, and the other FHLBanks;
§  
Changes in the value or liquidity of collateral underlying advances to FHLBank members or nonmember borrowers or collateral pledged by reverse repurchase and derivative counterparties;
§  
Competitive forces, including competition for loan demand, purchases of mortgage loans and access to funding;
§  
The ability of the FHLBank to introduce new products and services to meet market demand and to manage successfully the risks associated with new products and services;
§  
Our ability to keep pace with technological changes and the ability of the FHLBank to develop and support technology and information systems, including the ability to access the internet and internet-based systems and services, sufficient to effectively manage the risks of the FHLBank’s business;
§  
The ability of each of the other FHLBanks to repay the principal and interest on consolidated obligations for which it is the primary obligor and with respect to which the FHLBank has joint and several liability;
§  
Changes in the U.S. government’s long-term debt rating and the long-term credit rating of the senior unsecured debt issues of the FHLBank System;
§  
Changes in the fair value and economic value of, impairments of, and risks associated with, the FHLBank’s investments in mortgage loans and mortgage-backed securities (MBS) or other assets and related credit enhancement (CE) protections; and
§  
The volume of eligible mortgage loans originated and sold by participating members to the FHLBank through its various mortgage finance products (Mortgage Partnership Finance® (MPF®) Program1).
 
 
Readers of this report should not rely solely on the forward-looking statements and should consider all risks and uncertainties addressed throughout this report, as well as those discussed under Item 1A – “Risk Factors.”
 
All forward-looking statements contained in this Form 10-K are expressly qualified in their entirety by this cautionary notice. The reader should not place undue reliance on such forward-looking statements, since the statements speak only as of the date that they are made and the FHLBank has no obligation and does not undertake publicly to update, revise or correct any forward-looking statement for any reason.
 
 
 1  "Mortgage Partnership Finance," "MPF" and "eMPF" are registered trademarks of the Federal Home Loan Bank of Chicago

 
3

 


PART I
 
 
 
 
General
One of 12 FHLBanks, FHLBank Topeka is a federally chartered corporation organized on October 13, 1932 under the authority of the Federal Home Loan Bank Act of 1932, as amended (Bank Act). Our primary business is making collateralized loans and providing other banking services to member institutions and certain qualifying non-members (housing associates). We are a cooperative owned by our members and are generally limited to providing products and services only to those members. Each FHLBank operates as a separate corporate entity with its own management, employees and board of directors. We are exempt from federal, state and local taxation except real property taxes. We do not have any wholly- or partially-owned subsidiaries and do not have an equity position in any partnerships, corporations or off-balance sheet special purpose entities.
 
We are supervised and regulated by the Finance Agency, an independent agency in the executive branch of the U.S. government. The Finance Agency’s mission with respect to the FHLBanks is to provide effective supervision, regulation and housing mission oversight of the FHLBanks to promote their safety and soundness, support housing finance and affordable housing, and support a stable and liquid mortgage market.
 
Any federally insured depository institution, insurance company, or community development financial institution whose principal place of business is located in Colorado, Kansas, Nebraska or Oklahoma is eligible to become one of our members. Except for community financial institutions (CFIs), applicants for membership must demonstrate they are engaged in residential housing finance. CFIs are defined in the Housing and Economic Recovery Act of 2008 (Recovery Act) as those institutions that have, as of the date of the transaction at issue, less than a specified amount of average total assets over the three years preceding that date (subject to annual adjustment by the Finance Agency director based on the consumer price index). For 2011, this asset cap was $1.04 billion.
 
Our members are required to purchase and maintain our capital stock as a condition of membership, and only members are permitted to purchase capital stock. All capital stock transactions are governed by our capital plan, which was developed under, is subject to and operates within specific regulatory and statutory requirements.
 
Member institutions own nearly all of our outstanding capital stock and may receive dividends on that stock. Former members own capital stock as long as they have outstanding business transactions with us. A member must own capital stock in the FHLBank based on the amount of the member’s assets and the level of business activities it engages in with us. As a result of these stock purchase requirements, we conduct business with related parties in the normal course of business. For disclosure purposes, we include in our definition of a related party any member institution (or successor) that is known to be the beneficial owner of more than 5 percent of any class of our voting securities and any person who is, or at any time since the beginning of our last fiscal year was, one of our directors or executive officers, among others. Information on business activities with related parties is provided in Tables 92 and 93 under Item 12 – “Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.”
 
Our business activities include providing collateralized loans, known as advances, to members and housing associates, and acquiring residential mortgage loans from or through members. By law, only certain general categories of collateral are eligible to secure FHLBank obligations. We also provide members and housing associates with letters of credit and certain correspondent services, such as safekeeping, wire transfers, derivative intermediation and cash management.
 
Our primary funding source is consolidated obligations issued through the FHLBanks’ Office of Finance. The Office of Finance is a joint office of the FHLBanks that facilitates the issuance and servicing of the consolidated obligations. The Finance Agency and the U.S. Secretary of the Treasury have oversight over the issuance of FHLBank debt through the Office of Finance. Consolidated obligations are debt instruments that constitute the joint and several obligations of all FHLBanks. Although consolidated obligations are not obligations of, nor guaranteed by, the U.S. government, the capital markets have traditionally considered the FHLBanks’ consolidated obligations as “Federal agency” debt. As a result, the FHLBanks have traditionally had ready access to funding at relatively favorable spreads to U.S. Treasuries. Additional funds are provided by deposits (received from both member and non-member financial institutions), other borrowings and the issuance of capital stock.
 
Standard & Poor’s (S&P) and Moody’s Investor Service (Moody’s) base their ratings of the FHLBanks and the debt issues of the FHLBank System in part on the FHLBanks’ relationship with the U.S. government. S&P currently rates the long-term credit ratings on the senior unsecured debt issues of the FHLBank System and all 12 FHLBanks at AA+. S&P’s rating outlook for the FHLBank System’s senior unsecured debt and all 12 FHLBanks is negative. However, S&P still rates the short-term ratings of the FHLBanks and the FHLBank System’s short-term debt issues at A-1+. Moody’s Investors Service (Moody’s) has confirmed the long-term Aaa rating on the senior unsecured debt issues of the FHLBank System and the 12 FHLBanks. Moody’s rating outlook for the FHLBank System and the 12 FHLBanks is negative.
 
Business Segments
We currently do not manage or segregate our operations by segments.

 
4

 
Advances
We make advances to members and housing associates based on the security of residential mortgages and other eligible collateral. Following is a brief description of our standard advance product offerings:
§  
Line of credit advances are variable rate, non-amortizing, prepayable, revolving line products that provide an alternative to the purchase of Federal funds, brokered deposits or repurchase agreement borrowings;
§  
Short-term fixed rate advances are non-amortizing, non-prepayable loans with terms to maturity from 3 to 93 days;
§  
Regular fixed rate advances are non-amortizing loans, prepayable with a fee, with terms to maturity from 94 days to 180 months;
§  
Adjustable rate advances are non-amortizing loans, which are: (1) prepayable with fee on interest rate reset dates, if the variable interest rate is tied to any one of a number of standard indices including the London Interbank Offered Rate (LIBOR), Treasury bills, Federal funds, or Prime; or (2) prepayable without fee if the variable interest rate is tied to one of our short-term fixed rate advance products;
§  
Callable advances can have a fixed or variable rate of interest for the term of the advance and contain an option(s) that allows for the prepayment of the advance without a fee on specified dates;
§  
Amortizing advances are fixed rate loans, prepayable with fee, that contain a set of predetermined principal payments to be made during the life of the advance;
§  
Convertible advances are non-amortizing, fixed rate loans that contain an option(s) that allows us to convert the fixed rate advance to a prepayable, adjustable rate advance that re-prices monthly based upon our one-month short-term, fixed rate advance product. Once we exercise our option to convert the advance, it can be prepaid without fee on the initial conversion date or on any interest rate reset date thereafter; and
§  
Standby credit facility is a variable rate, non-amortizing, prepayable, revolving standby credit line that provides a greater level of assurance that secured funding can be provided during a market disruption.
 
 
Customized advances may be created on request including advances with embedded floors and caps. All embedded derivatives in customized advances are evaluated to determine whether they are clearly and closely related to the advances. See Note 9 in the Notes to Financial Statements under Item 8 for information on accounting for embedded derivatives. The types of derivatives used to hedge risks embedded in our advance products are indicated in Tables 72 and 73 under Item 7A – “Quantitative and Qualitative Disclosures About Market Risk – Risk Management – Interest Rate Risk Management.”
 
We also offer a variety of specialized advance products to address housing and community development needs. The products include advances priced at our cost of funds plus reasonable administrative expenses, as well as advances priced at our cost of funds. These advance products address needs for low-cost funding to create affordable rental and homeownership opportunities, and for commercial and economic development activities, including those that benefit low- and moderate-income neighborhoods. Refer to Item 1 – “Business – Other Mission-related Activities” for more details.
 
In addition to members, we make advances to certain non-members (housing associates). To qualify as a housing associate, the applicant must: (1) be approved under Title II of the National Housing Act of 1934; (2) be a chartered institution having succession; (3) be subject to the inspection and supervision of some governmental agency; (4) lend its own funds as its principal activity in the mortgage field; and (5) have a financial condition that demonstrates that advances may be safely made. Housing associates are not subject to certain provisions of the Bank Act that are applicable to members, such as the capital stock purchase requirements, but the same regulatory lending requirements generally apply to them as apply to members. Restrictive collateral provisions apply if the housing associate does not qualify as a state housing finance agency (HFA). We currently have three housing associates as customers and all three are state HFAs.
 
At the time an advance is originated, we are required to obtain and maintain a security interest in sufficient collateral eligible in one or more of the following categories:
§  
Fully disbursed, whole first mortgages on 1-4 family residential property (not more than 90 days delinquent) or securities representing a whole interest in such mortgages;
§  
Securities issued, insured or guaranteed by the U.S. government, U.S. government agencies and mortgage GSEs including, without limitation, MBS issued or guaranteed by Federal National Mortgage Association (Fannie Mae), Federal Home Loan Mortgage Corporation (Freddie Mac) or Government National Mortgage Association (Ginnie Mae);
§  
Cash or deposits in an FHLBank;
§  
Other acceptable real estate-related collateral, provided such collateral has a readily ascertainable market value and we can perfect a security interest in such property (e.g., privately issued collateralized mortgage obligations (CMOs), mortgages on multifamily residential real property, second mortgages on 1-4 family residential property, mortgages on commercial real estate); or
§  
In the case of any CFI, secured loans to small business, small farm and small agri-business or securities representing a whole interest in such secured loans.
 
 
As additional security for a member’s indebtedness, we have a statutory lien upon that member’s FHLBank stock. Plus, at our discretion, additional collateral may be required to secure a member’s or housing associate’s outstanding credit obligations at any time (whether or not such collateral would be eligible to originate an advance).
 
The Bank Act affords any security interest granted to us by any of our members, or any affiliate of any such member, priority over the claims and rights of any party, including any receiver, conservator, trustee, or similar party having rights of a lien creditor. The only exceptions are claims and rights held by actual bona fide purchasers for value or by parties that are secured by actual perfected security interests, and provided that such claims and rights would otherwise be entitled to priority under applicable law. In addition, our claims are given certain preferences pursuant to the receivership provisions in the Federal Deposit Insurance Act. Most members provide us a blanket lien covering substantially all of the member’s assets and consent for us to file a financing statement evidencing the blanket lien. Based on the blanket lien, the financing statement and the statutory preferences, we normally do not take control of collateral, other than securities collateral, pledged by blanket lien borrowers. We take control of all securities collateral through delivery of the securities to us or to an approved third-party custodian. With respect to non-blanket lien borrowers (typically insurance companies and housing associates), we take control of all collateral. In the event that the financial condition of a blanket lien member warrants such action because of the deterioration of the member’s financial condition, regulatory concerns about the member or other factors, we will take control of sufficient collateral to fully collateralize the member’s indebtedness to us.
 
 
5

 
Mortgage Loans
We purchase or fund various mortgage products from or through participating financial institutions (PFIs) under the MPF Program, a secondary mortgage market structure. Under the MPF Program, we invest in qualifying 5- to 30-year conventional conforming and government-insured or guaranteed (by the Federal Housing Administration (FHA), the Department of Veterans Affairs (VA), the Rural Housing Service of the Department of Agriculture (RHS) and the Department of Housing and Urban Development (HUD)) fixed rate mortgage loans on 1-4 family residential properties.
 
The MPF Program helps fulfill our housing mission and provides an additional source of liquidity to FHLBank members that choose to sell mortgage loans into the secondary market rather than holding them in their own portfolios. MPF Program loans are considered Acquired Member Assets (AMA), a core mission activity of the FHLBanks, as defined by Finance Agency regulations.
 
Allocation of Risk: The MPF Program is designed to allocate risks associated with MPF loans between us and the PFIs. PFIs have direct knowledge of their mortgage markets and have developed expertise in underwriting and servicing residential mortgage loans. By allowing PFIs to originate MPF loans, whether through retail or wholesale operations, and to retain or acquire servicing of MPF loans, the MPF Program gives control of those functions that most impact credit quality to PFIs. We are responsible for managing the interest rate, prepayment and liquidity risks associated with owning MPF loans.
 
Under the Finance Agency’s AMA regulation, the PFI must “bear the economic consequences” of certain losses with respect to a master commitment based upon the MPF product and other criteria. To comply with these regulations, MPF purchases and fundings are structured so the credit risk associated with MPF loans is shared with PFIs. The master commitment defines the pool of MPF loans for which the CE obligation is set so the risk associated with investing in such a pool of MPF loans is equivalent to investing in a AA-rated asset.
 
For conventional MPF loan products, PFIs assume or retain a portion of the credit risk. Subsequent to any private mortgage insurance (PMI), we share in the credit risk of the loans with the PFI. We assume the first layer of loss coverage as defined by the First Loss Account (FLA). If losses beyond the FLA layer are incurred for a pool, the PFI assumes the loan losses up to the amount of the CE obligation as specified in a master commitment agreement for each pool of mortgage loans purchased from the PFI. The CE obligation provided by the PFI ensures they retain a credit stake in the loans they sell and PFIs are paid a CE fee for managing this credit risk. In some instances, depending on the MPF product type (see Table 1), all or a portion of the CE fee may be performance based. Any losses in excess of our responsibility under the FLA and the member’s CE obligation for a pool of MPF loans are our responsibility. All loss allocations among us and our PFIs are based upon formulas specific to pools of loans covered by a specific MPF product and master commitment (see Table 2). PFIs’ CE obligations must be fully collateralized with assets considered eligible under our collateral policy. See Item 1 – “Business – Advances” for a discussion of eligible collateral.
 
There are five MPF loan products from which PFIs may choose (see Table 1). Four of these 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 product in which we “table fund” MPF loans; that is, we provide the funds through the PFI (via their settlement agent) as our agent to make the MPF loan to the borrower. Under all of the above MPF loan products, the PFI performs all traditional retail loan origination functions. With respect to the MPF 100 product, we are considered the originator of the MPF loan for accounting purposes since the PFI is acting as our agent when originating the MPF loan; however, we do not collect any origination fees.
 
PFI Eligibility: Members and eligible housing associates may apply to become PFIs. We review the general eligibility of the member, its servicing qualifications and its ability to supply documents, data and reports required to be delivered by PFIs under the MPF Program. A Participating Financial Institution Agreement provides the terms and conditions for the sale or funding of MPF loans, including required CE obligations, and establishes the terms and conditions for servicing MPF loans. All of the PFI’s CE obligations under this agreement are secured in the same manner as the other obligations of the PFI under its regular advances agreement with us. We have the right under the advances agreement to request additional collateral to secure the PFI’s MPF CE obligations.
 
MPF Provider: The FHLBank of Chicago serves as the MPF Provider for the MPF Program. The MPF Provider maintains the structure of MPF loan products and the eligibility rules for MPF loans. In addition, it manages the pricing and delivery mechanism for MPF loans and the back-office processing of MPF loans in its role as master servicer and master custodian. We have the capability under the individual bank pricing option to change the pricing offered to our PFIs, but the change affects all delivery commitment terms and loan note rates in the same amount for all PFIs. The MPF Provider has engaged Wells Fargo Bank N.A. as the vendor for master servicing and as the primary custodian for the MPF Program.
 
The MPF Provider publishes and maintains the MPF Origination, Underwriting and Servicing Guides and an MPF Xtra Guide, all of which detail the requirements PFIs must follow in originating, underwriting or selling and servicing MPF loans. Under the MPF Xtra product, we would be a conduit that PFIs would use to sell loans to FHLBank of Chicago, then simultaneously to Fannie Mae. We currently do not offer the MPF Xtra product although we have received conditional approval from the Finance Agency to do so. The MPF Provider maintains the infrastructure through which we can fund or purchase MPF loans through our PFIs. In exchange for providing these services, we pay the MPF Provider a fee, which is based upon the unpaid balances of MPF loans funded since January 1, 2004.
 
MPF Servicing: PFIs selling MPF loans may either retain the servicing function or transfer it. If a PFI chooses to retain the servicing function, they receive a servicing fee. Servicing-retained PFIs may utilize approved subservicers to perform the servicing duties. If the PFI chooses to transfer servicing rights to an approved third-party provider, the servicing is transferred concurrently with the sale of the MPF loan with the PFI receiving a service-released premium. The servicing fee is paid to the third-party servicer. All servicing-retained and servicing-released PFIs are subject to the rules and requirements set forth in the MPF Servicing Guide. Throughout the servicing process, the master servicer monitors PFI compliance with MPF Program requirements and makes periodic reports to the MPF Provider.
 
 
6

 
Mortgage Standards: PFIs are required to deliver mortgage loans that meet the eligibility requirements in the MPF Guides. The eligibility guidelines in the MPF Guides applicable to the conventional MPF loans in our portfolio are broadly summarized as follows:
§  
Mortgage characteristics: MPF loans must be qualifying 5- to 30-year conforming conventional, fixed rate, fully amortizing mortgage loans, secured by first liens on owner-occupied 1- to 4-unit single-family residential properties and single-unit second homes.
§  
Loan-to-value (LTV) ratio and PMI: The maximum LTV for conventional MPF loans is 95 percent, though Affordable Housing Program (AHP) mortgage loans may have LTVs up to 100 percent. Conventional MPF loans with LTVs greater than 80 percent are insured by PMI from a mortgage guaranty insurance company that has successfully passed an internal credit review and is approved under the MPF Program.
§  
Documentation and compliance: Mortgage documents and transactions are required to comply with all applicable laws. Mortgage loans are documented using standard Fannie Mae/Freddie Mac uniform instruments.
§  
Government loans: Government loans sold under the MPF Program have substantially the same parameters as conventional MPF loans except that their LTVs may not exceed the LTV limits set by the applicable government agency and they must meet all requirements to be insured or guaranteed by the applicable government agency.
§  
Ineligible mortgage loans: Loans not eligible for sale under the MPF Program include mortgage loans unable to be rated by S&P, loans not meeting eligibility requirements, loans classified as high cost, high rate, high risk, Home Ownership and Equity Protection Act loans or loans in similar categories defined under predatory or abusive lending laws, or subprime, non-traditional, or higher-priced mortgage loans.
 
 
Loss Calculations: Losses under the FLA are defined differently than losses for financial reporting purposes. The differences reside in the timing of the recognition of the loss and how the components of the loss are recognized. Under the FLA, a loss is the difference between the recorded loan value and the total proceeds received from the sale of an MPF property after paying any associated expenses, not to exceed the amount of the FLA. The loss is recognized upon sale of the mortgaged property. For financial reporting purposes, when an MPF loan is deemed a loss loan, the difference between the recorded loan value and the appraised value of the property securing the loan (fair market value) less the estimated costs to sell is recognized as a charge to the Allowance for Credit Losses on Mortgage Loans in the period the loss status is assigned to the loan. After foreclosure, any expenses associated with carrying the loan until sale are recognized as Real Estate Owned (REO) expenses in the current period. FLA and loss information for December 31, 2011 and 2010 can be found in Table 31.
 
A majority of the states, and some municipalities, have enacted laws against mortgage loans considered predatory or abusive. Some of these laws impose liability for violations not only on the originator, but also upon purchasers and assignees of mortgage loans. We take measures that we consider reasonable and appropriate to reduce our exposure to potential liability under these laws and are not aware of any claim, action or proceeding asserting that we are liable under these laws. However, there can be no assurance that we will never have any liability under predatory or abusive lending laws.
 
Table 1 presents a comparison of the different characteristics for each of the MPF products as of December 31, 2011:
 
 
Table 1
 
 
Product Name
Size of the FHLBank’s FLA
PFI CE Obligation Description
CE Fee
Paid to PFI
CE Fee Offset1
Servicing Fee
to PFI
Original MPF
4 basis points (bps) per year against unpaid balance, accrued monthly
After FLA, to bring to the equivalent of “AA”
10 bps per year, paid monthly; guaranteed
No
25 bps per year, paid monthly
           
MPF 1002
100 bps fixed based on gross fundings at closing
After FLA, to bring to the equivalent of “AA”
7 to 10 bps per year, paid monthly; performance based after 3 years
Yes; after first 3 years, to the extent recoverable in future years
25 bps per year, paid monthly
           
MPF 125
100 bps fixed based on gross fundings at closing
After FLA, to bring to the equivalent of “AA”
7 to 10 bps per year, paid monthly; performance based
Yes; to the extent recoverable in future years
25 bps per year, paid monthly
           
MPF Plus3
Sized to equal expected losses
0 to 20 bps after FLA and supplemental mortgage insurance (SMI), to bring to the equivalent of “AA”
7 bps per year plus 6 to 7 bps per year, performance based (delayed for 1 year); all fees paid monthly
Yes; to the extent recoverable in future years
25 bps per year, paid monthly
           
Original MPF for
Government Loans
N/A
N/A (unreimbursed servicing expenses only)
N/A4
N/A
44 bps per year, paid monthly
                   
1
Future payouts of performance-based CE fees are reduced when losses are allocated to the FLA. The offset is limited to fees payable in a given year but could be reduced in subsequent years. The overall reduction is limited to the FLA amount for the life of the pool of loans covered by a master commitment agreement.
2
The MPF 100 product is currently inactive due to new requirements relating to loan originator compensation guidance under the Dodd-Frank Act. However, FHLBank management is considering revisions to the MPF product that would bring the funding of loans into compliance with the new guidance.
3
Due to higher costs associated with the acquisition of supplemental insurance policies, the MPF Plus product is currently not active.
4
Two government master commitments have been grandfathered and paid 2 bps/year. All other government master commitments are not paid a CE fee.
 
 
 
 
 
7

 
 
Table 2 presents an illustration of the FLA and CE obligation calculation for each conventional MPF product type listed as of December 31, 2011:
 
 
Table 2
 
 
Product Name
FLA
CE Obligation Calculation
Original MPF
4 bps x unpaid principal, annually1
(LLCE2 x PSF3) x Gross Fundings
MPF 100
100 bps x loan funded amount
((LLCE x PSF) – FLA) x Gross Fundings
MPF 125
100 bps x loan funded amount
((LLCE x PSF) – FLA) x Gross Fundings
MPF Plus
5 x variable CE Fee
AA equivalent – FLA-SMI4 = PCE5
                   
1
Starts at zero and increases monthly over the life of the master commitment.
2
LLCE represents the weighted average loan level credit enhancement score of the loans sold into the pool of loans covered by the master commitment agreement.
3
The S&P Level’s Pool Size Factor (PSF) is applied at the MPF FHLBank level against the total of loans in portfolio. A PSF is greater than one if the number of loans in portfolio is less than 300 in total.
4
SMI represents the coverage obtained from the supplemental mortgage insurer. The initial premium for the insurance is determined based on a sample $100 million loan pool. The final premium determination is made during the 13th month of the master commitment agreement, at which time any premium adjustment is determined based on actual characteristics of loans submitted. The SMI generally covers a portion of the PFI’s CE obligation which typically ranges from 200 to 250 bps of the dollar amount of loans delivered into a mortgage pool, but the PFI may purchase an additional level of coverage to completely cover the PFI’s CE obligation. The CE fees paid to PFIs for this program are capped at a maximum of 14 bps, which is broken into two components, fixed and variable. The fixed portion of the CE fee is paid to the SMI insurer for the coverage discussed above and is a negotiated rate depending on the level of SMI coverage, ranging from 6 to 8 bps. The variable portion is paid to the PFI, and ranges from 6 to 8 bps, with payments commencing the 13th month following initial loan purchase under the master commitment agreement.
5
PCE represents the CE obligation that the PFI elects to retain rather than covering with SMI. Under this MPF product, the retained amount can range from 0 to 20 bps.
 
 
Investments
A portfolio of investments is maintained for liquidity, asset-liability management and income purposes and to invest capital within the established statutory and regulatory limits. We maintain a portfolio of short-term investments in highly rated institutions, including overnight Federal funds, term Federal funds, interest-bearing certificates of deposit, bank notes, bankers’ acceptances, commercial paper and securities purchased under agreement to resell (i.e., investment transactions often referred to as reverse repurchase transactions). A longer-term investment portfolio is also maintained, which includes securities issued or guaranteed by the U.S. government, U.S. government agencies and GSEs as well as MBS that are issued by U.S. government agencies and housing GSEs (GSE securities are not explicitly guaranteed by the U.S. government) or privately issued MBS or asset-backed securities (ABS) that carried the highest ratings from Moody’s, Fitch Ratings (Fitch) or S&P at the date of acquisition. We have not purchased a private-label MBS/ABS investment since June 2006. On March 24, 2011, our Board of Directors approved removal of our authority to purchase these types of investments from our Risk Management Policy (RMP).
 
Under Finance Agency regulations, we are prohibited from investing in certain types of securities including:
§  
Instruments, such as common stock, that represent an ownership in an entity, other than stock in small business investment companies or certain investments targeted to low-income persons or communities;
§  
Instruments issued by non-U.S. entities other than those issued by U.S. branches and agency offices of foreign commercial banks;
§  
Non-investment-grade debt instruments other than certain investments targeted to low-income persons or communities, and instruments that were downgraded after purchase;
§  
Whole mortgages or other whole loans other than: (1) those acquired under our MPF Program; (2) certain investments targeted to low-income persons or communities; (3) certain marketable direct obligations of state, local, or tribal government units or agencies, having at least the second highest credit rating from a Nationally-Recognized Statistical Rating Organization (NRSRO); (4) MBS or ABS backed by manufactured housing loans or home equity loans; and (5) certain foreign housing loans authorized under section 12(b) of the Bank Act;
§  
Non-U.S. dollar denominated securities;
§  
Interest-only or principal-only stripped MBS, CMOs, real estate mortgage investment conduits (REMICs) and eligible ABS;
§  
Residual-interest or interest-accrual classes of CMOs, REMICs and eligible ABS; and
§  
Fixed rate MBS, CMOs, REMICs and eligible ABS, or floating rate MBS, CMOs, REMICs and eligible ABS that on the trade date are at rates equal to their contractual cap or that have average lives which vary by more than six years under an assumed instantaneous interest rate change of 300 bps.
 
 
In addition to the above limitations on allowable types of MBS investments, the Finance Agency limits our total investment in MBS by requiring that the total amortized cost of MBS owned not exceed 300 percent of our previous month-end total regulatory capital on the day we purchase the securities. Under Finance Board Resolution 2008-08, the FHLBanks were granted temporary authority to increase MBS up to 600 percent of previous month-end total regulatory capital under specific conditions. See Item 7 – “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Balance Sheet Analysis – Investments” for further discussion of Finance Board Resolution 2008-08 and actions taken by the FHLBank.

Debt Financing – Consolidated Obligations
Consolidated obligations, consisting of bonds and discount notes, are our primary sources of liabilities and represent the principal source we use to fund our advances and mortgage programs and to purchase investments. Consolidated obligations are the joint and several obligations of the FHLBanks, backed only by the financial resources of the 12 FHLBanks. Consolidated obligations are not obligations of the U.S. government, and the U.S. government does not guarantee them. The capital markets have traditionally considered the FHLBanks’ obligations as “Federal agency” debt. Consequently, although the U.S. government does not guarantee the FHLBanks’ debt, the FHLBanks have historically had reasonably stable access to funding at relatively favorable spreads to U.S. Treasuries. Our ability to access the capital markets through the sale of consolidated obligations, across the entire maturity spectrum and through a variety of debt structures, assists in managing our balance sheet effectively and efficiently. Moody’s currently rates the FHLBanks’ consolidated obligations Aaa/P-1, and S&P currently rates them AA+/A-1+. These ratings measure the likelihood of timely payment of principal and interest on consolidated obligations and also reflect the FHLBanks’ status as GSEs, which generally implies the expectation of a high degree of support by the U.S. government even though their obligations are not guaranteed by the U.S. government.
 
 
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Finance Agency regulations govern the issuance of debt on behalf of the FHLBanks and related activities, and authorize the FHLBanks to issue consolidated obligations, through the Office of Finance as their agent, under the authority of Section 11(a) of the Bank Act. No FHLBank is permitted to issue individual debt under Section 11(a) without Finance Agency approval. We are primarily and directly liable for the portion of consolidated obligations issued on our behalf. In addition, we are jointly and severally liable with the other 11 FHLBanks for the payment of principal and interest on the consolidated obligations of all 12 FHLBanks under Section 11(a). The Finance Agency, at its discretion, may require any FHLBank to make principal or interest payments due on any consolidated obligations for which the FHLBank is not the primary obligor. Although it has never occurred, to the extent that an FHLBank would be required to make a payment on a consolidated obligation on behalf of another FHLBank, the paying FHLBank would be entitled to reimbursement from the non-complying FHLBank. However, if the Finance Agency determines that the non-complying FHLBank is unable to satisfy its obligations, then the Finance Agency may allocate the non-complying FHLBank’s outstanding consolidated obligation debt 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 the Finance Agency may determine. If the principal or interest on any consolidated obligation issued on behalf of an individual FHLBank is not paid in full when due, the FHLBank may not pay dividends to, or redeem or repurchase shares of stock from, any member of that individual FHLBank.
 
Table 3 presents the par value of our consolidated obligations and the combined consolidated obligations of the 12 FHLBanks as of December 31, 2011 and 2010 (in millions):
 
 
Table 3
 
 
   
12/31/2011
   
12/31/2010
 
Par value of consolidated obligations of the FHLBank
  $ 29,897     $ 34,999  
                 
Par value of consolidated obligations of all FHLBanks
  $ 691,868     $ 796,374  
 
 
Finance Agency regulations provide that we must maintain aggregate assets of the following types, free from any lien or pledge, in an amount at least equal to the amount of consolidated obligations outstanding:
§  
Cash;
§  
Obligations of, or fully guaranteed by, the U.S government;
§  
Secured advances;
§  
Mortgages, which have any guaranty, insurance or commitment from the U.S. government or any agency of the U.S. government;
§  
Investments described in Section 16(a) of the Bank Act, which, among other items, includes securities that a fiduciary or trust fund may purchase under the laws of the state in which the FHLBank is located; and
§  
Other securities that are assigned a rating or assessment by an NRSRO that is equivalent to or higher than the rating on consolidated obligations, except securities specifically prohibited in the Investments section of Item 1 – “Business – Investments.”
 
 
Table 4 illustrates our compliance with the Finance Agency’s regulations for maintaining aggregate assets at least equal to the amount of consolidated obligations outstanding as of December 31, 2011 and 2010 (in thousands):
 
 
Table 4
 
 
   
12/31/2011
   
12/31/2010
 
Total non-pledged assets
  $ 33,105,379     $ 38,600,798  
Total carrying value of consolidated obligations
  $ 30,145,591     $ 35,225,977  
                 
Ratio of non-pledged assets to consolidated obligations
    1.10       1.10  
 
 
The Office of Finance has responsibility for facilitating and executing the issuance of the consolidated obligations on behalf of the FHLBanks. It also prepares the FHLBanks’ Combined Quarterly and Annual Financial Reports, services all outstanding debt, serves as a source of information for the FHLBanks on capital market developments, administers the Resolution Funding Corporation (REFCORP) and the Financing Corporation, and manages the FHLBanks’ relationship with the NRSROs with respect to ratings on consolidated obligations.
 
Consolidated Obligation Bonds: Consolidated obligation bonds satisfy our term funding needs. Typically, the maturities of these bonds range from less than one year to 30 years, but the maturities are not subject to any statutory or regulatory limit. Consolidated obligation bonds can be issued and distributed through negotiated or competitively bid transactions with approved underwriters or selling group members.
 
Consolidated obligation bonds are generally issued with either fixed or variable rate payment terms that use a variety of standardized indices for interest rate resets including, but not limited to, LIBOR, Federal Funds Effective Rate, Constant Maturity Swap (CMS), Prime, Three Month Treasury Bill Auction Yield, and 11th District Cost of Funds Index (COFI). In addition, to meet the specific needs of certain investors in consolidated obligations, both fixed and variable rate bonds may also contain certain embedded features, which result in complex coupon payment terms and call features. Normally, when such a complex consolidated obligation bond is issued, we simultaneously enter into a derivative containing mirror or offsetting features to synthetically convert the terms of the complex bond to a simple variable rate callable bond tied to one of the standardized indices. We also simultaneously enter into derivatives containing offsetting features to synthetically convert the terms of some of our fixed rate callable and bullet bonds and floating rate bonds to a simple variable rate callable bond tied to one of the standardized indices.
 
 
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Consolidated Obligation Discount Notes: The Office of Finance also sells consolidated obligation discount notes on behalf of the FHLBanks to meet short-term funding needs. These securities have maturities up to one year and are offered daily through certain securities dealers in a discount note selling group. In addition to the daily offerings of discount notes, the FHLBanks auction specific amounts of discount notes with fixed maturity dates ranging from 4 to 26 weeks through competitive auctions held twice a week utilizing the discount note selling group. The amount of discount notes sold through the auctions varies based upon market conditions and on the funding needs of the FHLBanks. Discount notes are sold at a discount and mature at par.
 
 
Use of Derivatives
The FHLBank’s RMP establishes guidelines for our use of derivatives. Interest rate swaps, swaptions, interest rate cap and floor agreements, calls, puts, futures, forward contracts and other derivatives can be used as part of our interest-rate risk management and funding strategies. This policy, along with Finance Agency regulations, prohibits trading in or the speculative use of derivatives and limits credit risk to counterparties that arises from derivatives. In general, we have the ability to use derivatives only to reduce funding costs for consolidated obligations and to manage other risk elements such as interest-rate risk, mortgage prepayment risk, unsecured credit risk and foreign currency risk.
 
We use derivatives in three general ways: (1) by designating them as either a fair value or cash flow hedge of an underlying financial instrument, a firm commitment or a forecasted transaction (the swapped consolidated obligation bond transactions discussed in the next paragraph fall into this category); (2) by acting as an intermediary between members and the capital markets; or (3) in asset/liability management but not designated for hedge accounting. For example, we use derivatives in our overall interest rate risk management to adjust the interest rate sensitivity of consolidated obligations to approximate more closely to the interest rate sensitivity of assets, including advances, investments and mortgage loans, and/or to adjust the interest rate sensitivity of advances, investments and mortgage loans to approximate more closely to the interest rate sensitivity of liabilities. In addition to using derivatives to manage mismatches of interest rate terms between assets and liabilities, we also use derivatives to manage embedded options in assets and liabilities, to hedge the market value of existing assets, liabilities and anticipated transactions, to hedge the duration risk of prepayable instruments and to reduce funding costs as discussed below.
 
To reduce funding costs, we frequently execute derivatives concurrently with the issuance of consolidated obligation bonds (collectively referred to as swapped consolidated obligation bond transactions). At times, we also execute derivatives concurrently with the issuance of consolidated obligation discount notes. This allows us to create synthetic variable rate debt at a cost that is often lower than the cost of a comparable variable rate cash instrument issued directly by us. This strategy of issuing consolidated obligations while simultaneously entering into derivatives enables us to more effectively fund our variable rate and, to a lesser extent, short-term assets. It also allows us, in some instances, to offer a wider range of attractively priced advances to our members and housing associates than would otherwise be possible. The continued attractiveness of these swapped consolidated obligation transactions depends on price relationships in both the FHLBank consolidated obligation market and the derivatives market, primarily the interest rate swap market. If conditions in these markets change, we may alter the types or terms of the consolidated obligations issued and derivatives transacted to better match assets, to meet customer needs and to improve our funding costs. We frequently purchase interest rate caps with various terms and strike rates to manage embedded interest rate cap risk associated with our variable rate MBS and CMO portfolios. Although these derivatives are valid economic hedges against the prepayment and option risk of our portfolio of MBS and CMOs, they are not specifically linked to individual investment securities and, therefore, do not receive either fair value or cash flow hedge accounting. The derivatives are marked-to-market through earnings. We can also use interest rate caps and floors, swaptions and callable swaps to manage and hedge prepayment and option risk on MBS, CMOs and mortgage loans. 
 
Other common ways in which we use derivatives to manage our assets and liabilities are:
§  
To preserve an interest rate spread between the yield of an asset (e.g., an advance) and the cost of the supporting liability (e.g., the consolidated obligation bond used to fund the advance). Without the use of derivatives, this interest rate spread could be reduced or eliminated if there are non-parallel changes in the interest rate on the advance and/or the interest rate on the bond, or if the rates change at different times;
§  
To mitigate the adverse earnings effects of the contraction or extension of certain assets (e.g., advances or mortgage assets) and liabilities;
§  
To protect the value of existing asset or liability positions or of anticipated transactions; and
§  
To synthetically convert the terms of some of our fixed rate advances to simple variable rate advances tied to one of the standardized indices referred to above by simultaneously entering into derivatives containing offsetting features of the advance.
 
See Item 7A – “Quantitative and Qualitative Disclosures About Market Risk – Risk Management – Interest Rate Risk Management” for further information on derivatives.
 
Deposits
The Bank Act allows us to accept deposits from our members, housing associates, any institution for which we are providing correspondent services, other FHLBanks and other government instrumentalities. We offer several types of deposit programs to our members and housing associates, including demand, overnight and term deposits.
 
Liquidity Requirements: To support deposits, Finance Agency regulations require us to have at least an amount equal to current deposits invested in obligations of the U.S. government, deposits in eligible banks or trust companies, or advances with maturities not exceeding five years. In addition, we must meet the additional liquidity policies and guidelines outlined in our RMP. See Item 7 – “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Risk Management – Liquidity Risk Management” for further discussion of our liquidity requirements.
 
 
Capital, Capital Rules and Dividends
FHLBank Capital Adequacy and Form Rules: The Gramm-Leach-Bliley Act (GLB Act) allows us to have two classes of stock, and each class may have sub-classes. Class A stock is conditionally redeemable on six months’ written notice from the member, and Class B stock is conditionally redeemable on five years’ written notice from the member, subject in each case to certain conditions and limitations that may restrict the ability of the FHLBanks to effectuate such redemptions. Membership is voluntary. However, other than non-member housing associates (see Item 1 – “Business – Advances”), membership is required in order to utilize our credit and mortgage finance products. Members that withdraw from membership may not reapply for membership for five years.
 
The GLB Act and the Finance Agency rules and regulations define total capital for regulatory capital adequacy purposes as the sum of an FHLBank’s permanent capital, plus the amounts paid in by its stockholders for Class A stock; any general loss allowance, if consistent with U.S. generally accepted accounting principles (GAAP) and not established for specific assets; and other amounts from sources determined by the Finance Agency as available to absorb losses. The GLB Act and Finance Agency regulations define permanent capital for the FHLBanks as the amount paid in for Class B stock plus the amount of an FHLBank’s retained earnings, as determined in accordance with GAAP.
 
 
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Under the GLB Act and the Finance Agency rules and regulations, we are subject to risk-based capital rules. Only permanent capital can satisfy our risk-based capital requirement. In addition, the GLB Act specifies a 5 percent minimum leverage capital requirement based on total FHLBank capital, which includes a 1.5 weighting factor applicable to permanent capital, and a 4 percent minimum total capital requirement that does not include the 1.5 weighting factor applicable to permanent capital. We may not redeem or repurchase any of our capital stock without Finance Agency approval if the Finance Agency or our Board of Directors determines that we have incurred, or are likely to incur, losses that result in, or are likely to result in, charges against our capital, even if we are in compliance with our minimum regulatory capital requirements. Therefore, a member’s right to have its excess shares of capital stock redeemed is conditional on, among other factors, the FHLBank maintaining compliance with the three regulatory capital requirements: risk-based, leverage and total capital.
 
See Item 7 – “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Financial Condition – Capital” for additional information regarding our capital plan.
 
Dividends: We may pay dividends from unrestricted retained earnings and current income. (For a discussion regarding restricted retained earnings, please see Joint Capital Enhancement Agreement under this Item 1.) Our Board of Directors may declare and pay dividends in either cash or capital stock. Under our capital plan, all dividends that are payable in capital stock must be paid in the form of Class B Common Stock, regardless of the class upon which the dividend is being paid.
 
Consistent with Finance Agency guidance in Advisory Bulletin (AB) 2003-AB-08, Capital Management and Retained Earnings, we adopted a retained earnings policy, which provides guidelines to establish a minimum or threshold level for our retained earnings in light of alternative possible future financial and economic scenarios. Our minimum (threshold) level of retained earnings is calculated quarterly and re-evaluated by the Board of Directors as part of each quarterly dividend declaration. The retained earnings policy includes detailed calculations of four components: (1) market risk, which is based upon our projected dividend paying capacity under a two-year earnings analysis that includes multiple stress or extreme scenarios (amount necessary to pay dividends at three-month LIBOR over the period); (2) credit risk, which requires that retained earnings be sufficient to credit enhance all of our assets from their actual rating levels to the equivalent of triple-A ratings (where advances are considered to be triple-A rated); (3) operations risk, which is equal to 30 percent of the total of the market and credit risk amounts, subject to a $10 million floor; and (4) derivative hedging volatility, which is the projected income impact of derivative hedging activities under 100-basis-point shocks in interest rates (maximum derivative hedging loss under up or down shocks). The retained earnings policy was considered by the Board of Directors when dividends were declared during the last two years, but the retained earnings threshold calculated in accordance with the policy did not significantly affect the level of dividends declared and paid. Tables 5 and 6 reflect the quarterly retained earnings threshold calculations utilized during 2011 and 2010 (in thousands), respectively, compared to the actual amount of retained earnings at the end of each quarter:
 
 
Table 5
 
 
Retained Earnings Component (based upon prior quarter end)
 
12/31/2011
   
09/30/2011
   
06/30/2011
   
03/31/2011
 
Market Risk (dividend paying capacity)1
  $ 0     $ 0     $ 0     $ 0  
Credit Risk
    78,082       85,655       81,273       75,340  
Operations Risk
    23,424       25,696       24,382       22,602  
Derivative Hedging Volatility
    39,699       48,412       35,849       40,222  
Total Retained Earnings Threshold
    141,205       159,763       141,504       138,164  
Actual Retained Earnings as of End of Quarter
    401,461       376,863       386,529       369,212  
Overage (Shortage)
  $ 260,256     $ 217,100     $ 245,025     $ 231,048  
                   
1
Market risk is zero when we have sufficient income to pay a three-month LIBOR dividend in all scenarios modeled.
 
 
Table 6
 
 
Retained Earnings Component (based upon prior quarter end)
 
12/31/2010
   
09/30/2010
   
06/30/2010
   
03/31/2010
 
Market Risk (dividend paying capacity) 1
  $ 0     $ 0     $ 30,541     $ 654  
Credit Risk
    82,524       87,965       100,840       143,727  
Operations Risk
    24,757       26,390       39,414       43,314  
Derivative Hedging Volatility
    32,487       45,857       49,524       41,263  
Total Retained Earnings Threshold
    139,768       160,212       220,319       228,958  
Actual Retained Earnings as of End of Quarter
    351,754       327,235       314,770       315,138  
Overage (Shortage)
  $ 211,986     $ 167,023     $ 94,451     $ 86,180  
                   
1
Market risk is zero when we have sufficient income to pay a three-month LIBOR dividend in all scenarios modeled.
 
 
Under our retained earnings policy, any shortage of actual retained earnings with respect to the retained earnings threshold is to be met over a period generally not to exceed two years from the quarter-end calculation. The policy also provides that meeting the established retained earnings threshold shall have priority over the payment of dividends, but that the Board of Directors must balance dividends on capital stock against the period over which the retained earnings threshold is met. The retained earnings threshold level fluctuates from period to period because it is a function of the size and composition of our balance sheet and the risks contained therein at that point in time.
 
Joint Capital Enhancement Agreement (JCE Agreement) – Effective February 28, 2011, we, along with the other 11 FHLBanks, entered into a JCE Agreement intended to enhance the capital position of each FHLBank. On August 5, 2011, the FHLBanks also amended the JCE Agreement to reflect differences between the original agreement and capital plan amendments.
 
 
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The intent of the JCE Agreement is to allocate that portion of each FHLBank’s earnings historically paid to satisfy its REFCORP obligation to a Separate Restricted Retained Earnings Account (RRE Account) at that FHLBank. Each FHLBank was required to contribute 20 percent of its earnings toward payment of the interest on REFCORP bonds until the REFCORP obligation was satisfied. The Finance Agency certified on August 5, 2011 that the FHLBanks’ payments to the U.S. Department of the Treasury for the second quarter of 2011 resulted in full satisfaction of the FHLBanks’ REFCORP obligation.
 
Thus, in accordance with the JCE Agreement, starting in the third quarter of 2011, each FHLBank began allocating 20 percent of its net income to a RRE Account and will do so until the balance of the account equals at least 1 percent of that FHLBank’s average balance of outstanding consolidated obligations for the previous quarter.
 
For additional information regarding the JCE Agreement, see Note 14 of the Notes to the Financial Statements included under Item 1 – “Financial Statements.”

Tax Status
Although we are exempt from all federal, state and local taxation except for real property taxes, we were obligated to make payments to REFCORP in the amount of 20 percent of net earnings after operating expenses and AHP expenses through June 30, 2011. The Finance Agency certified on August 5, 2011 that the FHLBanks’ payments to the U.S. Department of the Treasury for the second quarter of 2011 resulted in full satisfaction of the FHLBanks’ REFCORP obligation. Starting in the third quarter of 2011, we began allocating 20 percent of our net income to a separate RRE account as described in Note 14 of the Notes to the Financial Statements included under Item 1 – “Financial Statements.” In addition to the RECORP obligation, the 12 FHLBanks were required to set aside annually the greater of an aggregate of $100 million or 10 percent of their current year’s income before charges for AHP (but after assessments for REFCORP). In accordance with Finance Agency guidance for the calculation of AHP expense, interest expense on mandatorily redeemable capital stock is added back to income before charges for AHP (but after assessments for REFCORP). Assessments for REFCORP and AHP through June 30, 2011 were the equivalent to an effective minimum income tax rate of 26.5 percent, but this effective rate will be slightly higher depending upon the amount of interest expense for mandatorily redeemable capital stock recorded by the FHLBank during the year. After June 30, 2011, required assessments for AHP were equivalent to an effective minimum income tax rate of 10 percent.
 
 
Other Mission-related Activities
In addition to supporting residential mortgage lending, one of our core missions is to support related housing and community development. We administer and fund a number of targeted programs specifically designed to fulfill that mission. These programs provide housing opportunities for thousands of very low-, low- and moderate-income households and strengthened communities primarily in Colorado, Kansas, Nebraska and Oklahoma.
 
Affordable Housing Program: Amounts specified by the AHP requirements described in Item 1 – “Business – Tax Status” are reserved for this program. AHP provides cash grants to members, creating a pool of no-cost or low-cost funds to finance the purchase, construction or rehabilitation of very low-, low- and moderate-income owner occupied or rental housing. In addition to the standard competition for AHP funds, customized homeownership set-aside programs under the AHP include:
§  
Rural First-time Homebuyer Program (RFHP) – RFHP provides down payment, closing cost or rehabilitation cost assistance to first-time homebuyers in rural areas and rehabilitation or rebuilding cost assistance to homeowners in rural federally declared disaster areas; and
§
Targeted Ownership Program (TOP) – TOP provides down payment, closing cost or rehabilitation cost assistance in rural and urban areas to disabled first-time homebuyers or first-time homebuyer households with a disabled member of the household.
 
Community Investment Cash Advance (CICA) Program. CICA loans to members specifically target underserved markets in both rural and urban areas. CICA loans represented 4.5 percent, 3.8 percent and 3.8 percent of total advances outstanding as of December 31, 2011, 2010 and 2009, respectively. Programs under the CICA Program, which is not funded through the AHP, include:
§  
Community Housing Program (CHP) – CHP makes loans available to members for financing the construction, acquisition, rehabilitation and refinancing of owner-occupied housing for households whose incomes do not exceed 115 percent of the area’s median income and rental housing occupied by or affordable for households whose incomes do not exceed 115 percent of the area’s median income. For rental projects, at least 51 percent of the units must have tenants that meet the income guidelines, or at least 51 percent of the units must have rents affordable to tenants that meet the income guidelines. We provide advances for CHP-based loans to members at our estimated cost of funds for a comparable maturity plus a mark-up for administrative costs;
§  
Community Housing Program Plus (CHP Plus) – CHP Plus makes up to $25 million in loans available to members annually to help finance the construction, acquisition or rehabilitation of rental housing occupied by or affordable for households whose incomes do not exceed 80 percent of the area’s median income level. At least 51 percent of the units must have tenants that meet the income guidelines, or at least 51 percent of the units must have rents affordable to tenants that meet the income guidelines. We provide advances for CHP Plus-based loans to members at our estimated cost of funds for a comparable maturity;
§  
Community Development Program (CDP) – CDP provides advances to members to finance CDP-qualified member financing including loans to small businesses, farms, agri-businesses, public or private utilities, schools, medical and health facilities, churches, day care centers or for other community development purposes that meet one of the following criteria: (1) loans to firms that meet the Small Business Administration’s (SBA) definition of a qualified small business concern; (2) financing for businesses or projects located in an urban neighborhood, census tract or other area with a median income at or below 100 percent of the area median; (3) financing for businesses, farms, ranches, agri-businesses or projects located in a rural community, neighborhood, census tract or unincorporated area with a median income at or below 115 percent of the area median; (4) firms or projects located in a Federal Empowerment Zone, Enterprise Community or Champion Community, Native American Area, Brownfield Area, Federally Declared Disaster Area, Military Base Closing Area or Community Adjustment and Investment Program Area; (5) businesses in urban areas in which at least 51 percent of the employees of the business earn at or below 100 percent of the area median; or (6) businesses in rural areas in which at least 51 percent of the employees of the business earn at or below 115 percent of the area median. We provide advances for CDP-based loans to members at our estimated cost of funds for a comparable maturity plus a mark-up for administrative costs; and
§  
Housing and Community Development Emergency Loan Program (HELP) – HELP provides up to $25 million in advances annually for members to finance recovery efforts in federally-declared disaster areas. We provide advances for HELP-based loans to members at our estimated cost of funds for a comparable maturity.
 
 
 
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Other Housing and Community Development Programs. A number of other voluntary housing and community development programs specifically developed for our members have also been established. These programs are not funded through the AHP and include the following:
§  
Joint Opportunities for Building Success (JOBS) – In 2011, $1,225,000, in JOBS funds were distributed to assist members in promoting employment growth in their communities. We distributed $1,247,000 and $975,000 in 2010 and 2009, respectively. A charitable grant program, JOBS funds are allocated annually to support economic development projects. For 2012, the Board of Directors has approved up to $1,000,000 in funds that may be made available under this program. The following are elements of the JOBS program: (1) funds made available to projects only through our members; (2) $25,000 maximum funding per member ($25,000 per project) annually; (3) loan pools and similar funding mechanisms are eligible to receive more than one JOBS award annually provided there is an eligible project in the pool for each JOBS application funded; (4) members and project participants agree to participate in publicity highlighting their roles as well as the FHLBank’s contribution to the project and community/region; (5) projects that appear to be “bail outs” are not eligible; (6) members cannot use JOBS funds for their own direct benefit (e.g., infrastructure improvements to facilitate a new branch location) or any affiliate of the member; (7) projects can only be located in FHLBank Topeka’s District (Colorado, Kansas, Nebraska and Oklahoma); (8) applications of a political nature will not be accepted (JOBS funds cannot be used for any lobbying activity at the local, state or national level); and (9) FHLBank employees and members of their households may not receive JOBS funds except in their capacity as a volunteer of a nonprofit entity;
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Community Initiative – The Community Initiative is a flexible direct grant program created to address housing and community development needs within the district that are not fully addressed by our other programs. In order to provide the maximum flexibility in identifying and addressing housing and community development needs, the program does not have prescribed criteria. Available funding used for the Community Initiative was $16,000 in 2011, $9,000 in 2010 and $13,000 in 2009. Up to $16,000 in funding has been allocated for this program for 2012; and
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Rural First-time Homebuyer Education Program – We provide up to $100,000 annually to support rural homeownership education and counseling while actively encouraging participating organizations to seek supplemental funding from other sources. Goals of the program are to support rural education and counseling in all four states in the district, especially in those areas with RFHP-participating stockholders. We used $75,000, $78,000 and $49,000 of the available funds for this program during 2011, 2010 and 2009, respectively. For, 2012, $100,000 has been allocated to this program again.
 
 
Competition
Advances: Demand for advances is affected by, among other things, the cost of alternative sources of liquidity available to our members, including deposits from members’ customers and other sources of liquidity that are available to members. Such other suppliers of wholesale funds may include investment banks, commercial banks, and U.S. government lending programs. Smaller members generally have access to alternative funding sources through brokered deposits and the sale of securities under agreements to repurchase, while larger members typically have access to a broader range of funding alternatives. Large members may also have independent access to the national and global credit markets. The availability of alternative funding sources to members can significantly influence member demand for advances and can change as a result of a variety of factors including, among others, market conditions, product availability through the FHLBank, the member’s creditworthiness and availability of member collateral for other types of borrowings.
 
Mortgage Loans: We are subject to significant competition in purchasing conventional, conforming fixed rate mortgage loans and government-guaranteed mortgage loans. We face competition in customer service, the prices paid for these assets, and in ancillary services such as automated underwriting. The most direct competition for purchasing mortgages comes from the other housing GSEs, which also purchase conventional, conforming fixed rate mortgage loans, specifically Fannie Mae and Freddie Mac. To a lesser extent, we also compete with regional and national financial institutions that buy and/or invest in mortgage loans. Depending on market conditions, these investors may seek to hold, securitize or sell conventional, conforming fixed rate mortgage loans. We continuously reassess our potential for success in attracting and retaining members for our mortgage loan products and services, just as we do with our advance products. We compete for the purchase of mortgage loans primarily on the basis of price, products, structures and services offered.
 
Debt Issuance: We compete with the U.S. government (including debt programs explicitly guaranteed by the U.S. government), U.S. government agencies, Fannie Mae, Freddie Mac and other GSEs as well as corporate, sovereign and supranational entities for funds raised through the issuance of unsecured debt in the national and global capital markets. Collectively, Fannie Mae, Freddie Mac and the FHLBanks are generally referred to as the housing GSEs, and the cost of the debt of each can be positively or negatively affected by political, financial or other news that reflects upon any of the three housing GSEs. If the supply of competing debt products increases without a corresponding increase in demand, our debt costs may rise or less debt may be issued at the same cost than would otherwise be the case. In addition, the availability and cost of funds raised through the issuance of certain types of unsecured debt may be adversely affected by regulatory initiatives that tend to reduce investment by certain depository institutions in unsecured debt with greater price volatility or interest rate sensitivity than similar maturity fixed rate, non-callable instruments of the same issuer.
 
Derivatives: The sale of callable debt and the simultaneous execution of callable interest rate swaps with options that mirror the options in the debt have been an important source of competitive funding for us. As such, the depth of the markets for callable debt and mirror-image derivatives is an important determinant of our relative cost of funds. There is considerable competition among high-credit-quality issuers, especially among the three housing GSEs, for callable debt and for derivatives. There can be no assurance that the current breadth and depth of these markets will be sustained.
 
 
Regulatory Oversight, Audits and Examinations
General: We are supervised and regulated by the Finance Agency, which is an independent agency in the executive branch of the U.S. government. The Finance Agency is responsible for providing effective supervision, regulation and housing mission oversight of the FHLBank to promote its safety and soundness, support housing finance and affordable housing, and support a stable and liquid mortgage market. The Finance Agency is headed by a director appointed by the President of the United States for a five-year term, with the advice and consent of the Senate. The Director (currently an acting Director) has designated and prescribed functions, powers and duties to a Deputy Director responsible for explicit oversight of the FHLBanks. The Federal Housing Finance Oversight Board advises the Director with respect to overall strategies and policies in carrying out the duties of the Director. The Federal Housing Finance Oversight Board is comprised of the Secretary of the Treasury, Secretary of HUD, Chairman of the Securities and Exchange Commission (SEC) and the Director, who serves as the Chairperson of the Board. The Finance Agency is funded in part through assessments from the 12 FHLBanks, with the remainder of its funding provided by Fannie Mae and Freddie Mac; no tax dollars or other appropriations support the operations of the Finance Agency or the FHLBanks. To assess our safety and soundness, the Finance Agency conducts annual, on-site examinations, as well as periodic on-site and off-site reviews. Additionally, we are required to submit monthly information on our financial condition and results of operations to the Finance Agency. This information is available to all FHLBanks.
 
 
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The Government Corporation Control Act provides that, before a government corporation issues and offers obligations to the public, the Secretary of the Treasury shall prescribe the form, denomination, maturity, interest rate and conditions of the obligations; the manner and time issued; and the selling price. The Bank Act also authorizes the Secretary of the Treasury, at his or her discretion, to purchase consolidated obligations up to an aggregate principal amount of $4 billion. No borrowings under this authority have been outstanding since 1977. The U.S. Treasury receives the Finance Agency’s annual report to Congress, monthly reports reflecting securities transactions of the FHLBanks, and other reports reflecting the operations of the FHLBanks.
 
Audits and Examinations: We have an internal audit department and our Board of Directors has an audit committee. The Chief Internal Audit Officer reports directly to the Board of Director’s Audit Committee. In addition, an independent registered public accounting firm audits our annual financial statements and effectiveness of internal controls over financial reporting. The independent registered public accounting firm conducts these audits following standards of the Public Company Accounting Oversight Board (United States) and Government Auditing Standards issued by the Comptroller General. The FHLBanks, the Finance Agency and Congress all receive the audit reports. We must submit annual management reports to Congress, the President of the United States, the Office of Management and Budget, and the Comptroller General. These reports include a statement of financial condition, a statement of operations, a statement of cash flows, a statement of internal accounting and administrative control systems, and the report of the independent public accounting firm on the financial statements.
 
The Comptroller General has authority under the Bank Act to audit or examine the Finance Agency and the individual FHLBanks and to decide the extent to which they fairly and effectively fulfill the purposes of the Bank Act. Furthermore, the Government Corporation Control Act provides that the Comptroller General may review any audit of the financial statements conducted by an independent registered public accounting firm. If the Comptroller General conducts such a review, then he or she must report the results and provide his or her recommendations to Congress, the Office of Management and Budget, and the applicable FHLBank. The Comptroller General may also conduct his or her own audit of any financial statements of any individual FHLBank.
 
 
Personnel
As of March 15, 2012, we had 203 employees. The employees are not represented by a collective bargaining unit and we consider our relationship with our employees good.
 
 
Legislation and Regulatory Developments
The legislative and regulatory environment for the FHLBank has been one of profound change over the past few years, beginning with the enactment of the Recovery Act and continuing as financial regulators issue proposed and/or final rules to implement the Dodd-Frank Act enacted in July 2010, and Congress considers housing finance and GSE reform. The FHLBanks’ business operations, funding costs, rights, obligations, and/or the environment in which the FHLBanks carry out their housing finance mission are likely to be materially affected by the Dodd-Frank Act; however, the full effect of the Dodd-Frank Act will become known only after the required regulations, studies and reports are issued and finalized. Significant regulatory actions and developments for the period covered by this report are summarized below.
 
Future Legislation: Various legislation, including proposals to substantially change the regulatory system for the FHLBanks and other housing GSEs, is from time to time introduced in Congress. Such proposed legislation may change applicable statutes and our operating environment in substantial and unpredictable ways. If enacted, legislation could increase or decrease the cost of doing business, limit or expand permissible activities or affect the competitive balance among the FHLBanks and other housing GSEs. We cannot predict whether any of this potential legislation will be enacted and, if enacted, the effect that it, or any implementing regulations, could have on our business, results of operations or financial condition.
 
On February 11, 2011, the Department of the Treasury and HUD issued a report to Congress on Reforming America’s Housing Finance Market. The report primarily focused on Fannie Mae and Freddie Mac by providing options for the long-term structure of housing finance. The report recognized the vital role the FHLBanks play in helping financial institutions access liquidity and capital to compete in an increasingly competitive marketplace and noted that the Obama Administration would work, in consultation with the Finance Agency and Congress, to restrict the areas of mortgage finance in which Fannie Mae, Freddie Mac and the FHLBanks operate so that overall government support of the mortgage market is substantially reduced. Specifically, with respect to the FHLBanks, the report stated the Obama Administration supports limiting the level of advances and reducing portfolio investments, consistent with the FHLBanks’ mission of providing liquidity and access to capital for insured depository institutions.
 
Dodd-Frank Act:
Derivatives Transactions. 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.
 
Mandatory Clearing of Derivatives Transactions. The Commodity Futures Trading Commission (CFTC) has issued a final rule regarding the process to determine which types of swaps will be subject to mandatory clearing, but has not yet made any such determinations. The CFTC has also issued a proposal setting forth an implementation schedule for effectiveness of its mandatory clearing determinations. Pursuant to this proposal, regardless of when the CFTC determines that a type of swap is required to be cleared, such mandatory clearing would not take effect until certain rules being issued by the CFTC and the SEC under the Dodd-Frank Act have been finalized. In addition, the proposal provides that each time the CFTC determines that a type of swap is required to be cleared, the CFTC would have the option to implement such requirement in three phases. Under the proposal, we would be a “category 2 entity” and would therefore have to comply with mandatory clearing requirements for a particular swap during phase 2 (within 180 days of the CFTC’s issuance of such requirements). Based on the CFTC’s proposed implementation schedule and the time periods set forth in the rule for CFTC determinations regarding mandatory clearing, it is not expected that any of our swaps will be required to be cleared until the fourth quarter of 2012, at the earliest.
 
Collateral Requirements for Cleared Swaps. Cleared swaps will be subject to initial and variation margin requirements established by the clearinghouse and its clearing members. While clearing swaps may reduce counterparty credit risk, the margin requirements for cleared swaps have the potential of making derivative transactions more costly. In addition, mandatory swap clearing will require us to enter into new relationships, including accompanying documentation, with clearing members (which the FHLBank is currently negotiating) and additional documentation with our swap counterparties.
 
 
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The CFTC has issued a final rule requiring that collateral posted by swap customers to a clearinghouse in connection with cleared swaps be legally segregated on a customer-by-customer basis (the LSOC Model). Pursuant to the LSOC Model, customer collateral must be segregated by customer on the books of a futures commission merchant (FCM) and derivatives clearing organization but may be commingled with the collateral of other customers of the same FCM in one physical account. The LSOC model affords greater protection to collateral posted for cleared swaps than is currently afforded to collateral posted for futures contracts. However, because of operational and investment risks inherent in the LSOC Model and because of certain provisions applicable to FCM insolvencies under the U.S. Bankruptcy Code, the LSOC Model does not afford complete protection to cleared swaps customer collateral. To the extent the CFTC’s final rule places our posted collateral at greater risk of loss in the clearing structure than under the current over-the-counter market structure, we may be adversely impacted.
 
Definitions of Certain Terms under New Derivatives Requirements. The Dodd-Frank Act will require swap dealers and certain other large users of derivatives to register as “swap dealers” or “major swap participants,” as the case may be, with the CFTC and/or the SEC. Based on the definitions in the proposed rules jointly issued by the CFTC and SEC, it does not appear likely that we will be required to register as a “major swap participant,” although this remains a possibility. Also, based on the definitions in the proposed rules, it does not appear likely that we will be required to register as a “swap dealer” for the derivative transactions that we enter into with dealer counterparties for the purpose of hedging and managing our interest rate risk. However, based on the proposed rules, it is possible that we could be required to register with the CFTC as a swap dealer based on the intermediated swaps we have historically entered into with our members.
 
It is also unclear how the final rule will treat the call and put optionality in certain advances to our members. The CFTC and SEC have issued joint proposed rules further defining the term “swap” under the Dodd-Frank Act. These proposed rules and accompanying interpretive guidance attempt to clarify what products will and will not be regulated as “swaps.” While it is unlikely that advance transactions between us and our members will be treated as “swaps,” the proposed rules and accompanying interpretive guidance are not entirely clear on this issue.
 
Depending on how the terms “swap” and “swap dealer” are defined in the final regulations, we may be faced with the business decision of whether to continue to offer certain types of advance products and intermediated derivatives activity, or both, to our members if those transactions would require us to register as a swap dealer. Designation as a swap dealer would subject us to significant additional regulation and costs including, without limitation, registration with the CFTC, new internal and external business conduct standards, additional reporting requirements, and additional swap-based capital and margin requirements. Even if we are designated as a swap dealer as a result of our advance activities, the proposed regulations would permit us to apply to the CFTC to limit such designation to those specified activities for which we are acting as a swap dealer. Upon such a designation, our hedging activities would not be subject to the full requirements that will generally be imposed on traditional swap dealers.
 
Uncleared Derivatives Transactions. The Dodd-Frank Act will also change the regulatory landscape for derivative transactions that are not subject to mandatory clearing requirements (uncleared trades). While we expect to continue to enter into uncleared trades on a bilateral basis, such trades will be subject to new regulatory requirements, including mandatory reporting, documentation, and minimum margin and capital requirements. Under the proposed margin rules, we will have to post both initial margin and variation margin to our swap dealer counterparties, but may be eligible in both instances for modest unsecured thresholds as “low-risk financial end users.” Pursuant to additional Finance Agency proposals, we will be required to collect both initial margin and variation margin from our swap dealer counterparties, without any unsecured thresholds. These margin requirements and any related capital requirements could adversely impact the liquidity and pricing of certain uncleared derivative transactions entered into by us, making such trades more costly.
 
The CFTC has proposed a rule setting forth an implementation schedule for the effectiveness of the new margin and documentation requirements for uncleared swaps. Pursuant to the proposed rule, regardless of when the final rules pertaining to these requirements are issued, such rules would not take effect until: (1) certain other rules being issued under the Dodd-Frank Act take effect; and (2) a certain additional time period has elapsed. The length of this additional time period depends on the type of entity entering into the uncleared swaps. We believe we would be a “category 2 entity” and would therefore have to comply with the new requirements during phase 2 (within 180 days of the effectiveness of the final applicable rulemaking). Accordingly, it is not likely that we would have to comply with such requirements until the fourth quarter of 2012, at the earliest.
 
Temporary Exemption from Certain Provisions. While certain provisions of the Dodd-Frank Act took effect on July 16, 2011, the CFTC has issued an order (and an amendment to that order) temporarily exempting persons or entities with respect to provisions of Title VII of the Dodd-Frank Act that reference “swap dealer,” “major swap participant,” “eligible contract participant,” and “swap.” These exemptions will expire upon the earlier of: (i) the effective date of the applicable final rule further defining the relevant terms; or (ii) July 16, 2012. In addition, the provisions of the Dodd-Frank Act that will have the most effect on us did not take effect on July 16, 2011, but will take effect no sooner than 60 days after the CFTC publishes final regulations implementing such provisions. The CFTC is expected to publish such final regulations during the first half of 2012, but it is not expected that such final regulations will become effective until later in 2012, and delays beyond that time are possible. In addition, as discussed above, mandatory clearing requirements and new margin and documentation requirements for uncleared swaps may be subject to additional implementation schedules, further delaying the effectiveness of such requirements.
 
Together with the other FHLBanks, we are actively participating in the regulatory process regarding the Dodd-Frank Act by formally commenting to the regulators regarding a variety of rulemakings that could impact the FHLBanks. We are also working with the other FHLBanks, to the extent possible, to implement the processes and documentation necessary to comply with the Dodd-Frank Act’s new requirements for derivatives.
 
Regulation of Certain Nonbank Financial Companies:
Board of Governors of the Federal Reserve System (Board of Governors) Issues Proposed Rulemaking on Definitions of “Predominantly Engaged in Financial Activities” and “Significant” Nonbank Financial Company. On February 11, 2011, the Board of Governors issued a proposed rule to establish the criteria for determining whether a company is “predominantly engaged in financial activities” and define the term “significant nonbank financial company” for purposes of Title I of the Dodd-Frank Act. The proposed rule generally provides that a company is predominantly engaged in financial activities if the consolidated annual gross financial revenues, or total financial assets, of the company represent 85 percent or more of the company’s consolidated annual gross revenues, or consolidated total assets, in that fiscal year. The proposed rule would define a significant nonbank financial company as: (1) any nonbank financial company supervised by the Board of Governors; and (2) any other nonbank financial company that had $50 billion or more in total consolidated assets as of the end of its most recently completed fiscal year. Comments on the proposed rule were due by March 30, 2011.
 
 
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Financial Stability Oversight Council (FSOC) Issues Second Notice of Proposed Rulemaking on Authority to Require Supervision and Regulation of Certain Nonbank Financial Companies. On January 26, 2011, the FSOC issued a proposed rule which would implement section 113 of the Dodd-Frank Act, which gives the FSOC the authority to require that a nonbank financial company be supervised by the Board of Governors and be subject to enhanced prudential standards. In response to comments submitted on the first proposed rule, on October 18, 2011, the FSOC issued a second notice of proposed rulemaking and proposed interpretative guidance to provide: (1) additional details regarding the framework that the FSOC intends to use in the process of assessing whether a nonbank financial company could pose a threat to U.S. financial stability; and (2) further opportunity for public comment on the FSOC’s proposed approach. Under the second proposed rule, the FSOC would establish a three-stage process to assist in the determination of whether an entity should be supervised by the Board of Governors. Under the first stage, the FSOC will identify those U.S. nonbank financial companies that have $50 billon or more of total consolidated assets and exceed any one of five threshold indicators of interconnectedness or susceptibility to material financial distress, including whether the company has $20 billion or more of borrowing outstanding. A company that meets the standards identified in the first stage would proceed to the second stage, where the FSOC would conduct a comprehensive analysis of the potential for the identified nonbank financial companies to pose a threat to U.S. financial stability. Stage three would build on the quantitative and qualitative information provided through the first two stages of the review and the FSOC will determine whether to subject a nonbank financial company to Board of Governors supervision and prudential standards based on the results of the analyses conducted during each stage of the review. Comments on the proposed rule were due by December 19, 2011.
 
Board of Governors Issues Proposed Prudential Standards. On January 5, 2012, the Board of Governors issued a proposed rule that would implement the enhanced prudential standards and early remediation standards required by the Dodd-Frank Act for nonbank financial companies identified by the FSOC as posing a threat to the U.S. financial stability. Such proposed prudential standards include: risk-based capital and leverage requirements, liquidity standards, requirements for overall risk management, single-counterparty credit limits, stress test requirements and a debt-to-equity limit. The capital and liquidity requirements would be implemented in phases and would be based on or exceed the Basel international capital and liquidity framework (as discussed in further detail below under Additional Developments). Comments on the proposed rule are due by April 30, 2012.
 
Significant Finance Agency Regulatory Actions:
Finance Agency Issues Regulatory Policy Guidance on Reporting of Fraudulent Financial Instruments. On January 27, 2010, the Finance Agency issued a final regulation on reporting of fraudulent financial instruments. The final regulation implements Section 1379E of the Federal Housing Enterprises Financial Safety and Soundness Act of 1992 (Safety and Soundness Act), as amended by the Recovery Act, which subjects the FHLBanks to both fraud reporting and internal control requirements. The final regulation requires Fannie Mae and Freddie Mac (the Enterprises) and the FHLBanks (collectively with the Enterprises, the Regulated Entities) to establish and maintain adequate and efficient controls, policies, procedures, and an operational training program to discover and report fraud or possible fraud in connection with the purchase or sale of any loan or financial instrument.
 
On March 29, 2011, the Finance Agency issued Regulatory Policy Guidance on the Reporting of Fraudulent Financial Instruments. The Regulatory Policy Guidance sets forth the Finance Agency’s guidance to the Regulated Entities under the Finance Agency’s regulation on Reporting of Fraudulent Finance Instruments. The Guidance requires each Regulated Entity to develop and implement or enhance existing reporting structures, policies, procedures, internal controls, and operational training programs to sufficiently discover and report fraud or possible fraud. The guidance became effective upon issuance.
 
Finance Agency Issues Final Regulation on Office of the Ombudsman. On February 10, 2011, the Finance Agency published a final regulation establishing an Office of the Ombudsman. The final regulation implements Section 1105(e) of the Recovery Act, which requires the Director of the Finance Agency to establish, by regulation, an Office of the Ombudsman. The Office of the Ombudsman is responsible for considering complaints and appeals from the Regulated Entities and the Office of Finance, and from any person that has a business relationship with a Regulated Entity or the Office of Finance, regarding any matter relating to the regulation and supervision of the Regulated Entities or the Office of Finance by the Finance Agency. The final regulation became effective March 14, 2011.
 
Finance Agency Issues Final Rule on Temporary Increases in Minimum Capital Levels. On March 3, 2011, the Finance Agency issued a final rule authorizing the Director of the Finance Agency to increase the minimum capital level for an FHLBank if the Director determines that the current level is insufficient to address such FHLBank’s risks. The final rule establishes standards for imposing a temporary increase and for rescinding such an increase, and a time frame for review of such an increase. The Director of the Finance Agency may impose a temporary minimum-capital increase if consideration of one or more of the following factors leads the Director of the Finance Agency to the judgment that the current minimum capital requirement for a Regulated Entity is insufficient to address the Regulated Entity’s risks:
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Current or anticipated declines in the value of assets held by the Regulated Entity and its ability to access liquidity and funding;
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Credit, market, operational and other risks;
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Current or projected declines in the capital held by the Regulated Entity;
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A Regulated Entity’s material non-compliance with regulations, written orders or agreements;
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Housing finance market conditions;
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Levels of retained earnings;
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Initiatives, operations, products or practices that entail heightened risk;
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The ratio of market value of equity to the par value of capital stock; and/or
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Other conditions as identified by the Director of the Finance Agency.
 
The rule provides that the Director of the Finance Agency shall consider the need to maintain, modify or rescind any such increase no less than every 12 months. The final rule became effective on April 4, 2011.
 
Finance Agency Issues Final Rule on FHLBank Investments. On May 20, 2011, the Finance Agency issued a final rule which generally reorganized and readopted existing investment regulations that apply to the FHLBanks. The final regulation incorporates limits on our investment in MBS and certain ABS that were previously set forth in the Federal Housing Finance Board’s (Finance Board) Financial Management Policy (FMP). The FMP was established by the Finance Board, the predecessor to the Finance Agency, to consolidate into one document the previously separate policies on funds management, hedging, interest-rate swaps, unsecured credit and interest-rate risks. Most of the provisions of the FMP had been previously superseded by regulation, and upon incorporating the remaining FMP provisions into regulation pursuant to the final rule, the FMP was terminated. The final rule became effective on June 20, 2011.
 
 
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Finance Agency Issues Final Rule on Record Retention. On June 8, 2011, the Finance Agency issued a final rule which sets forth minimum requirements for a record retention program for the Regulated Entities and the Office of Finance. The requirements are intended to further prudent management of records as well as to ensure that complete and accurate records of each Regulated Entity and the Office of Finance are readily accessible to the Finance Agency. The final regulation requires each Regulated Entity and the Office of Finance to establish and maintain a written record retention program which shall: (1) assure that retained records are complete and accurate; (2) assure that the form of retained records and the retention period are appropriate and comply with applicable laws and regulations; (3) assign in writing the authorities and responsibilities for record retention activities; (4) include policies and procedures concerning record holds; (5) include an accurate, current and comprehensive record retention schedule; (6) include appropriate security and internal controls to protect records from unauthorized access and data alteration; (7) provide for appropriate back-up and recovery of records; (8) provide for periodic testing of the ability to access records; and (9) provide for the proper disposition of records. The final rule became effective on July 8, 2011.
 
Finance Agency Issues Final Rule on Conservatorship and Receivership. On June 20, 2011, the Finance Agency issued a final rule to establish a framework for conservatorship and receivership operations for the Regulated Entities. The final rule implements section 1367 of the Safety and Soundness Act on Authority Over Critically Undercapitalized Regulated Entities. The final rule includes provisions that describe the basic authorities of the Finance Agency when acting as conservator or receiver, including the enforcement and repudiation of contracts, and also establishes procedures for priorities of claims for contract parties and other claimants. Additionally, the final rule sets forth the authority of limited-life regulated entities and provisions regarding capital distributions while in conservatorship. The final rule became effective on July 20, 2011.
 
Finance Agency Issues Final Rule on Rules of Practice and Procedure. On August 26, 2011, the Finance Agency issued a final rule to implement the Recovery Act amendments to the Safety and Soundness Act and the Bank Act pertaining to the civil enforcement powers of the Finance Agency, and the Rules of Practice and Procedure for enforcement proceedings. The Safety and Soundness Act authorizes the Finance Agency to initiate enforcement proceedings against the Regulated Entities, and entity-affiliated parties, which include directors, officers and employees of the Regulated Entities. The final rule governs the conduct of Finance Agency administrative hearings on the record for enforcement proceedings as provided in the Safety and Soundness Act, including for cease and desist proceedings, proceedings for civil money penalties and removal and suspension proceedings, and also delineates the specific enforcement authority of the Director of the Finance Agency. The final rule became effective on September 26, 2011.
 
Finance Agency Issues Final Rule on Voluntary Mergers. On November 28, 2011, the Finance Agency issued a final rule that establishes the conditions and procedures for the consideration and approval of voluntary mergers between FHLBanks. Under the rule, two or more FHLBanks may merge provided:
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The FHLBanks have agreed upon the terms of the proposed merger and the board of directors of each such FHLBank has authorized the execution of the merger agreement;
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The FHLBanks have jointly filed a merger application with the Finance Agency to obtain the approval of the Director of the Finance Agency;
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The Director of the Finance Agency has granted approval of the merger, subject to any closing conditions as the Director may determine must be met before the merger is consummated;
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The members of each such FHLBank ratify the merger agreement;
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The Director of the Finance Agency has received evidence that the closing conditions have been met; and
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The Director of the Finance Agency has accepted the organization certificate of the surviving FHLBank.
 
The final rule became effective on December 28, 2011.
 
Finance Agency Issues Final Rule on Private Transfer Fee Covenants. On March 16, 2012, the Finance Agency issued a final rule prohibiting the Regulated Entities from purchasing, investing or otherwise dealing in any mortgages on properties encumbered by private transfer fee covenants, securities backed by such mortgages, or securities backed by the income stream from such covenants, except for certain limited types of private transfer fee covenants. The final rule also prohibits the FHLBanks from accepting such mortgages or securities as collateral. Pursuant to the final rule, the foregoing restrictions would apply only to mortgages on properties encumbered by private transfer fee covenants, if those covenants are created on or after February 8, 2011, to securities backed by such mortgages, and to securities issued after that date and backed by revenue from private transfer fees regardless of when the covenants were created. The Regulated Entities are required to comply with the final rule by July 16, 2012.
 
Finance Agency Issues Proposed Rule on Incentive-based Compensation Arrangements. On April 14, 2011, the Finance Agency, in conjunction with the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, the FDIC, the Office of Thrift Supervision, the National Credit Union Administration, and the SEC (the Agencies), issued a proposed rule on incentive-based compensation arrangements. The proposed rule implements Section 956 of the Dodd-Frank Act, which requires the Agencies to prohibit incentive-based compensation arrangements, or any feature of any such arrangement, at certain institutions, including the FHLBank, that the Agencies determine encourage inappropriate risks by a financial institution by providing excessive compensation or that could expose the institution to inappropriate risks that could lead to a material financial loss. The proposed rule would prohibit excessive compensation and also would prohibit us from establishing or maintaining any type of incentive-based compensation arrangement, or any feature of any such arrangement, that encourages inappropriate risks by the FHLBank, by providing incentive-based compensation to any executive officer, employee or director that could lead to material financial loss to the FHLBank. In addition to identifying certain requirements for all incentive-based compensation arrangements, the proposed rule establishes certain deferral requirements for incentive-based compensation for executive officers. The proposed rule identifies executive officers as the president, the chief financial officer, and the three other most highly compensated officers, and any other officer as identified by the Director of the Finance Agency. An incentive-based compensation arrangement for an executive officer must provide for: (i) at least 50 percent of the annual incentive-based compensation of the executive officer to be deferred over a period of no less than three years, with the release of deferred amounts to occur no faster than on a pro rata basis; and (ii) the adjustment of the amount required to be deferred to reflect actual losses or other measures or aspects of performance that are realized or become better known during the deferral period. Comments on the proposed rule were due by May 31, 2011.
 
 
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Finance Agency Issues Proposed Rule on Credit Risk Retention for Asset-Backed Securities. On April 29, 2011, the Federal banking agencies, the Finance Agency, the Department of Housing and Urban Development and the SEC jointly issued a proposed rule which proposes to require sponsors of ABS to retain a minimum of five percent economic interest in a portion of the credit risk of the assets collateralizing ABS, unless all the assets securitized satisfy specified qualifications. The proposed rule specifies criteria for qualified residential mortgage, commercial real estate, auto and commercial loans that would make them exempt from the risk retention requirement. Key issues in the proposed rule include: (1) the appropriate terms for treatment as a qualified residential mortgage; (2) the extent to which the Enterprises’ related securitizations will be exempt from the risk retention rules; and (3) the possibility of creating a category of high quality non-qualified residential mortgage loans that would have less than a five percent risk retention requirement. Comments on the proposed rule were due by August 1, 2011.
 
Finance Agency Issues Proposed Rule on Prudential Management and Operations Standards. On June 20, 2011, the Finance Agency issued a proposed rule on Prudential Management and Operations Standards to implement section 1108 of the Recovery Act, which requires the Finance Agency to establish prudential standards relating to the management and operations of the Regulated Entities. Section 1108 of the Recovery Act requires the Director of the Finance Agency to establish standards that address 10 separate areas relating to the management and operation of the Regulated Entities, including adequacy of internal controls and information systems, adequacy and independence of internal audit systems, management of interest rate risk, management of market risk, adequacy of liquidity and reserves, management of growth in assets and in the investment portfolio, management of investments and acquisition of assets to ensure that they are consistent with the purposes of the Safety and Soundness Act, adequacy of overall risk management processes, adequacy of credit and counterparty risk management practices, and maintenance of records that allow an accurate assessment of the institution’s financial condition. The proposed rule provides that the prudential standards may be established by the Director of the Finance Agency as guidelines. In the event the Finance Agency determines that a Regulated Entity has failed to meet one or more of the standards, the Regulated Entity must submit a corrective action plan, which shall describe the actions the Regulated Entity will take to correct its failure to meet one or more of the standards. In the event a Regulated Entity fails to submit a corrective action plan or fails to implement or otherwise comply with an approved corrective action plan, the Finance Agency may limit the activities of the Regulated Entity. Comments on the proposed rule were due by August 19, 2011.
 
Finance Agency Issues Proposed Rulemaking on FHLBank Community Support Amendments. On November 10, 2011, the Finance Agency issued a proposed rule to amend the Finance Agency’s Community Support Requirements regulation. The proposed amendments would require the FHLBanks to monitor and assess the eligibility of each FHLBank member for access to long-term advances through compliance with the regulations’ Community Reinvestment Act of 1977 (CRA) and first-time homebuyer standards. The proposed rule would also replace the current practice in which members submit to the Finance Agency biennial community support statements containing their most recent CRA evaluations. Instead, the FHLBanks would be responsible for verifying a member’s CRA rating and overseeing members’ compliance with first-time homebuyer requirements. Comments on the proposed rule were due by February 8, 2012.
 
Finance Agency Issues Advance Notice of Proposed Rulemaking on Alternatives to Use of Credit Ratings in Finance Agency Regulations. On January 31, 2011, the Finance Agency published an advance notice of proposed rulemaking on alternatives to the use of credit ratings in regulations governing the Regulated Entities. Section 939A of the Dodd-Frank Act provides Federal agencies with one year to review regulations that require the use of an assessment of the creditworthiness of a security or money market instrument and any references to, or requirements in, such regulations regarding credit ratings, and to remove such references or requirements. The Finance Agency requested comments on the advance notice of proposed rulemaking to help it assess how it can change its regulations and to identify standards that may be appropriate as replacements for credit ratings issued by NRSROs. Comments on the advance notice of proposed rulemaking were due by March 17, 2011.
 
Finance Agency Issues Advance Notice of Proposed Rulemaking on Mortgage Assets Affected by PACE Programs. On January 26, 2012, the Finance Agency issued an advance notice of proposed rulemaking on mortgage assets affected by Property Assessed Clean Energy (PACE) Programs. PACE programs provide a means of financing certain kinds of home-improvement projects. Specifically, PACE programs permit local governments to provide financing to property owners for the purchase of energy-related home-improvement projects. The Finance Agency identified that it is concerned that PACE programs that involve subordination of any mortgage holder’s security interest in the underlying property to that of the provider of PACE financing may increase the financial risk borne by the Enterprises as holders of mortgages on properties subject to PACE obligations, as well as mortgage-backed securities based on such mortgages. The proposed action would direct the Enterprises not to purchase any mortgage that is subject to a first-lien PACE obligation or that could become subject to first-lien PACE obligations without the consent of the mortgage holder. Comments on the advance notice of proposed rulemaking are due by March 26, 2012.
 
Other Significant Regulatory Actions:
FDIC Publishes Final Rule on Assessments and Large Bank Pricing and a Notice of Adoption of an FDIC Restoration Plan. On February 25, 2011, the FDIC published a final rule to implement revisions to the Federal Deposit Insurance Act made by the Dodd-Frank Act by modifying the definition of an institution’s deposit insurance assessment base, to change the assessment rate adjustments, to revise the deposit insurance assessment rate schedules in light of the new assessment base and altered adjustments, to implement the Dodd-Frank Act’s dividend provisions, to revise the large insured depository institution assessment system to better differentiate for risk and better take into account losses from large institution failures that the FDIC may incur, and to make technical and other changes to the FDIC’s assessment rules. The Dodd-Frank Act revised the statutory authorities governing the FDIC’s management of the Deposit Insurance Fund (DIF). With respect to the FDIC’s authority, the Dodd-Frank Act, among other things: (1) raised the minimum designated reserve ratio (DRR), which the FDIC must set each year, to 1.35 percent (from the former minimum of 1.15 percent) and removed the upper limit on the DRR (which was formerly capped at 1.5 percent) and therefore the size of the DIF; (2) required that the DIF reserve ratio reach 1.35 percent by September 30, 2020 (rather than 1.15 percent by the end of 2016, as formerly required); (3) required that, in setting assessments, the FDIC offset the effect of requiring that the reserve ratio reach 1.35 percent by September 30, 2020 rather than 1.15 percent by the end of 2016 on insured depository institutions with total consolidated assets of less than $10 billion; (4) eliminated the requirement that the FDIC provide dividends from the fund when the reserve ratio is between 1.35 percent and 1.5 percent; and (5) continued the FDIC’s authority to declare dividends when the reserve ratio at the end of a calendar year is at least 1.5 percent, but granted the FDIC sole discretion in determining whether to suspend or limit the declaration or payment of dividends. The Dodd-Frank Act also required that the FDIC amend its regulations to redefine the assessment base used for calculating deposit insurance assessments. Pursuant to the Dodd-Frank Act and the final rule, the assessment base must, with some possible exceptions, equal average consolidated total assets minus average tangible equity. In addition, on December 20, 2010, the FDIC published a final rule implementing a comprehensive, long-range management plan for the DIF and setting the DRR at 2 percent. The final rule could have the effect of making advances more costly and less attractive to our members. The final rule on assessments became effective April 1, 2011.
 
 
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FDIC Publishes Final Rule Implementing Certain Orderly Liquidation Authority Provisions of the Dodd-Frank Act. On January 25, 2011, the FDIC published an interim final rule which implements certain provisions of its authority to resolve covered financial companies under Title II of the Dodd-Frank Act. Section 209 of the Dodd-Frank Act authorizes the FDIC, in consultation with the FSOC, to prescribe rules to implement the liquidation process under Title II of the Dodd-Frank Act’s mandate of transparency in the liquidation of failing systemic financial companies. Title II of the Dodd-Frank Act provides a process for the appointment of the FDIC as receiver of a failing financial company that poses significant risk to the financial stability of the United States (covered financial company). On July 15, 2011, the FDIC published a final rule to implement the orderly liquidation process. We are not considered a covered financial company pursuant to the Dodd-Frank Act. While ensuring that creditors bear the losses of the company’s failure under a specific claims priority, Title II incorporates procedural and other protections for creditors to ensure they are treated fairly. Pursuant to the Dodd-Frank Act, creditors are guaranteed that they will receive no less than the amount they would have received if the covered financial company had been liquidated under Chapter 7 of the Bankruptcy Code. The final rule could negatively impact our ability to lend to insurance company members and other members that may be considered covered financial companies. The final rule became effective on August 15, 2011.
 
Federal Banking Agencies Issue Final Rules to Permit Payment of Interest on Demand Deposit Accounts. The Dodd-Frank Act repealed the statutory prohibition against the payment of interest on demand deposits effective July 21, 2011. To conform their regulations to such provision, Federal banking regulators rescinded their regulations prohibiting paying interest on demand deposits effective July 21, 2011. FHLBank members’ ability to pay interest on their customers’ demand deposit accounts may increase their ability to attract or retain customer deposits, which could reduce their funding needs from FHLBank.
 
Financial Crimes Enforcement Network (FinCEN) Issues Notice of Proposed Rulemaking on Anti-Money Laundering and Suspicious Activity Reporting Requirements for Housing GSEs. On November 8, 2011, FinCEN, a bureau of the Department of the Treasury, issued a proposed rule defining certain Housing GSEs, including the FHLBanks, as financial institutions for the purpose of requiring Housing GSEs to establish anti-money laundering programs and report suspicious activities pursuant to the Bank Secrecy Act (BSA). As amended by the USA PATRIOT Act, the BSA requires financial institutions to establish anti-money laundering programs that include, at a minimum: (1) the development of internal policies, procedures, and controls; (2) the designation of a compliance officer; (3) an ongoing employee training program; and (4) an independent audit function to test programs. The proposed rule would require that each Housing GSE develop and implement an anti-money laundering program reasonably designed to prevent the Housing GSE from being used to facilitate money laundering or the financing of terrorist activities, and other financial crimes, including mortgage fraud. The proposed rule would also require the Housing GSEs to file suspicious activity reports directly with FinCEN in the event certain suspicious transactions are conducted or attempted by, at, or through a Housing GSE. The Housing GSEs are currently subject to Finance Agency regulations and guidance on the Reporting of Fraudulent Financial Instruments. Should FinCEN issue a final rule imposing anti-money laundering and suspicious activity report requirements on the Housing GSEs, the Finance Agency may amend the regulations and/or guidance to avoid any conflicts or duplicative requirements with FinCEN’s regulations. Comments on the proposed rulemaking were due by January 9, 2012.
 
National Credit Union Administration Issues Advance Notice of Proposed Rulemaking on Emergency Liquidity. On December 22, 2011, the National Credit Union Administration (NCUA) issued an advance notice of proposed rulemaking that would require federally insured credit unions to have access to backup federal liquidity sources for use in times of financial emergency and distressed economic circumstances. The advance notice of proposed rulemaking would require federally insured credit unions, as part of their contingency funding plans, to have access to backup federal liquidity sources through one of four ways:
§  
Becoming a member in good standing of the Central Liquidity Facility (CLF) directly;
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Becoming a member in good standing of CLF indirectly through a corporate credit union;
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Obtaining and maintaining demonstrated access to the Federal Reserve Discount Window; or
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Maintaining a certain percentage of assets in highly liquid Treasury securities.
 
The FHLBanks are not identified by the advance notice of proposed rulemaking as a backup federal liquidity source. The rule would apply to both federal and state-chartered credit unions. Comments on the advance notice of proposed rulemaking were due by February 21, 2012.

Additional Developments:
Home Affordable Refinance Program (HARP) Changes. The Finance Agency, with the Enterprises, have announced a series of changes to HARP that are intended to assist more eligible borrowers who can benefit from refinancing their home mortgages. The changes include: (1) lowering or eliminating certain risk-based fees; (2) removing the current 125 percent LTV ceiling on fixed rate mortgages that are purchased by the Enterprises; (3) waiving certain representations and warranties; (4) eliminating the need for a new property appraisal where there is a reliable automated valuation model estimate provided by the Enterprises; and (5) extending the end date for the program until December 31, 2013 for loans originally sold to the Enterprises on or before May 31, 2009. If HARP Program changes result in a significant number of prepayments on mortgage loans underlying our investments in Agency MBS, such investments will be paid off in advance of our expectations subjecting us to associated reinvestment risk.
 
Basel Committee on Banking Supervision Capital Framework. In September 2010, the Basel Committee on Banking Supervision (Basel Committee) approved a new capital framework for internationally active banks. Banks subject to the new framework will be required to have increased amounts of capital with core capital being more strictly defined to include only common equity and other capital assets that are able to fully absorb losses. The Basel Committee also proposed a liquidity coverage ratio for short-term liquidity needs that would be phased in by 2015, as well as a net stable funding ratio for longer-term liquidity needs that would be phased in by 2018.
 
On January 5, 2012, the Board of Governors announced its proposed rule on enhanced prudential standards and early remediation requirements, as required by the Dodd-Frank Act, for nonbank financial companies designated as systemically important by the FSOC. The proposed rule declines to finalize certain standards such as liquidity requirements until the Basel Committee framework gains greater international consensus, but the Board of Governors proposes a liquidity buffer requirement that would be in addition to the final Basel Committee framework requirements. The size of the buffer would be determined through liquidity stress tests, taking into account a financial institution’s structure and risk factors.
 
While it is still uncertain how the capital and liquidity standards being developed by the Basel Committee ultimately will be implemented by the U.S. regulatory authorities, the new framework and the Board of Governors’ proposed plan could require some of our members to divest assets in order to comply with the more stringent capital and liquidity requirements, thereby tending to decrease their need for advances; on the other hand, the new framework may incent our members to take our term advances to create balance sheet liquidity. The requirements may also adversely affect investor demand for consolidated obligations.
 
 
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Where to Find Additional Information
We file our annual, quarterly and current reports and other information with the SEC. You may read and copy such material at the public reference facilities maintained by the SEC at 100 F Street, NE, Washington, DC 20549. Please call the SEC at 1-800-732-0330 for more information on the public reference room. You can also find our SEC filings at the SEC’s Web site at www.sec.gov. Additionally, on our Web site at www.fhlbtopeka.com, you can find a link to the SEC’s Web site which can be used to access our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 (Exchange Act), as soon as reasonably practicable after we electronically file such material with, or furnish it to, the SEC.

 
 
Our business has been and may continue to be adversely impacted by recently enacted legislation and other ongoing actions by the U. S. government in response to disruptions in the financial markets. Disruptions in the financial markets over the last four or five years have significantly impacted the financial services industry, our members and us. In response to the economic downturn and the recession that ended in 2010, the U.S. government established certain governmental programs that have and may continue to adversely impact our access to and cost of funds and our competitive position for providing advances. These and future governmental programs could create increased funding costs for consolidated obligations and decreased borrowing activity from our members that could have a material adverse impact on our financial condition and results of operations. See Item 1 – “Business – Legislation and Regulatory Developments” for further discussion of government programs and initiatives.
 
These initiatives or proposed initiatives have at various times adversely impacted our competitive position with respect to accessing financing as well as the rate that we pay for borrowed funds. For example, the U.S. government’s financial backing of Fannie Mae and Freddie Mac have resulted in the debt securities of Fannie Mae and Freddie Mac being marginally more attractive to investors at various times than the debt securities of the FHLBanks.
 
On July 21, 2010, the President signed into law the Dodd-Frank Act. The Dodd-Frank Act, among other things: (1) creates an inter-agency oversight council that will identify and regulate systemically important financial institutions; (2) regulates the over-the-counter derivatives market; and (3) establishes new requirements, including a risk-retention requirement, for MBS. Our business operations, funding costs, rights, obligations, and/or the manner in which we carry out our housing-finance mission may be affected by the Dodd-Frank Act.
 
The Dodd-Frank Act may also subject the FHLBanks to heightened prudential standards established by the Federal Reserve Board if the FHLBanks are identified as being systemically important financial institutions. These standards may include risk-based capital requirements, liquidity requirements, risk management and a resolution plan. Other standards could encompass such matters as a requirement to issue contingent capital instruments, additional public disclosures, and limits on short-term debt. The Dodd-Frank Act also requires systemically important financial institutions to report to the Federal Reserve on the nature and extent of their credit exposures to other significant companies and undergo semi-annual stress tests and may subject us to higher capital requirements. Oversight by the Federal Reserve Board may result in an increase in our cost of doing business due to compliance with new regulatory requirements, and may result in FHLBank being assessed for the costs of additional regulatory oversight.
 
Finally, the Dodd-Frank Act requires federal regulatory agencies to establish regulations to implement the legislation. For example, regulations on the over-the-counter derivatives market that may be issued under the Dodd-Frank Act could materially affect an FHLBank’s ability to hedge its interest rate risk exposure from advances and mortgage loan purchases, achieve the FHLBank’s risk management objectives, and act as an intermediary between its members and counterparties. Recent regulatory actions taken by the CFTC may subject us to increased regulatory requirements which have the potential of making derivative transactions more costly and less attractive as risk management tools. We may be subject to initial and variation margin requirements and may be designated as a Swap Dealer or Major Swap Participant, and therefore subject to registration with the CFTC and additional reporting, recordkeeping and internal business conduct standards. Such regulatory actions also have the potential to impact the costs of certain transactions between us and our members if those transactions are treated as “swaps” by the CFTC.
 
Furthermore, as required by the Dodd-Frank Act, effective April 1, 2011, the FDIC revised the assessment base for insured depository institutions to equal average consolidated total assets minus average tangible equity. The change in the assessment base could have the effect of reducing commercial bank leverage and consequently reduce their demand for short-term funding instruments, which could negatively impact the spread we earn on our short-term investment portfolio, and could have the effect of making advances more costly and less attractive to our members, thereby having a potential adverse impact on our assets and earnings.
 
Our primary regulator, the Finance Agency, also continues to issue proposed and final regulatory requirements as a result of the Recovery Act, the Dodd-Frank Act and other mandates.
 
We cannot predict the effect of any new regulations on our operations. Changes in regulatory requirements could result in, among other things, an increase in our cost of funding or overall cost of doing business, or a decrease in the size, scope or nature of our lending or investments, which could negatively affect our financial condition and results of operations.
 
The U.S. Congress is also considering broad legislation for reform of GSEs as a result of the disruptions in the financial and housing markets and the conservatorships of Fannie Mae and Freddie Mac. A report released by the U.S. Treasury Department and HUD on February 11, 2011 outlines possible GSE reforms, including potential reforms to the business models of Fannie Mae, Freddie Mac and the FHLBanks. We do not know how or to what extent GSE reform legislation will impact the business or operations of FHLBank or the FHLBank System.
 
To the extent that these initiatives, proposed initiatives and other actions by the U.S. government in response to the financial crisis cause a significant decrease in the aggregate amount of advances or increase our operating costs, our financial condition and results of operations may be adversely affected. See Item 1 – “Business – Competition” for further discussion of the reduction in member borrowings as a result of competition arising from actions of the U.S. government. See Item 1 – “Legislative and Regulatory Developments” for more information on potential future legislation regarding GSE reform and other regulatory activity affecting FHLBank.
 
 
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We may become liable for all or a portion of the consolidated obligations of one or more of the other FHLBanks. We are jointly and severally liable with the other FHLBanks for all consolidated obligations issued on behalf of all 12 FHLBanks through the Office of Finance. We cannot pay any dividends to members or redeem or repurchase any shares of our capital stock unless the principal and interest due on all our consolidated obligations have been paid in full. If another FHLBank were to default on its obligation to pay principal or interest on any consolidated obligation, the Finance Agency may allocate the outstanding liability among one or more of the remaining FHLBanks on a pro rata basis or on any other basis the Finance Agency may determine. As a result, our ability to pay dividends to our members or to redeem or repurchase shares of our capital stock could be affected not only by our own financial condition, but also by the financial condition of one or more of the other FHLBanks. However, no FHLBank has ever defaulted on its debt obligations since the FHLBank System was established in 1932.
 
We are subject to a complex body of laws and regulations that could change in a manner detrimental to our operations. The FHLBanks are GSEs organized under the authority of the Bank Act, and, as such, are governed by federal laws and regulations adopted and applied by the Finance Agency. In addition, Congress may amend the Bank Act or pass other legislation that significantly affects the rights, obligations and permissible activities of the FHLBanks and the manner in which the FHLBanks carry out their housing-finance and liquidity missions and business operations. FHLBank is, or may also become, subject to regulations promulgated by the SEC, CFTC, Federal Reserve Board, or other regulatory agencies.
 
We cannot predict whether new regulations will be promulgated by the Finance Agency or other regulatory agencies, or whether Congress will enact new legislation, and we cannot predict the effect of any new regulations or legislation on our operations. Changes in regulatory or statutory requirements could result in, among other things, an increase in our cost of funding and the cost of operating our business, a change in our permissible business activities, or a decrease in the size, scope or nature of our membership or our lending, investment or MPF Program activities, which could negatively affect our financial condition and results of operations.
 
We share a regulator with Fannie Mae and Freddie Mac. The Finance Agency currently serves as the federal regulator of the FHLBanks and the Office of Finance, Fannie Mae and Freddie Mac. Because the business models of Fannie Mae and Freddie Mac are significantly different from that of the FHLBanks, there is a risk that actions by the Finance Agency toward Fannie Mae and Freddie Mac may have an unfavorable impact on the FHLBanks’ operations and/or financial condition.
 
There is a risk that our funding costs and access to funds could be adversely affected by changes in investors’ perception of the systemic risks associated with Fannie Mae and Freddie Mac. For example, the conservatorship of Fannie Mae and Freddie Mac, the U.S. Treasury financing agreements, and negative accounting and other announcements by Fannie Mae and Freddie Mac created pressure on debt pricing from time to time, as investors have perceived GSE debt instruments as bearing increased risk. These actions resulted in somewhat increased spreads on GSE debt, including FHLBank debt relative to U.S. Treasury securities. In addition, the special status of Fannie Mae and Freddie Mac debt securities could result in higher relative funding costs on FHLBank debt. As a result of the foregoing, we may have to pay a higher rate of interest on consolidated obligations to make them attractive to investors relative to Fannie Mae and Freddie Mac debt securities. If we maintain our existing pricing on advances, the resulting increase in the cost of issuing consolidated obligations could cause our advances to be less profitable and reduce our net interest spreads (the difference between the interest rate received on advances and the interest rate paid on consolidated obligations). If we change the pricing of our advances in response to this potential decrease in net interest spreads, the advances may no longer be as attractive to our members, and any outstanding advance balances may decrease. In either case, the increased cost of issuing consolidated obligations could negatively affect our financial condition and results of operations.
 
Our funding depends upon our ability to access the capital markets. Our primary source of funds is the sale of consolidated obligations in the capital markets, including the short-term discount note market. Our ability to obtain funds through the sale of consolidated obligations depends in part on prevailing conditions in the capital markets (including investor demand) at the time. At times during the recently ended economic downturn and recession that ended in 2010, our cost of issuing term debt increased significantly relative to U.S. Treasury obligations and LIBOR and resulted in us becoming more reliant on the issuance of consolidated obligation discount notes, with maturities of one year or less. Had there also been any significant disruption in the short-term debt markets during that period, it could have had a serious effect on our business and the business of the other FHLBanks. If such a significant market disruption in the short-term debt markets had occurred for an extended time, we might not have been able to obtain short-term funding on acceptable terms and the high cost of longer-term liabilities would likely have caused us to increase advance rates, which could have adversely affected demand for advances and, in turn, our results of operations. Alternatively in such a scenario, continuing to fund longer-term variable rate assets with very short-term liabilities could have adversely impacted our results of operations if the cost of those short-term liabilities had risen to levels above the yields on the long-term variable rate assets being funded. Accordingly, we cannot make any assurance that we will be able to obtain funding on terms acceptable to us in the future, if we are able to obtain funding at all in the case of another severe financial and economic disruption. If we cannot access funding when needed, our ability to support and continue our operations would be adversely affected, negatively affecting our financial condition and results of operations.
 
Changes in interest rates could significantly affect our earnings. Changes in interest rates that are detrimental to our investment position could negatively affect our financial condition and results of operations. Like many financial institutions, we realize income primarily from earnings on our invested capital as well as the spread between interest earned on our outstanding advances, mortgage loans and investments and interest paid on our borrowings and other liabilities. Although we use various methods and procedures to monitor and manage our exposures to risk due to changes in interest rates, we may experience instances when our interest-bearing liabilities will be more sensitive to changes in interest rates than our interest-earning assets, or vice versa. These impacts could be exacerbated by prepayment and extension risk, which is the risk that mortgage-related assets will be refinanced in low interest-rate environments or will remain outstanding at below-market yields when interest rates increase.
 
Changes in our credit ratings may adversely affect our business operations. We are currently rated Aaa with a negative outlook by Moody’s and AA+ with a negative outlook by S&P. Our rating from S&P was downgraded from AAA, to AA+, on August 8, 2011. Additional revisions to or the withdrawal of our credit ratings could adversely affect us in a number of ways. It could require the posting of additional collateral for derivatives transactions and might influence counterparties to limit the types of transactions they would be willing to enter into with us or cause counterparties to cease doing business with us. We have issued letters of credit to support deposits of public unit funds with our members. In some circumstances, loss of our current rating could result in our letters of credit no longer being acceptable to collateralize public unit deposits or other transactions. We have also executed various standby bond purchase agreements with two state HFAs in which we provide a liquidity facility for bonds issued by the HFAs by agreeing to purchase the bonds in the event they are tendered and cannot be remarketed in accordance with specified terms and conditions. If our current short-term ratings are reduced, suspended or withdrawn, the issuers will have the right to terminate these standby bond purchase agreements, resulting in the loss of future fees that would be payable to us under these agreements.
 
 
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Changes in the credit standing of the U.S. Government or other FHLBanks, including the credit ratings assigned to the U.S. Government or those FHLBanks, could adversely affect us. Pursuant to criteria used by S&P and Moody’s, the FHLBank System’s debt is linked closely to the U.S. sovereign rating because of the FHLBanks’ status as a government-sponsored enterprise and the view that the FHLBank System would be likely to receive U.S. government support in the event of a crisis. Changes in the credit standing or rating of the U.S. government could result in a revision of the rating assigned to us or the consolidated obligations of the FHLBank System.
 
The FHLBanks issue consolidated obligations that are the joint and several liability of all 12 FHLBanks. Significant developments affecting the credit standing of one or more of the other 11 FHLBanks, including revisions in the credit ratings of one of the other FHLBanks, could adversely affect the cost of consolidated obligations. An increase in the cost of consolidated obligations would affect our cost of funds and negatively affect our financial condition. The consolidated obligations of the FHLBanks are rated Aaa/P-1 by Moody’s and AA+/A-1+ by S&P. All 12 of the FHLBanks are rated AA+ with a negative outlook by S&P and Aaa with a negative outlook by Moody’s. Changes in the credit standing or credit ratings of one or more of the other FHLBanks could result in a revision or withdrawal of the ratings of the consolidated obligations by the rating agencies at any time, negatively affecting our cost of funds and may negatively affect our ability to issue consolidated obligations for our benefit.
 
We may not be able to meet our obligations as they come due or meet the credit and liquidity needs of our members in a timely and cost-effective manner. We seek to be in a position to meet our members’ credit and liquidity needs and to pay our obligations without maintaining excessive holdings of low-yielding liquid investments or being forced to incur unnecessarily high borrowing costs. In addition, in accordance with the Finance Agency’s requirement to maintain five calendar days of contingent liquidity, we maintain a contingency liquidity plan designed to protect against temporary disruptions in access to the FHLBank debt markets in response to a rise in capital markets volatility. Our efforts to manage our liquidity position, including carrying out our contingency liquidity plan, may not enable us to meet our obligations and the credit and liquidity needs of our members, which could have an adverse effect on our net interest income, and thereby, our financial condition and results of operations.
 
We face competition for loan demand, purchases of mortgage loans and access to funding which could adversely affect our earnings. Our primary business is making advances to our members. We compete with other suppliers of wholesale funding, both secured and unsecured, including U.S. government programs, investment banks, commercial banks and, in certain circumstances, other FHLBanks. Our members have access to alternative funding sources, which may offer more favorable terms on their loans than we offer on our advances, including more flexible credit or collateral standards. In addition, many of our competitors are not subject to the same regulations that are applicable to us. This enables those competitors to offer products and terms that we are not able to offer.
 
The availability of alternative funding sources to our members, such as the ability to sell covered bonds, may significantly decrease the demand for our advances. Any change we might make in pricing our advances, in order to compete more effectively with these competitive funding sources, may decrease our profitability on advances. A decrease in the demand for our advances, or a decrease in our profitability on advances, would negatively affect our financial condition and results of operations.
 
Likewise, our MPF business is subject to significant competition. The most direct competition for purchases of mortgage loans comes from other buyers of conventional, conforming, fixed rate mortgage loans, such as Fannie Mae and Freddie Mac. Increased competition can result in the acquisition of a smaller market share of the mortgage loans available for purchase and, therefore, lower income from this business activity.
 
We also compete in the capital markets with Fannie Mae, Freddie Mac, other GSEs and U.S. government programs, as well as corporate, sovereign and supranational entities for funds raised through the issuance of consolidated obligations and other debt instruments. We face increased competition in the Agency/GSE and other related debt markets as a result of government debt programs, including those explicitly guaranteed by the U.S. and foreign governments. Our ability to obtain funds through the issuance of debt depends in part on prevailing market conditions in the capital markets (including investor demand), such as effects on the reduction in liquidity in financial markets, which are beyond our control. Accordingly, we may not be able to obtain funding on terms that are acceptable to us. Increases in the supply of competing debt products in the capital markets may, in the absence of increases in demand, result in higher debt costs to us or lesser amounts of debt issued at the same cost than otherwise would be the case. Although our supply of funds through issuance of consolidated obligations has always kept pace with our funding needs, we cannot assure that this will continue in the future, especially in the case of financial market disruptions when the demand for advances by our members typically increase.
 
The yield on or value of our MBS investments may be adversely affected by increased delinquency rates and credit losses related to mortgage loans that back our MBS investments. Delinquencies and losses with respect to residential mortgage loans have generally remained high, particularly in the nonprime sector, including subprime and alternative documentation loans. In addition, residential property values in many states have continued to decline or are just beginning to stabilize, after extended periods during which those values appreciated. If delinquency and/or default rates on mortgages continue to increase, and/or there is a rapid decline in residential real estate values, we could experience reduced yields or losses on our MBS investments. Furthermore, market illiquidity has, from time to time, increased the amount of management judgment required to value private-label MBS and certain other securities. Subsequent valuations may result in significant changes in the value of private-label MBS and other investment securities. If we decide to sell securities due to credit deterioration, the price we may ultimately realize will depend on the demand and liquidity in the market at that time and may be materially lower than the fair value reflected in our financial statements.
 
Loan modification and liquidation programs could have an adverse impact on the value of our MBS investments. As mortgage loans continue to experience increased delinquencies and loss severities, mortgage servicers continue their efforts to modify these loans in order to mitigate losses. Such loan modifications increasingly may include reductions in interest rates and/or principal on these loans. Losses from such loan modifications may be allocated to investors in MBS backed by these loans in the form of lower interest payments and/or reductions in future principal amounts received. In addition, efforts by the U.S. government to address the downturn in the housing market could result in reductions in interest rates and/or principal and may also result in additional foreclosures that could result in an adverse impact on the value of our MBS investments.
 
Many servicers are contractually required to advance principal and interest payments on delinquent loans backing MBS investments, regardless of whether the servicer has received payment from the borrower, provided that the servicer believes it will be able to recoup the advanced funds from the underlying property securing the mortgage loan. Once the related property is liquidated, the servicer is entitled to reimbursement for these advances and other expenses incurred while the loan was delinquent. Such reimbursements, combined with decreasing property values in many areas, may result in higher losses than we may have expected or experienced to date being allocated to our MBS investments backed by such loans.
 
 
22

 
Securities or mortgage loans pledged as collateral by our members could be adversely affected by the devaluation or inability to liquidate the collateral in the event of a default by the member. Although we seek to obtain sufficient collateral on our credit obligations to protect ourselves from credit losses, changes in market conditions or other factors may cause the collateral to deteriorate in value, which could lead to a credit loss in the event of a default by a member and adversely affect our financial condition and results of operations. A reduction in liquidity in the financial markets or otherwise could have the same effect.
 
Counterparty credit risk could adversely affect us. We assume unsecured credit risk when entering into money-market transactions and financial derivatives transactions with counterparties. The insolvency or other inability of a significant counterparty to perform on its obligations under such transactions or other agreements could have an adverse effect on our financial condition and results of operations.
 
Defaults by one or more of our institutional counterparties on its obligations to us could adversely affect our results of operations or financial condition. We have a high concentration of credit risk exposure to financial institutions as counterparties, which are currently perceived to present a higher degree of risk than they were perceived to present in the past due to the continued reduced liquidity in financial markets for certain financial transactions, difficulties in the current housing market and the deterioration in the financial performance and condition of financial institutions in general, including many European and domestic financial institutions. Our primary exposures to institutional counterparty risk are with: (1) obligations of mortgage servicers that service the loans we have as collateral on our credit obligations; (2) third-party providers of credit enhancements on the MBS that we hold in our investment portfolio, including mortgage insurers, bond insurers and financial guarantors; (3) third-party providers of private and supplemental mortgage insurance for mortgage loans purchased under the MPF Program; (4) derivative counterparties; and (5) unsecured money market and Federal funds investment transactions. The liquidity and financial condition of some of our counterparties may have been adversely affected by the continued reduced liquidity in the financial markets for certain financial transactions and difficulties in the housing market. A default by a counterparty with significant obligations to us could adversely affect our ability to conduct operations efficiently and at cost-effective rates, which in turn could adversely affect our results of operations or financial condition.
 
We rely upon derivatives to lower our cost of funds and reduce our interest-rate, option and prepayment risk, and we may not be able to enter into effective derivative instruments on acceptable terms. We use derivatives to: (1) obtain funding at more favorable rates; and (2) reduce our interest-rate risk, option risk and mortgage-prepayment risk. Management determines the nature and quantity of hedging transactions using derivatives based on various factors, including market conditions and the expected volume and terms of advances. As a result, our effective use of derivatives depends upon management’s ability to determine the appropriate hedging positions in light of: (1) our assets and liabilities; and (2) 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 the quantities necessary to hedge our corresponding obligations, interest-rate risk or other risks. The cost of entering into derivative instruments has increased as a result of: (1) consolidations, mergers and bankruptcy or insolvency of financial institutions, which have led to fewer counterparties, resulting in less liquidity in the derivatives market; and (2) increased uncertainty related to the potential changes in legislation and regulations regarding over-the-counter derivatives including increased margin and capital requirements, increased regulatory costs and transaction fees associated with clearing and custodial arrangements. If we are unable to manage our hedging positions properly, or are unable to enter into derivative hedging instruments on desirable terms, we may incur higher funding costs, be required to limit certain advance product offerings and be unable to effectively manage our interest-rate risk and other risks, which could negatively affect our financial condition and results of operations.
 
We may not be able to pay dividends at rates consistent with past practices. Our Board of Directors may only declare dividends on our capital stock, payable to members, from our unrestricted retained earnings and current income. Our ability to pay dividends also is subject to statutory and regulatory requirements, including meeting all regulatory capital requirements. For example, the potential promulgation of regulations by the Finance Agency that would require higher levels of retained earnings or mandated revisions to our retained earnings policy could lead to higher levels of retained earnings, and thus, lower amounts of unrestricted retained earnings available to be paid out to our members as dividends. Failure to meet any of our regulatory capital requirements would prevent us from paying any dividend.
 
Further, events such as changes in our market-risk profile, credit quality of assets held and increased volatility of net income caused by the application of certain GAAP may affect the adequacy of our retained earnings and may require us to increase our threshold level of retained earnings and correspondingly reduce our dividends from historical dividend payout ratios in order to achieve and maintain the threshold amounts of retained earnings under our retained earnings policy. Additionally, Finance Agency regulations on capital classifications could restrict our ability to pay a dividend.
 
Our ability to declare dividends in the form of capital stock may be restricted by Finance Agency rules regarding excess stock. Pursuant to Finance Agency regulations, any FHLBank with excess stock greater than one percent of its total assets will be prohibited from further increasing member excess stock by paying stock dividends or otherwise issuing new excess stock. If our total assets are significantly decreased, our ability to issue dividends in stock may be impaired which could, in turn, adversely affect demand for our advances.
 
Lack of a public market and restrictions on transferring our stock could result in an illiquid investment for the holder. Under the GLB Act, Finance Agency regulations and our capital plan, our Class A Common Stock may be redeemed upon the expiration of a six-month redemption period and our Class B Common Stock after a five-year redemption period following our receipt of a redemption request. Only capital stock in excess of a member’s minimum investment requirement, capital stock held by a member that has submitted a notice to withdraw from membership or capital stock held by a member whose membership has been terminated may be redeemed at the end of the redemption period. Further, we may elect to repurchase excess capital stock of a member at any time at our sole discretion.
 
We cannot guarantee, however, that we will be able to redeem capital stock even at the end of the redemption periods. The redemption or repurchase of our capital stock is prohibited by Finance Agency regulations and our capital plan if the redemption or repurchase of the capital stock would cause us to fail to meet our minimum regulatory capital requirements. Likewise, under such regulations and the terms of our capital plan, we could not honor a member’s capital stock redemption request if the redemption would cause the member to fail to maintain its minimum capital stock investment requirement. Moreover, since our capital stock may only be owned by our members (or, under certain circumstances, former members and certain successor institutions), and our capital plan requires our approval before a member may transfer any of its capital stock to another member, we cannot assure that a member would be allowed to sell or transfer any excess capital stock to another member at any point in time.
 
 
23

 
We may also suspend the redemption of capital stock if we reasonably believe that the redemption would prevent us from maintaining adequate capital against a potential risk, or would otherwise prevent us from operating in a safe and sound manner. In addition, approval from the Finance Agency for redemptions or repurchases is required if the Finance Agency or our Board of Directors were to determine that we have incurred, or are likely to incur, losses that result in, or are likely to result in, charges against our capital. Under such circumstances, we cannot assure that the Finance Agency would grant such approval or, if it did, upon what terms it might do so. We may also be prohibited from repurchasing or redeeming our capital stock if the principal and interest due on any consolidated obligations that we issued through the Office of Finance has not been paid in full or if we become unable to comply with regulatory liquidity requirements or satisfy our current obligations.
 
Accordingly, there are a variety of circumstances that would preclude us from redeeming or repurchasing our capital stock that is held by a member. Since there is no public market for our capital stock and transfers require our approval, we cannot assure that a member’s purchase of our capital stock would not effectively become an illiquid investment.
 
Changes in the application of relevant accounting standards, especially those related to the accounting for derivatives, could materially increase earnings volatility. We are subject to earnings volatility because of our use of derivatives and the application of GAAP for those derivatives. This earnings volatility is caused by hedge ineffectiveness, which is the difference in the amounts recognized in our earnings for the changes in fair value of a derivative and the related hedged item, and by the changes in the fair values of derivatives that do not qualify for hedge accounting (referred to as economic hedges where the change in fair value of the derivative is not offset by any change in fair value on a hedged item). If we did not apply hedge accounting, the result could be an increase in volatility of our earnings from period to period. Such increases in earnings volatility could affect our ability to pay dividends, our ability to meet our retained earnings threshold, and our members’ willingness to hold the stock necessary for membership and/or activity with us, such as advance and mortgage loan activities.
 
We rely heavily upon information systems and other technology. We rely heavily upon information systems and other technology to conduct and manage our business. To the extent that we experience a failure or interruption in any of these systems or other technology, we may be unable to conduct and manage our business effectively, including, without limitation, our funding, hedging and advance activities. While we have implemented disaster recovery and business continuity plans, we can make no assurance that these plans will be able to prevent, timely and adequately address, or mitigate the negative effects of any such failure or interruption. Any failure or interruption could significantly harm our customer relations, risk management and profitability, which could negatively affect our financial condition and results of operations.
 
We rely on financial models to manage our market risk, to make business decisions and for financial accounting and reporting purposes. The impact of financial models and the underlying assumptions used to value financial instruments may have an adverse impact on our financial condition and results of operations. We make significant use of financial models for managing risk. For example, we use models to measure and monitor exposures to interest rate and other market risks, including prepayment risk, as well as credit risk. We also use models in determining the fair value of financial instruments for which independent price quotations are not available or reliable. The degree of management judgment in determining the fair value of a financial instrument is dependent upon the availability of quoted market prices or observable market parameters. For financial instruments 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. Pricing models and their underlying assumptions are based on management's best estimates for discount rates, prepayments, market volatility, and other factors. These assumptions may have a significant effect on the reported fair values of assets and liabilities, including derivatives, the related income and expense, and the expected future behavior of assets and liabilities. While the models we use to value instruments and measure risk exposures are subject to regular validation by independent parties, rapid changes in market conditions could impact the value of our instruments. The use of different models and assumptions, as well as changes in market conditions, could impact our financial condition and results of operations.
 
The information provided by these models is also used in making business decisions relating to strategies, initiatives, transactions and products, and in financial statement reporting. We have adopted policies, procedures, and controls to monitor and manage assumptions used in these models. However, models are inherently imperfect predictors of actual results because they are based on assumptions about future performance. Changes in any models or in any of the assumptions, judgments or estimates used in the models may cause the results generated by the model to be materially different. If the 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. Furthermore, any strategies that we employ to attempt to manage the risks associated with the use of models may not be effective.
 
We could be negatively affected by local and national business and economic conditions, as well as other events that are outside of our control. Local and national economic conditions could be less favorable than expected or could have a more direct and pronounced effect on our business than expected. For example, conditions affecting interest rates, money supply and capital markets, including those stemming from policies of governmental entities such as the Federal Reserve Board or the U.S. Treasury, have a significant impact on our operations. Changes in these conditions could adversely affect our ability to increase and maintain the quality of our interest-earning assets and could increase the costs of our interest-bearing liabilities. For example, a prolonged or worsening economic downturn or the continued deterioration of property values could cause higher delinquency and default rates on our outstanding mortgage loans and even cause a loss on our advances, although we have never incurred a credit loss on an advance.
 
Furthermore, natural disasters, acts of terrorism and other events outside of our control, especially if they occur in our four-state district, could negatively affect us, including damaging our members’ businesses, our real property and the collateral for our advances and mortgage loans, and in other ways. For example, if there is a natural disaster or other event, such as the terrorist attacks of September 11, 2001, that limits or prevents the FHLBank System from accessing the capital markets for a period of time, our business would be significantly affected, including our ability to provide advances to our members.
 
We could experience losses on our MBS/CMO and HFA investments as a result of losses in the home mortgage loan market or the failure of a third-party insurer. Increased delinquency rates and credit losses related to mortgage loans pooled into MBS/CMO and HFA securities, which are insured by one of the monoline mortgage insurance companies, could adversely affect the yield on or value of our MBS/CMO and HFA investments. The magnitude of the losses in the home mortgage loan market could potentially overwhelm one or more of the monoline mortgage insurance companies resulting in such company’s failure to perform. If the collateral losses exceed the coverage ability of the insurance company, the MBS/CMO or HFA bondholders could experience losses of principal.
 
 
24

 
A third-party insurer (obligated under PMI or SMI) of portions of our MPF Program loans could also fail to perform as expected. Should a PMI third-party insurer fail to perform, it would increase our credit risk exposure because our FLA is the next layer to absorb credit losses on mortgage loan pools. Likewise, if an SMI third-party insurer fails to perform, it would increase our credit risk exposure because it would reduce the participating member’s CE obligation loss layer since SMI is purchased by PFIs to cover all or a portion of their CE obligation exposure for mortgage pools.
 
Reliance on the FHLBank of Chicago as MPF Provider could have a negative impact on our business if the FHLBank of Chicago were to default on its contractual obligations owed to us. 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 or selling and servicing MPF mortgage 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 products 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 engaged in the operation of the MPF Program were to experience operational or technical difficulties.
 
The government support for the home mortgage market could have an adverse impact on our mortgage loans held for portfolio. Government policy and actions by the U.S. Treasury, the Federal Reserve, Fannie Mae, Freddie Mac, and the FDIC have been focused on lowering home mortgage rates. These actions may increase the rate of mortgage prepayments which may adversely affect the earnings on our mortgage investments.
 
A high proportion of advances and capital is concentrated with a few members, and a loss of, or change in business activities with, such institutions could adversely affect us. We have a high concentration of advances (see Table 23) and capital with a few institutions. A reduction in advances by such institutions, or the loss of membership by such institutions, whether through merger, consolidation, withdrawal, or other action, may result in a reduction in our total assets and a possible reduction of capital as a result of the repurchase or redemption of capital stock. The reduction in assets and capital may also reduce our net income.
 
Merger or consolidation of our members may result in a loss of business to us. The financial services industry periodically experiences consolidation. If future consolidation occurs within our district, it may reduce the number of current and potential members in our district, resulting in a loss of business to us and a potential reduction in our profitability. If our advances are concentrated in a smaller number of members, our risk of loss resulting from a single event (such as the loss of a member’s business due to the member’s acquisition by a nonmember) would become proportionately greater.
 
Member failures, out-of-district consolidations and changes in member business with us may adversely affect our financial condition and results of operations. Over the last several years, the financial services industry has experienced increasing defaults on, among other things, home mortgage, commercial real estate, and credit card loans, which caused increased regulatory scrutiny and required capital to cover non-performing loans. These factors led to an increase in both the number of financial institution failures and the number of mergers and consolidations. During that time, we experienced member failures, member consolidations and significant changes in the level of advance activity with certain members. If the number of member institution failures and consolidations accelerates, these activities may reduce the number of current and potential members in our district. The resulting loss of business could negatively impact our financial condition and the results of operations, as well as our operations generally.
 
Further, while member failures may cause us to liquidate pledged collateral if the outstanding advances are not repaid, the failures of the past several years have been resolved either through repayment directly from the FDIC or through the purchase and assumption of the advances by another surviving financial institution. Liquidation of pledged collateral may cause financial statement losses. Additionally, as members become financially distressed, we may, at the request of their regulators, decrease lending limits or, in certain circumstances, cease lending activities to certain members if they do not have adequate eligible collateral to support additional borrowings. If members are unable to obtain sufficient liquidity from us, further deterioration of that member institution may continue. This may negatively impact our reputation and, therefore, negatively impact our financial condition and results of operations.
 
Our controls and procedures may fail or be circumvented, and risk management policies and procedures may be inadequate. We may fail to identify and manage risks related to a variety of aspects of our business, including without limitation, operational risk, interest-rate risk, legal and compliance risk, human capital risk, liquidity risk, market risk and credit risk. We have adopted controls, procedures, policies and systems to monitor and manage these risks. Our management cannot provide complete assurance that such controls, procedures, policies and systems are adequate to identify and manage the risks inherent in our business and because our business continues to evolve, we may fail to fully understand the implications of changes in our business, and therefore, we may fail to enhance our risk governance framework to timely or adequately address those changes. Failed or inadequate controls and risk management practices could have an adverse effect on our financial condition, reputation, results of operations, and value to our membership.
 
 
 
 
Not applicable.
 
 
 
 
We occupy approximately 62,796 square feet of leased office space at One Security Benefit Place, Suite 100, Topeka, Kansas. We also maintain in Topeka a leased off-site back-up facility with approximately 3,000 square feet. A small office is leased in Oklahoma for member account management personnel.
 
 
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We are subject to various pending legal proceedings arising in the normal course of business. After consultation with legal counsel, management does not anticipate that the ultimate liability, if any, arising out of these matters will have a material adverse effect on our financial condition or results of operations. Additionally, management does not believe that we are subject to any material pending legal proceedings outside of ordinary litigation incidental to our business.
 

Not applicable.

 
 
Item 5: Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
 
 
As a cooperative, members own almost all of our Class A Common Stock and Class B Common Stock with the remainder of the capital stock held by former members that are required to retain capital stock ownership to support outstanding advances executed and mortgage loans sold while they were members. Note, however, that the portion of our capital stock subject to mandatory redemption is treated as a liability and not as capital, including the capital stock of former members. There is no public trading market for our capital stock.
 
All of our member directors are elected by and from the membership, and we conduct our business in advances and mortgage loan acquisitions almost exclusively with our members. Depending on the class of capital stock, it may be redeemed at par value either six months (Class A Common Stock) or five years (Class B Common Stock) after we receive a written request by a member, subject to regulatory limits and to the satisfaction of any ongoing stock investment requirements applying to the member under our capital plan. We may repurchase shares held by members in excess of the members’ required stock holdings at our discretion at any time at par value. Par value of all common stock is $100 per share. As of March 9, 2012, we had 842 stockholders of record and 5,956,011 shares of Class A Common Stock and 7,541,606 shares of Class B Common Stock outstanding, including 70,457 shares of Class A Common Stock and 10,529 shares of Class B Common Stock subject to mandatory redemption by members or former members. We are not currently required to register either class of our stock under the Securities Act of 1933 (as amended). The Recovery Act amended the Exchange Act to require the registration of a class of common stock of each FHLBank under Section 12(g) and for each FHLBank to maintain such registration and to be treated as an “issuer” under the Exchange Act, regardless of the number of members holding such a class of stock at any given time. Pursuant to a Finance Agency regulation, we were required to file a registration statement in order to voluntarily register one of our classes of stock pursuant to section 12(g)(1) of the Exchange Act. Our registration was effective July 14, 2006.
 
We paid quarterly stock dividends during the years ended December 31, 2011 and 2010, which excludes dividends treated as interest expense for mandatorily redeemable shares. Dividends paid on capital stock are outlined in Table 7 (in thousands):
 
 
Table 7
 
 
   
Class A Common Stock
   
Class B Common Stock
 
   
Percent
   
Dividends
Paid in Cash1
   
Dividends Paid
in Class B
Common Stock
   
Total
Dividends
Paid2
   
Percent
   
Dividends
Paid in Cash1
   
Dividends Paid
in Class B
Common Stock
   
Total
Dividends
Paid2
 
12/31/2011
    0.25 %   $ 41     $ 313     $ 354       3.50 %   $ 28     $ 6,688     $ 6,716  
09/30/2011
    0.25       46       333       379       3.50       41       6,945       6,986  
06/30/2011
    0.40       41       567       608       3.00       27       5,885       5,912  
03/31/2011
    0.40       45       558       603       3.00       93       5,968       6,061  
12/31/2010
    0.40       43       573       616       3.00       26       6,328       6,354  
09/30/2010
    0.75       43       841       884       3.00       38       8,204       8,242  
06/30/2010
    0.75       45       522       567       3.00       37       9,822       9,859  
03/31/2010
    0.75       44       499       543       3.00       40       9,764       9,804  
                   
1
The cash dividends listed are cash dividends paid for partial shares and dividends paid to former members. Stock dividends are paid in whole shares.
2
Excludes dividends paid on mandatorily redeemable capital stock classified as interest expense.
 
 
 
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Management anticipates that we will continue to pay quarterly dividends in the future, primarily in shares of Class B Common Stock. Dividends may be paid in cash or Class B Common Stock as authorized under our capital plan and approved by our Board of Directors. We believe that dividends paid in the form of stock are advantageous to members because FHLBank stock dividends generally qualify as tax-deferred stock dividends under the Internal Revenue Code (IRC) and are, therefore, not taxable at the time declared and credited to a member. Dividends paid in stock can be utilized by members to support future activity with us or can be redeemed by the member if the amounts represent excess stock, subject to stock redemption request procedures and limitations. Our dividends generally increase as short-term interest rates rise and decrease as short-term interest rates fall. The dividend percent paid has historically been a function of or closely tied to our net income for a dividend period. We have a retained earnings policy that was considered by the Board of Directors when dividends were declared during 2011 and 2010, but the retained earnings threshold calculated in accordance with the policy did not significantly affect the level of dividends declared and paid in any of those periods. See Item 1 – “Business – Capital, Capital Rules and Dividends” for more information regarding our retained earnings policy, and also see Item 7 – “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Capital” for a discussion of restrictions on dividend payments in the form of capital stock. We do not expect that our retained earnings policy will significantly affect dividends paid during 2012. We expect that we will continue to be able to make additions to retained earnings while paying Class B Common Stock dividends at or above short-term market interest rates and Class A Common Stock dividends (paid in cash or in Class B Common Stock) at or slightly below short-term market interest rates, on average. While the average Class A Common Stock dividend rate for 2011 was 0.33 percent per annum, well above short-term interest rates such as overnight Federal funds (average of 0.10 percent for 2011), this relationship will not remain at such levels when short-term interest rates begin to rise. There is also a possibility that dividend levels might be reduced in order to meet the threshold level of retained earnings under the policy since the threshold level fluctuates from period to period, because it is a function of the size and composition of our balance sheet and the risks contained therein.
 
In accordance with Finance Agency regulation, we are limited in our ability to create member excess stock under certain circumstances. Any FHLBank with excess stock greater than one percent of its total assets will be barred from further increasing member excess stock by paying stock dividends or otherwise issuing new excess stock. We anticipate that we will be able to manage our excess capital stock position in order to continue to pay stock dividends, but cannot guarantee that we will always be able to do so in the future.
 
 
 
27

 
Item 6: Selected Financial Data
 
 
Table 8
 
 
Selected Financial Data (dollar amounts in thousands):
 
 
   
12/31/2011
   
12/31/2010
   
12/31/2009
   
12/31/2008
   
12/31/2007
 
Statement of Condition (as of year end)
                             
Total assets
  $ 33,190,182     $ 38,706,067     $ 42,631,611     $ 58,556,231     $ 55,304,572  
Investments1
    10,576,537       14,845,941       16,347,941       19,435,809       20,515,451  
Advances
    17,394,399       19,368,329       22,253,629       35,819,674       32,057,139  
Mortgage loans, net2
    4,933,332       4,293,431       3,333,784       3,023,805       2,352,301  
Deposits
    997,371       1,209,952       1,068,757       1,703,531       1,340,816  
Consolidated obligation discount notes, net3
    10,251,108       13,704,542       11,586,835       26,261,411       19,896,098  
Consolidated obligation bonds, net3
    19,894,483       21,521,435       27,524,799       27,421,634       31,213,358  
Total consolidated obligations, net3
    30,145,591       35,225,977       39,111,634       53,683,045       51,109,456  
Mandatorily redeemable capital stock
    8,369       19,550       22,437       34,806       36,147  
Capital stock
    1,327,827       1,454,396       1,602,696       2,240,335       2,091,187  
Total retained earnings
    401,461       351,754       355,075       156,922       208,763  
Accumulated other comprehensive income (loss)
    (27,841 )     (22,672 )     (11,861 )     (2,012 )     (2,096 )
Total capital
    1,701,447       1,783,478       1,945,910       2,395,245       2,297,854  
                                         
Statement of Income (for the year ended)
                                       
Net interest income
    230,926       249,876       259,011       247,287       231,825  
Provision for (reversal of) credit losses on mortgage loans
    1,058       1,582       1,254       196       (25 )
Other income (loss)
    (78,538 )     (154,503 )     108,021       (168,312 )     10,220  
Other expenses
    53,571       48,090       43,586       40,002       37,254  
Income before assessments
    97,759       45,701       322,192       38,777       204,816  
Assessments
    20,433       12,153       85,521       10,338       54,510  
Net income
    77,326       33,548       236,671       28,439       150,306  
                                         
Ratios and Other Financial Data
                                       
Dividends paid in cash4
    362       316       367       345       373  
Dividends paid in stock4
    27,257       36,553       41,500       79,935       114,647  
Weighted average dividend rate5
    1.99 %     2.36 %     2.29 %     3.64 %     5.83 %
Dividend payout ratio6
    35.72 %     109.90 %     17.69 %     282.29 %     76.52 %
Return on average equity
    4.43 %     1.79 %     11.24 %     1.17 %     6.93 %
Return on average assets
    0.21 %     0.08 %     0.48 %     0.05 %     0.29 %
Average equity to average assets
    4.73 %     4.46 %     4.31 %     4.15 %     4.14 %
Net interest margin7
    0.63 %     0.60 %     0.53 %     0.43 %     0.44 %
Total capital ratio8
    5.13 %     4.61 %     4.56 %     4.09 %     4.15 %
Regulatory capital ratio9
    5.24 %     4.72 %     4.64 %     4.15 %     4.22 %
Ratio of earnings to fixed charges10
    1.31       1.12       1.56       1.02       1.08  
                   
1
Includes trading securities, available-for-sale securities, held-to-maturity securities, interest-bearing deposits, securities purchased under agreements to resell and Federal funds sold.
2
Includes mortgage loans held for portfolio and held for sale. The allowance for credit losses on mortgage loans held for portfolio was $3,473,000, $2,911,000, $1,897,000, $884,000 and $844,000 as of December 31, 2011, 2010, 2009, 2008 and 2007, respectively.
3
Consolidated obligations are bonds and discount notes that we are primarily liable to repay. See Note 11 to the financial statements for a description of the total consolidated obligations of all 12 FHLBanks for which we are jointly and severally liable under the requirements of the Finance Agency which governs the issuance of debt for the 12 FHLBanks.
4
Dividends reclassified as interest expense on mandatorily redeemable capital stock and not included as GAAP dividends were $174,000, $346,000, $504,000, $609,000 and $2,101,000 for the years ended December 31, 2011, 2010, 2009, 2008 and 2007, respectively.
5
Dividends paid in cash and stock on both classes of stock as a percentage of average capital stock eligible for dividends.
6
Dividends declared as a percentage of net income.
7
Net interest income as a percentage of average earning assets.
8
GAAP capital stock, which excludes mandatorily redeemable capital stock, plus retained earnings and AOCI as a percentage of total assets.
9
Regulatory capital (i.e., permanent capital and Class A capital stock) as a percentage of total assets.
10
Total earnings divided by fixed charges (interest expense including amortization/accretion of premiums, discounts and capitalized expenses related to indebtedness).

 
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Item 7: Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
 
The following Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) is intended to assist the reader in understanding our business and assessing our operations both historically and prospectively. This discussion should be read in conjunction with our audited financial statements and related notes presented under Item 8 of this annual report on Form 10-K. Our MD&A includes the following sections:
§  
Executive Level Overview – a general description of our business and financial highlights;
§  
Financial Market Trends – a discussion of current trends in the financial markets and overall economic environment, including the related impact on our operations;
§  
Critical Accounting Policies and Estimates – a discussion of accounting policies that require critical estimates and assumptions;
§  
Results of Operations – an analysis of our operating results, including disclosures about the sustainability of our earnings;
§  
Financial Condition – an analysis of our financial position;
§  
Liquidity and Capital Resources – an analysis of our cash flows and capital position;
§  
Risk Management – a discussion of our risk management strategies; and
§  
Recently Issued Accounting Standards.
 
 
Executive Level Overview
We are a regional wholesale bank that makes advances (loans) to, purchases mortgages from, and provides other financial services to our member and other eligible institutions. We are one of 12 district FHLBanks which, together with the Office of Finance, a joint office of the FHLBanks, make up the FHLBank System. As independent, member-owned cooperatives, the FHLBanks seek to maintain a balance between their public purpose and their ability to provide adequate returns on the capital supplied by their members. The FHLBanks are supervised and regulated by the Finance Agency, an independent agency in the executive branch of the U.S. government. The Finance Agency’s mission with respect to the FHLBanks is to provide effective supervision, regulation and housing mission oversight of the FHLBanks to promote their safety and soundness, support housing finance and affordable housing, and support a stable and liquid mortgage market.
 
We serve eligible financial institutions in Colorado, Kansas, Nebraska and Oklahoma (collectively, the Tenth District of the FHLBank System). Initially, members are required to purchase shares of Class A Common Stock to give them access to advance borrowings or to enable them to sell mortgage loans to us under the MPF Program. Our capital increases when members are required to purchase additional capital stock in the form of Class B Common Stock to support an increase in advance borrowings or when members sell additional mortgage loans to us. At our discretion, we may repurchase excess capital stock from time to time if a member’s advances or mortgage loan balances decline. During 2011, we continued to: (1) achieve our liquidity, housing finance and community development missions by meeting member credit needs by offering advances, supporting residential mortgage lending through the MPF Program and offering other products and services to our members; (2) repurchase excess capital stock in order to appropriately manage the size of our balance sheet; and (3) pay market-rate dividends.
 
Our net income for 2011 increased by $43.8 million, increasing from $33.5 million for 2010 to $77.3 million for 2011. The significant changes in the components of net income are as follows:
§
$19.0 million decrease in net interest income (decrease income);
§
$6.3 million increase related to net gains (losses) on trading securities (increase income);
§
$65.9 million increase related to net gains (losses) on derivatives and hedging activities (increase in income);
§
$5.5 million increase in other expenses (decrease income); and
§
$8.3 million increase in assessments (decrease income).
 
 
As indicated above, the significant increase in net income was primarily due to the positive impact of a smaller net loss related to derivatives and hedging activities combined with a net gain in the market values of trading securities. The net gains on trading securities and net losses on derivatives and hedging activities for 2011 are primarily the result of significant declines in interest rates and a flattening of the interest rate curve despite a slight increase in interest rate volatility. See “Net Gain (Loss) on Derivative and Hedging Activities” and “Net Gain (Loss) on Trading Securities” in this Item 7 for additional discussion.
 
Net interest income, which does not include the above mentioned market value fluctuations, has also posted year-over-year declines in each of the past two years as the impact of a smaller balance sheet over these periods outweighed improvements in net interest margin.
 
The overall decrease in total assets from December 31, 2010 to December 31, 2011 was primarily due to declines in investments and advances that were partially offset by an increase in mortgage loans held for portfolio (see Table 20). A majority of the decline in advances is due to net pay downs by two large borrowers with a smaller portion of pay downs resulting from the failure of two members with $554.8 million of advances outstanding at the time of failure that were subsequently repaid. Total investments decreased during the fourth quarter of 2011 largely as a result of a conscious decision by management to reduce non-mortgage investments as a percent of total assets in the current credit environment. Additionally, the composition of the remaining non-mortgage investments has changed as management decreased purchases of unsecured foreign investments in favor of GSE debentures and the use of secured reverse repurchase transactions. Also contributing to the decline in total investments were significant pay downs in our MBS/CMO investment portfolio. We strive to help our members compete for mortgage loans in their local markets by offering competitive pricing and through our outreach and education activities. As a result of these value-added efforts, the number of loans being sold into the MPF Program by existing PFIs and, to a lesser extent, the number of members using the MPF Program as an outlet for their mortgage originations has increased during 2011. The increase in participating members has led to mortgage purchases exceeding principal repayments by a significant margin in the current low mortgage rate environment.
 
On the liability side of the balance sheet, long-term bonds declined in absolute dollars in 2011 but increased as a percentage of total consolidated obligations. An important factor in the increased percentage includes growth in our unswapped callable bond portfolio used to fund the increase in fixed rate mortgage loans purchased through the MPF Program during 2011 discussed previously and, to a lesser extent, an increase in fixed rate advances from the end of 2010 to the end of 2011. Shorter-term discount notes decreased both in absolute dollars and as a percentage of total consolidated obligations during 2011. This decrease was primarily a function of the decline in total assets, specifically declines in both adjustable rate advances and short-term investments.
 
 
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The decrease in our weighted average dividend rate paid during 2011 compared to 2010 can be attributed to a 35 basis point decrease in the Class A Common Stock dividend initiated in December 2010 followed by an additional decrease of 15 bps in September 2011. This decrease in Class A Common Stock dividend was partially offset by a 50 basis point increase in the dividend rate on Class B Common Stock initiated in September 2011. Refer to this Item 7 – “Capital Distributions” for further information regarding dividend payments.
 
 
Financial Market Trends
The primary external factors that affect net interest income are market interest rates and the general state of the economy. Table 9 presents selected market interest rates as of the dates or periods shown.
 
Table 9
 
Market Instrument
 
Average Rate
for 2011
   
Average Rate
for 2010
   
December 31, 2011
Ending Rate
   
December 31, 2010
Ending Rate
 
Overnight Federal funds effective/target rate1
    0.10 %     0.18 %  
0.0 to 0.25
 %  
0.0 to 0.25
 %
FOMC target rate for overnight Federal funds1
 
0.0 to 0.25
   
0.0 to 0.25
   
0.0 to 0.25
   
0.0 to 0.25
 
Three-month Treasury bill1
    0.05       0.13       0.01       0.12  
Three-month LIBOR1
    0.34       0.34       0.58       0.30  
Two-year U.S. Treasury note1
    0.44       0.70       0.25       0.60  
Five-year U.S. Treasury note1
    1.51       1.92       0.85       2.01  
Ten-year U.S. Treasury note1
    2.76       3.20       1.88       3.31  
30-year residential mortgage note rate2
    4.53       4.74       4.07       4.85  
                   
1
Source is Bloomberg (Overnight Federal funds rate is the effective rate for the yearly averages and the target rate for the ending rates).
2
Mortgage Bankers Association weekly 30-year fixed rate mortgage contract rate obtained from Bloomberg.
 
 
At its March 13, 2012 meeting, the FOMC maintained the Federal funds target rate at a range of zero to 0.25 percent. However, the tone of the FOMC’s March 13, 2012 statement slightly improved from its January 25, 2012 meeting, where the FOMC unexpectedly stated that it expected that economic conditions “... are likely to warrant exceptionally low levels for the Federal funds rate at least through late 2014.” The FOMC retained this language in its March 13, 2012 statement. The FOMC had previously changed its forecast in the August 9, 2011 statement from “an extended period” to “at least through mid-2013.” The March 13, 2012 statement positively noted that it expected “. . . moderate economic growth over coming quarters” and recognized improvement in labor market conditions. While recognizing a “notable” decline in the unemployment rate, the committee stated the rate remains “elevated.” The FOMC also recognized the recent reduction in global financial market stress but cautioned that this market continues to “. . . pose significant downside risks to the economic outlook” and noted continued weakness in the housing sector. The FOMC continued to appear to signal the potential for additional quantitative easing by saying that it is prepared to adjust its securities holdings as needed to encourage a “stronger” economic recovery. The previous quantitative easing operation which was announced at its November 2010 meeting ended on June 30, 2011 and included the purchase of $600 billion of longer-term U.S. Treasuries. The FOMC will continue “Operation Twist,” announced in its September 21, 2011 statement (see additional discussion below), and its previous policies of reinvesting principal payments from its Agency debenture debt and Agency MBS holdings back into Agency MBS and of rolling maturing U.S. Treasury securities at auction. In January 2012 economic projections, released concurrently with the January 25, 2012 FOMC statement, Federal Reserve Board Members and Federal Reserve Bank Presidents reduced their projections of economic growth through 2013 and reduced their projections for the unemployment rate from their November 2011 projections. In January 2012, for the first time, the FOMC also released charts that detailed FOMC participants’ projections of the appropriate time to begin increasing the target rate and the appropriate level for the target rate. While this initial overview showed that the majority of the participants did not project raising the target rate until 2014 or later, there was a notable portion of participants that believed that appropriate time for increasing the target rate was 2012 or 2013. The majority of the participants believed that over the longer run four percent was the appropriate level for the target Federal funds rate.

Average three-month LIBOR was unchanged from 2010 to 2011, but increased 28 bps from the end of 2010 to the end of 2011. While the rate remained relatively steady from approximately December 2010 through March 2011, it began decreasing during the second quarter of 2011 until reaching its low point in late June and early July 2011. Important factors driving this decline include: (1) high levels of investable cash balances; (2) a reduction in the supply of collateral available for repurchase agreements that drove the rates on repurchase agreements down; and (3) the market’s response to changes in how the FDIC assesses premiums on insured depository institutions (discussed below). However, the rate began steadily increasing, albeit in relatively small increments, in the third quarter of 2011 through the end of 2011 likely reflecting the financial turmoil in Europe. The rate peaked in early January 2012 when it began declining slightly. The three-month LIBOR rate on December 31, 2011 was the highest setting of 2011. Changes in LIBOR rates have an impact on interest income and expense because a considerable portion of our assets and liabilities are either directly or indirectly tied to LIBOR. Imbalances in the mix of these assets and liabilities results in exposure to basis risk which can negatively or positively impact net interest income. Other short-term rates such as those for U.S. Treasury bills and our consolidated obligation discount notes have remained extremely low throughout most of 2011 as the FOMC has maintained its monetary easing policy and as investors have sought the relative safety of U.S. Treasury and Agency securities.
 
 
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Except for a temporary spike for a period of time during the debt ceiling crisis, short-term U.S. Treasury rates declined from their already low levels in 2011. The long-term portion of the U.S. Treasury rate curve (two-year and beyond) increased significantly in the fourth quarter of 2010 and remained at a relatively high level throughout the first quarter of 2011 but began decreasing in April 2011 throughout the remainder of the year with sharp declines in August 2011 following the debt ceiling crisis and subsequent S&P downgrade of the U.S. government’s sovereign rating. Much of this decline in interest rates, especially for terms of five years or greater, took place in the third quarter of 2011. The decrease in longer-term U.S. Treasury rates appears to have been in response to economic data that showed slowdown in economic growth, a continued stagnant housing market, persistently high unemployment and flight-to-quality demand resulting from the European sovereign debt crisis and other international economic and geopolitical events. The shape of the yield curve has flattened significantly from December 31, 2010 to December 31, 2011. During this period of time, the spread between the two-year U.S. Treasury note and the 10-year U.S. Treasury note and the two-year U.S. Treasury note and the 30-year U.S. Treasury bond declined by 108 bps and 115 bps, respectively, likely reflecting the market’s deteriorating outlook for economic growth. A portion of the flattening which occurred in the third quarter of 2011 might be attributable to market anticipation of potential Federal Reserve Bank purchase operations that would target long-term U.S. Treasury bonds and be funded through the sale of short-term U.S. Treasury bonds. When the economy improves and the Federal Reserve ends its purchases of U.S. Treasury bonds, the inflationary impact of large budget deficits and the current and anticipated volumes of U.S. Treasury issuance will likely result in increasing interest rates. Because we issue debt at a spread above U.S. Treasury securities, higher interest rates increase the cost of issuing FHLBank consolidated obligations and increase the cost of long-term advances to our members.
 
Indicative spreads of fixed rate, non-callable FHLBank debt relative to similar term U.S. Treasury instruments have increased from December 31, 2010 to December 31, 2011 for most tenors of two years or greater. For example, the spread between the on-the-run FHLBank two-year bullet debenture and the two-year U.S. Treasury note increased from 11 bps on December 31, 2010 to 15 bps on December 31, 2011. The spread between the on-the-run FHLBank five-year bullet debenture and the five-year U.S. Treasury note increased from 24 bps on December 31, 2010 to 28 bps as of December 31, 2011. Indicative FHLBank three-month lockout callable bond spreads to U.S. Treasuries for two to seven year tenors decreased from December 31, 2010 to December 31, 2011 while the indicative three-month lockout callable bond spreads to U.S. Treasury for a one- year tenor and longer-term tenors (10 years and greater) increased over the same period. We fund a large portion of our fixed rate mortgage assets and amortizing advances with unswapped callable bonds. For further discussion see this Item 7 – “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Financial Condition – Consolidated Obligations.” The spreads on FHLBank fixed rate, non-callable debentures relative to the LIBOR swap curve has improved notably for most tenors out to 10 years from December 31, 2010 to December 31, 2011. Theoretical spreads relative to LIBOR for tenors greater than 10 years deteriorated during the same period of time. Most of the improvement occurred during the fourth quarter of 2011 as market spreads between the LIBOR swap curve and our debt widened in response to the increasing concern over the European debt crisis. Spreads have narrowed in early 2012, reflecting some improvement in market perception of the European situation. Theoretical spreads relative to LIBOR for tenors greater than 10 years deteriorated during the same period of time. The theoretical swap level of the on-the-run FHLBank two-year bullet improved significantly from three-month LIBOR minus 5.7 bps on December 31, 2010 to three-month LIBOR minus 32.0 bps on December 31, 2011. The theoretical swap level of the on-the-run FHLBank five-year bullet also improved significantly from three-month LIBOR plus 10.1 bps on December 31, 2010 to three-month LIBOR minus 9.1 bps on December 31, 2011.
 
Despite several adverse ratings actions in 2011 as noted in Item 1 – “Business – General,” investors continued to view short-term FHLBank consolidated obligations as carrying a relatively strong credit profile during 2011, even after the ratings downgrade, at least partially due to the implicit support from the U.S. government. This has resulted in strong investor demand for FHLBank discount notes and short-term bonds in 2011. Because of this strong demand and other factors (some of which are listed below), the overall cost to issue short-term consolidated obligations remained extremely low throughout most of 2011. Yields on discount notes decreased from December 31, 2010 to December 31, 2011 due to: (1) a decrease in supply of competing instruments, such as U.S. Treasury bills and U.S. Agency discount notes; (2) flight to quality from international economic and geopolitical events, particularly the European sovereign debt crisis; (3) renewed concerns about the U.S. economy; and (4) strong support of GSE obligations in the U.S. Treasury Department’s white paper on GSE reform.
 
As mentioned previously, the FOMC plans to continue Operation Twist as initially introduced in its September 21, 2011 statement. Under Operation Twist, the Federal Reserve will purchase $400 billion par amount of U.S. Treasuries with remaining terms of six to 30 years and sell $400 billion par amount of U.S. Treasuries with remaining maturities of three years or less by the end of June 2012. Operation Twist might have been a factor in the flattening yield curve, and could result in further flattening, which might result in relatively lower costs to issue our longer-term consolidated obligations; however, shorter-term costs, including discount notes, could increase due to the sale of shorter-term U.S. Treasuries. The flatter curve could also result in increasing prepayments on our MBS/CMO and mortgage loan holdings, which would likely result in lower-yielding assets.
 
Foreign investor holdings of Agencies (both debentures and MBS), as reported by the Federal Reserve System, decreased on a daily average basis for the week ended December 28, 2011 from the week ended December 29, 2010 although the decline was less than the overall decline experienced from December 30, 2009 to December 29, 2010. Foreign investor holdings of U.S. Treasury securities increased significantly over the same periods, although the increase was less in 2011 than in 2010. Foreign investors have historically been significant buyers of FHLBank debentures and decreasing demand from this investor segment can negatively impact our cost of funds. Taxable money market fund assets in the category that includes discount notes and the percentage of total money market fund assets allocated to this category continued to decline from 2010 throughout much of the first half of 2011 likely a result of new SEC rules governing money market funds and relatively low absolute money market fund returns driving investors to seek higher yielding alternatives. However, the declines reversed in the second half of 2011 and increased modestly throughout most of the second half of 2011, likely reflecting a flight-to-quality response to European credit concerns. However, the amount of variable rate notes, which includes our variable rate consolidated obligation bonds, declined throughout much of the second half of 2011 after increasing through much of the first half of the year. Because money market funds are such a large and important investor base for FHLBank short-term obligations, lower demand from money market funds for FHLBank discount notes, variable rate consolidated obligation bonds and short-term consolidated obligation bonds will likely result in higher costs to issue these instruments and typically increase the cost of advances for our members.
 
 
31

 
Effective April 1, 2011, the FDIC changed the method used for determining the base on which insurance premiums are assessed from an institution’s deposit base to an institution’s total assets less tangible capital. While the long-term implications of this assessment change on the investment and funding behavior of insured depositories are unknown, this change resulted in the depositories’ reassessment of marginal arbitrage opportunities that are now subject to premium assessment. One arbitrage strategy that insured depositories have focused on recently is acquiring overnight Federal funds and leaving the cash at the Federal Reserve Bank where they receive interest income on their excess reserves. In order to preserve the arbitrage spread that they have been receiving on this transaction, insured depositories must reduce the rate at which they are willing to purchase Federal funds. This is likely an important factor driving the decline in the overnight Federal funds rate and in short-term investment securities that occurred surrounding the change in the assessment base. Initially, this change had a significant downward impact on money market yields including those for Federal funds, short-term investment securities, repurchase agreements, LIBOR and, to some extent, consolidated obligation discount notes. Other than the increases in LIBOR rates discussed above, yields on these instruments remained relatively low throughout most of the remainder of 2011. Unless the cost to issue our consolidated obligation discount notes also remains low, declining returns on our overnight Federal funds investments could result in a decline in net interest income and/or a reduction in balances of liquid assets.
 
On July 21, 2010, the Dodd-Frank Act was signed into law. The Dodd-Frank Act provides for new statutory and regulatory requirements for derivative transactions, including those utilized by the FHLBank to hedge 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. The new statutory and regulatory requirements for derivative transactions will result in higher operating costs, likely increase funding costs, and may limit the availability of or alter the structure of certain advance products. Derivative market participants were originally expected to comply with the Dodd-Frank Act by July 16, 2011. However, the Commodity Futures Trading Commission (CFTC) acknowledged that it will fail to meet deadlines for rulemaking and as a result, certain provisions of the Dodd-Frank Act that require a CFTC rulemaking may not become effective until sometime in 2012 or beyond. In 2011, the CFTC, SEC and our regulator, the Finance Agency, in addition to other regulators, have promulgated numerous preliminary and final rules detailing the implementation of the Dodd-Frank Act. We continue working to implement these rules to meet any required compliance dates.
 
Several rating agencies took action during the third quarter of 2011 in response to steps taken by the U.S. government to address the U.S. government’s borrowing limit and overall U.S. debt burden. Because of the credit rating agencies’ methodology and their assumption of the U.S. government’s implicit support of FHLBank debt, changes to the credit rating of U.S. Treasuries were passed through to the credit ratings of FHLBank debentures and to the ratings of individual FHLBanks as outlined under Item 1 – “Business - General.” Credit ratings downgrades can adversely impact us in the following ways: (1) increase the funding cost of FHLBank debt issues; (2) have negative liquidity implications; (3) increase collateral posting requirements under certain of our derivatives agreements (see Note 9 of the Notes to the Financial Statements under Item 8 for additional information regarding derivative collateral requirements); and (4) impact our ability to offer certain member credit products such as letters of credit, which are generally dependent upon our credit rating. Following the downgrade by S&P, the FHLBank observed some minor and temporary impacts in several of these areas; however, we did not consider any of them to be significant or material. It is possible that the United States’ long-term sovereign credit rating will be further downgraded or downgraded by additional credit rating agencies in 2012. Additional downgrades could increase the likelihood and/or the severity of the impacts detailed above.
 
On July 21, 2011, Regulation Q, which prohibits Federal Reserve Bank members from paying interest on demand deposits, was repealed. It is possible that the repeal might allow commercial banks to compete directly with money market funds and could result in reductions in money market fund assets and increases in bank deposits. The repeal might adversely impact demand for (and cost of) our discount notes because money market funds are important investors in our discount notes. Additionally, increases in deposits at commercial banks might result in declining demand for advances. Other possible impacts of the repeal include higher LIBOR rates and less supply on short-term, money market investments (commercial paper and certificates of deposit). Each of these potential impacts of the repeal of Regulation Q would affect our profitability and liquidity.
 
On October 24, 2011, the Finance Agency announced significant changes to the Home Affordable Refinance Program (HARP) that are designed to inspire refinancing among borrowers with current LTV ratios above 80 percent who have had their loans sold to Fannie Mae or Freddie Mac on or before May 31, 2009. For these borrowers, the changes include: (1) eliminating some risk-based fees for borrowers who refinance into shorter-term mortgages and lower fees for other borrowers; (2) removing the current 125 percent LTV ceiling; (3) waiving some lender representations and warranties for loans owned or guaranteed by Freddie Mac and Fannie Mae; (4) eliminating the need for property appraisals in some instances; and (5) extending the end date for HARP to December 31, 2013 for eligible loans. We anticipate that these changes to HARP could result in increased prepayments on our Agency variable rate MBS/CMO portfolio which is backed by higher coupon fixed rate mortgages issued by Fannie Mae and Freddie Mac.

Critical Accounting Policies and Estimates
The preparation of our financial statements in accordance with GAAP requires management to make a number of judgments and assumptions that affect our reported results and disclosures. Several of our accounting policies are inherently subject to valuation assumptions and other subjective assessments and are more critical than others in terms of their importance to results. These assumptions and assessments include the following:
§  
Accounting related to derivatives;
§  
Fair value determinations;
§  
Accounting for OTTI of investments;
§  
Accounting for deferred premium/discount associated with MBS; and
§  
Determining the adequacy of the allowance for credit losses.
 
 
Changes in any of the estimates and assumptions underlying critical accounting policies could have a material effect on our financial statements.
 
The accounting policies that management believes are the most critical to an understanding of our financial results and condition and require complex management judgment are described below.
 
 
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Accounting for Derivatives: Derivative instruments are carried at fair value on the Statements of Condition. Any change in the fair value of a derivative is recorded each period in current period earnings or other comprehensive income (OCI), depending upon whether the derivative is designated as part of a hedging relationship and, if it is, the type of hedging relationship. A majority of our derivatives are structured to offset some or all of the risk exposure inherent in our lending, mortgage purchase, investment and funding activities. We are required to recognize unrealized gains or losses on derivative positions, regardless of whether offsetting gains or losses on the underlying assets or liabilities being hedged may be recognized in a symmetrical manner. Therefore, the accounting framework introduces the potential for considerable income variability from period to period. Specifically, a mismatch can exist between the timing of income and expense recognition from assets or liabilities and the income effects of derivative instruments positioned to mitigate market risk and cash flow variability. Therefore, during periods of significant changes in interest rates and other market factors, reported earnings may exhibit considerable variability. We emphasize hedging techniques that are effective under the hedge accounting requirements. However, in some cases, we have elected to retain or enter into derivatives that are economically effective at reducing our risk but do not meet the hedge accounting requirements, either because the cost of the derivative hedge was economically superior to non-derivative hedging alternatives or because no non-derivative hedging alternative was available. As required by Finance Agency regulation and our RMP, derivative instruments that do not qualify as hedging instruments may be used only if we document a non-speculative purpose at the inception of the derivative transaction.
 
A hedging relationship is created from the designation of a derivative financial instrument as either hedging our exposure to changes in the fair value of a financial instrument or changes in future cash flows attributable to a balance sheet financial instrument or anticipated transaction. 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. Highly effective hedges that use interest rate swaps as the hedging instrument and that meet certain stringent criteria can qualify for “shortcut” fair value hedge accounting. Shortcut accounting allows for the assumption of no ineffectiveness, which means that the change in fair value of the hedged item can be assumed to be equal to the change in fair value of the derivative. If the hedge is not designated for shortcut accounting, it is treated as a “long haul” fair value hedge, where the change in fair value of the hedged item must be measured separately from the derivative, and for which effectiveness testing must be performed regularly with results falling within established tolerances. If the hedge fails effectiveness testing, the hedge no longer qualifies for hedge accounting and the derivative is marked to estimated fair value through current period earnings without any offsetting change in estimated fair value related to the hedged item. We discontinued using shortcut hedge accounting for all derivative transactions entered into on or after July 1, 2008.
 
For derivative transactions that potentially qualify for long haul fair value hedge accounting treatment, management must assess how effective the derivatives have been, and are expected to be, in hedging offsetting changes in the estimated fair values attributable to the risks being hedged in the hedged items. Hedge effectiveness testing is performed at the inception of the hedging relationship and on an ongoing basis for long haul fair value hedges. We perform testing at hedge inception based on regression analysis of the hypothetical performance of the hedging relationship using historical market data. We then perform regression testing on an ongoing basis using accumulated actual values in conjunction with hypothetical values. Specifically, each month we use a consistently applied statistical methodology that employs a sample of 30 historical interest rate environments and includes an R-squared test (commonly used statistic to measure correlation of the data), a slope test and an F-statistic test (commonly used statistic to measure how well the regression model describes the collection of data). These tests measure the degree of correlation of movements in estimated fair values between the derivative and the related hedged item. For the hedging relationship to be considered effective, results must fall within established tolerances.
 
Given that a derivative qualifies for long haul fair value hedge accounting treatment, the most important element of effectiveness testing is the price sensitivity of the derivative and the hedged item in response to changes in interest rates and volatility as expressed by their effective durations. The effective duration will be influenced mostly by the final maturity and any option characteristics. In general, the shorter the effective duration, the more likely it is that effectiveness testing would fail because of the impact of the short-term LIBOR side of the interest rate swap. In this circumstance, the slope criterion is the more likely factor to cause the effectiveness test to fail.
 
The estimated fair values of the derivatives and hedged items do not have any cumulative economic effect if the derivative and the hedged item are held to maturity, or contain mutual optional termination provisions at par. Since these fair values fluctuate throughout the hedge period and eventually return to zero (derivative) or par value (hedged item) on the maturity or option exercise date, the earnings impact of fair value changes is only a timing issue for hedging relationships that remain outstanding to maturity or the call termination date.
 
For derivative instruments and hedged items that meet the requirements as described above, we do not anticipate any significant impact on our financial condition or operating performance. For derivative instruments where no identified hedged item qualifies for hedge accounting, changes in the market value of the derivative are reflected in income. As of December 31, 2011 and 2010, we held a portfolio of derivatives that are marked to market with no offsetting qualifying hedged item. This portfolio includes interest rate caps and floors hedging MBS, interest rate swaps hedging trading securities, interest rate swaps hedging duration of equity (DOE) risk and interest rate swaps used to lower our cost of funds. The total fair value of these positions, including accrued net interest, was $(136.0) million and $(60.7) million as of December 31, 2011 and 2010, respectively. While the fair value of these derivative instruments, with no offsetting qualifying hedged item, will fluctuate with changes in interest rates and the impact on our earnings can be material, the change in market value of trading securities being hedged by economic hedges is expected to partially offset that impact. The change in fair value of the derivatives classified as economic hedges is only partially offset by the change in the market value of trading securities being hedged by economic hedges because the amount of economic hedges exceeds the amount of swapped trading securities. As of December 31, 2011, our economic hedges consisted primarily of: (1) notional amount of interest rate caps and floors of $6.9 billion hedging changes in interest rates and overall duration of variable rate MBS; (2) notional amount of interest rate swaps of $2.1 billion hedging the cost and overall duration of consolidated obligation bonds; (3) notional amount of interest rate swaps of $1.1 billion hedging GSE debentures in trading securities; and (4) notional amount of interest rate swaps and caps of $0.2 billion for intermediary transactions. The total par value of trading securities related to economic hedges was $1.1 billion as of December 31, 2011, which matches the notional amount of interest rate swaps hedging the GSE debentures in trading securities on that date. As of December 31, 2010, our economic hedges consisted primarily of: (1) notional amount of interest rate caps and floors of $7.5 billion hedging changes in interest rates and overall duration of variable rate MBS; (2) notional amount of interest rate swaps of $2.1 billion hedging the cost and overall duration of consolidated obligation bonds; (3) notional amount of interest rate swaps of $1.4 billion hedging GSE debentures in trading securities; and (4) notional amount of interest rate swaps and caps of $0.3 billion for intermediary transactions. The total par value of trading securities related to economic hedges was $1.4 billion as of December 31, 2010, which matches the notional amount of interest rate swaps hedging the GSE debentures in trading securities on that date. For asset/liability management purposes, the majority of our GSE debentures currently classified as trading are matched to interest rate swaps that effectively convert the securities from fixed rate investments to variable rate instruments. See Tables 15 through 17 under this Item 7, which show the relationship of gains/losses on economic derivative hedges and gains/losses on the trading GSE debentures being hedged by economic derivatives. Our projections of changes in fair value of the derivatives have been consistent with actual results. For the balance sheet risks that these derivatives hedge, changes in value historically have been directionally consistent with changes in actual interest rates.
 
 
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Fair Value: As of December 31, 2011 and 2010, certain assets and liabilities, including investments classified as trading, and all derivatives were presented in the Statements of Condition at fair value. Under GAAP, fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Fair values play an important role in the valuation of certain assets, liabilities and derivative transactions. The fair values we generate directly impact the Statements of Condition, Statements of Income, Statements of Capital and Statements of Cash Flows as well as risk-based capital, DOE and market value of equity (MVE) disclosures. Management also estimates the fair value of collateral that borrowers pledge against advance borrowings and other credit obligations to confirm that we have sufficient collateral to meet regulatory requirements and to protect ourselves from a credit loss.
 
Fair values are based on market prices when they are available. If market quotes are not available, fair values are based on discounted cash flows using market estimates of interest rates and volatility, or on prices of similar instruments. Pricing models and their underlying assumptions are based on our best estimates for discount rates, prepayment speeds, market volatility and other factors. We validate our financial models at least annually and the models are calibrated to values from outside sources on a monthly basis. We validate modeled values to outside valuation services routinely to determine if the values generated from discounted cash flows are reasonable. Additionally, due diligence procedures are completed for third-party pricing vendors. The assumptions used by third-party pricing vendors or within our models may have a significant effect on the reported fair values of assets and liabilities, including derivatives, and the related income and expense. See Note 16 of the Notes to the Financial Statements included under Item 8 – “Financial Statements and Supplementary Data” for a detailed discussion of the assumptions used to calculate fair values and the due diligence procedures completed. The use of different assumptions as well as changes in market conditions could result in materially different net income and retained earnings.
 
As of December 31, 2011, we had no fair values that were classified as level 3 valuations for financial instruments that are measured on a recurring basis at fair value. However, we have held-to-maturity securities with OTTI charges and real estate owned (REO), which were written down to their fair values and considered level 3 valuations as of year-end. Based on the validation of our inputs and assumptions with other market participant data, we have concluded that the pricing derived should be considered level 3 valuations.
 
Accounting for OTTI of Investments: The continued deterioration of credit performance related to residential mortgage loans and the accompanying decline in residential real estate values in a significant number of localities in the U.S. have increased the level of credit risk to which we are exposed in our investments in mortgage-related securities, primarily private-label MBS. Investments in mortgage-related securities are directly or indirectly supported by underlying mortgage loans. Due to the decline in values of residential U.S. real estate and difficult conditions in the credit markets, we closely monitor the performance of our investment securities classified as held-to-maturity on at least a quarterly basis to evaluate our exposure to the risk of loss on these investments in order to determine whether a loss is other-than-temporary.
 
When the fair value of a debt security is less than its amortized cost as of the balance sheet date, an entity is required to assess whether: (1) it has the intent to sell the debt security; (2) it is more likely than not that it will be required to sell the debt security before its anticipated recovery; (3) or it does not expect to recover the entire amortized cost basis of the security. If any of these conditions is met, an OTTI on the security must be recognized.
 
In instances in which a determination is made that a credit loss (defined as the difference between the present value of the cash flows expected to be collected and the amortized cost basis) exists, but we do not intend to sell the debt security, nor is it more likely than not that we will be required to sell the debt security before the anticipated recovery of its remaining amortized cost basis (i.e., the amortized cost basis less any current-period credit loss), both the credit and non-credit components of OTTI are presented in the Statements of Income. In these instances, the OTTI is separated into: (1) the amount of the OTTI related to the credit loss; and (2) the amount of the OTTI related to all other factors (non-credit component). If our analysis of expected cash flows results in a present value of expected cash flows that is less than the amortized cost basis of a security (that is, a credit loss exists), an OTTI is considered to have occurred. If there is no credit loss, any impairment is not other-than-temporary. If we determine that an OTTI exists, the investment security is accounted for as if it had been purchased on the measurement date of the OTTI at an amortized cost basis equal to the previous amortized cost basis less OTTI recognized in non-interest income. The difference between the new amortized cost basis and the cash flows expected to be collected is accreted into interest income prospectively over the remaining life of the investment security based on the amount and timing of estimated future cash flows (with no effect on other income (loss) unless the security is subsequently sold or there are additional decreases in cash flows expected to be collected). See additional discussion regarding the recognition and presentation of OTTI in Note 1 of the Notes to the Financial Statements included under Item 8 – “Financial Statements and Supplementary Data.”
 
Beginning in the first quarter of 2009, to ensure consistency in determination of the OTTI for investment securities among all FHLBanks, the FHLBanks began using the same key modeling assumptions for purposes of their cash flow analysis. During the second quarter of 2009, the FHLBanks formed an OTTI Governance Committee consisting of representatives from each FHLBank. The OTTI Governance Committee develops the modeling assumptions to be used by the FHLBanks to produce expected cash flows for use in analyzing credit losses and OTTI for residential private-label MBS.
 
Guidance provided by the Finance Agency, some of which was based upon written guidance and other of which was provided only through informal comments to the FHLBanks, indicated that an FHLBank may use an alternative risk model with alternative loan information data if certain conditions are met. The written guidance also indicated that an FHLBank that does not have access to the required risk model and loan information data sources or does not meet the conditions for using an alternative risk model as required under the Finance Agency guidance may engage another FHLBank to perform the cash flow analysis underlying its OTTI determination.
 
Private-label MBS are evaluated by estimating projected cash flows using models that incorporate projections and assumptions typically based on the structure of the security and certain economic environment assumptions such as delinquency and default rates, loss severity, home price appreciation/depreciation, interest rates and securities’ prepayment speeds while factoring in the underlying collateral and credit enhancement. A significant input to such analysis is the forecast of housing price changes for the relevant states and metropolitan statistical areas, which are based on an assessment of the relevant housing markets. See additional discussion regarding the projections and assumptions in Note 5 of the Notes to the Financial Statements included under Item 8 – “Financial Statements and Supplementary Data.” The loan level cash flows and losses are allocated to various security classes, including the security classes owned by the FHLBank, based on the cash flow and loss allocation rules of the individual security.
 
For certain private-label MBS where underlying collateral data is not available, alternative procedures as determined by each FHLBank are used to assess these securities for OTTI. These evaluations are inherently subjective and consider a number of qualitative factors. In addition to monitoring the credit ratings of these securities for downgrades, as well as placement on negative outlook or credit watch, we evaluate other factors that may be indicative of OTTI. These include, but are not limited to, an evaluation of the type of security, the length of time and extent to which the fair value of a security has been less than its cost, any credit enhancement or insurance, and certain other collateral-related characteristics such as credit scores provided by Fair Isaac Corporation (FICO®), LTV ratios, delinquency and foreclosure rates, geographic concentration and the security’s past performance.
 
 
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Each FHLBank is responsible for making its own determination of OTTI and performing the required present value calculations using appropriate historical cost bases and yields. FHLBanks that hold in common private-label MBS are required to consult with one another to ensure that any decision that a commonly-held private-label MBS is other-than-temporarily impaired, including the determination of fair value and the credit loss component of the unrealized loss, is consistent between or among those FHLBanks. The process of estimating the future cash flows of the private-label MBS requires a significant amount of judgment to formulate the assumptions that are utilized in this process. The assumptions we utilize for the majority of our private-label MBS are reviewed and approved by the FHLBanks’ OTTI Governance Committee.
 
Deferred Premium/Discount Associated with MBS: When we purchase MBS, we often pay an amount that is different than the unpaid principal balance. The difference between the purchase price and the contractual note amount is a premium if the purchase price is higher and a discount if the purchase price is lower. Accounting guidance permits us to amortize (or accrete) the premiums (or discounts) in a manner such that the yield recognized on the underlying asset is constant over the asset’s estimated life. We typically pay more than the unpaid principal balances when the interest rates on the MBS are greater than prevailing market rates for similar MBS on the transaction date. The net purchase premiums paid are then amortized using the level-yield method over the expected lives of the MBS as a reduction in yield (decreases interest income). Similarly, if we pay less than the unpaid principal balance because interest rates on the MBS are lower than prevailing market rates on similar MBS on the transaction date, the net discounts are accreted in the same manner as the premiums, resulting in an increase in yield (increases interest income). The level-yield amortization method is applied using expected cash flows that incorporate prepayment projections that are based on mathematical models which describe the likely rate of consumer mortgage loan refinancing activity in response to incentives created (or removed) by changes in interest rates. Changes in interest rates have the greatest effect on the extent to which mortgage loans may prepay, although, during the current disruption in the financial market, tight credit and declining home prices, consumer mortgage refinancing behavior is also significantly affected by the borrower’s credit score and the value of the home in relation to the outstanding loan value. Generally, however, when interest rates decline, mortgage loan prepayment speeds are likely to increase, which accelerates the amortization of premiums and the accretion of discounts. The opposite occurs when interest rates rise. We use a third-party data service that provides estimates of cash flows, from which we determine expected asset lives for the MBS. The level-yield method uses actual prepayments received and projected future mortgage prepayment speeds, as well as scheduled principal payments, to determine the amount of premium/discount that must be recognized and will result in a constant monthly yield until maturity. Amortization of MBS premiums could accelerate in falling interest-rate environments or decelerate in rising interest-rate environments. Exact trends will depend on the relationship between market interest rates and coupon rates on outstanding MBS, the historical evolution of mortgage interest rates, the age of the underlying mortgage loans, demographic and population trends, and other market factors such as increased foreclosure activity, falling home prices, tightening credit standards by mortgage lenders and the other housing GSEs, and other repercussions from the current financial market conditions.
 
Allowance for Credit Losses: We have established an allowance methodology for each of our portfolio segments to estimate the allowance for credit losses, if necessary, to provide for probable losses inherent in our portfolio segments.
 
Mortgage Loans – We estimate the allowance for loan loss on homogeneous pools of mortgage loans or on an individual mortgage loan basis to assess the credit losses that are inherent in the portfolio but have not been realized.
§  
Collectively Evaluated Mortgage Loans – The assessment of loan loss for the pools of loans entails breaking the loan pool into strata based on each of the current classifications of each loan (i.e., current, delinquent, non-performing, referred to foreclosure). We perform a migration analysis to determine the probability of default for each stratum of loans based on a short- and mid-term horizon utilizing historical statistics. In addition, we determine the pool’s historical loss statistics based on a short- and mid-term horizon to determine the loss severity. Loan balances, probability of default and loss severity are then utilized to determine the expected loan loss for the pool.
§  
Individually Evaluated Mortgage Loans – We calculate an allowance for loan loss on individual loans if events or circumstances make it probable that we will not be able to collect all amounts due according to the contractual terms for a subset of the mortgage loans. We have determined that all mortgage loans in the MPF Program are considered collateral dependent and have elected to measure individual loan impairment based on collateral value less estimated cost to sell. Collateral value is based on appraisals, if available, or estimated property values using housing pricing indices. If the collateral value less cost to sell is less than the recorded investment in the loan, the loan is considered impaired. The excess of the recorded investment in the loan over the loan’s collateral value less cost to sell is recorded as the loan’s estimate of allowance for loan loss. If a loan has an individual impairment recorded, it is excluded from the collectively evaluated assessment process.
 
Once the collectively evaluated and individually evaluated assessments are completed, the total estimates of loan losses are accumulated to the master commitment level to determine if, and by how much, the estimated loan losses exceed the FLA. The estimated loan losses in excess of the FLA by master commitment may be covered up to the PFI’s CE obligation amount (provided directly by the PFI or through the PFI’s purchase of supplemental mortgage insurance). We are responsible for any estimated loan losses in excess of the PFI’s CE obligation for each master commitment. For additional information on the loss allocation rules for each MPF product, see Item 1 – “Business – Mortgage Loans.” The estimated losses that will be allocated to us (i.e., excluding estimated losses covered by CE obligations) are recorded as the balance in the allowance for loan loss with the resulting offset being presented as the provision for credit losses on mortgage loans.
 
Credit products – We have never experienced a credit loss on an advance and we currently do not anticipate any credit losses on advances. Based on the collateral held as security for advances, credit analysis and prior repayment history, no allowance for losses on advances is deemed necessary. We are required by statute to obtain and maintain security interests in sufficient collateral on advances to protect against losses, and to accept as collateral on such advances only certain qualified types of collateral, which are primarily U.S. government or government Agency/GSE securities, certain residential mortgage loans, deposits in the FHLBank and other real estate related assets. See Item 1 – “Business – Advances” for a more detailed collateral discussion.
 
Direct financing lease receivable – We have a recorded investment in a direct financing lease receivable with a member for a building complex and property. Under the office complex agreement, we have all rights and remedies under the lease agreement as well as all rights and remedies available under the members’ Advance, Pledge and Security Agreement. Consequently, we can apply any excess collateral securing credit products to any shortfall in the leasing arrangement.
 
The process of determining the allowance for credit losses requires a high degree of judgment. It is possible that others, given the same information, may at any point in time reach different reasonable conclusions. Because of variability in the data underlying the assumptions made in the process of determining the allowance for credit losses, estimates of the portfolio’s inherent risks will change as warranted by changes in the economy. The degree to which any particular change would affect the allowance for credit losses would depend on the severity of the change.
 
 
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For additional information regarding allowances for credit losses, see Note 8 of the Notes to Financial Statements included under Item 8 – “Financial Statements and Supplementary Data.”

Results of Operations (Years Ended December 31, 2011, 2010 and 2009)
The primary source of our earnings is net interest income, which is interest earned on advances, mortgage loans, and investments less interest paid on consolidated obligations, deposits, and other borrowings. The decrease in net interest income from 2010 to 2011 can primarily be attributed to a decrease in average interest-earning assets that is somewhat offset by an improvement in both our net interest spread and net interest margin. Our margin improvement was achieved by actively managing our debt costs and by adjusting the mix of our assets. The growth in the size of the mortgage loan portfolio, both nominally and relative to other assets, offset the declining rates in all of our other asset categories. We have also reduced our allocation to lower yielding money market instruments within the investment portfolio. These actions resulted in the 2011 yield on earning assets being nearly unchanged from 2010. On the liability side, declining interest rates have allowed us to actively manage the debt used to fund long-term assets by calling higher cost callable debt and replacing with lower cost callable and/or bullet debt. As a result, our 2011 liability yield decreased six bps from 2010. The decrease in net interest income from 2009 to 2010 can also be attributed to a decrease in average interest-earning assets that was partially offset by similar compositional changes in our asset mix and by actively managing our callable debt portfolio. See Tables 13 and 14 for further information.
 
Although net interest income had relatively minor fluctuations due to a shrinking balance sheet, falling interest rates, and asset mix changes; net income experienced significant fluctuations during 2011, 2010 and 2009. This was due to large changes in the market value of various derivatives and trading securities. See “Net Gain (Loss) on Derivative and Hedging Activities” and “Net Gain (Loss) on Trading Securities” in this Item 7 for a discussion of the impact of these activities by year.
 
We fulfill our mission by: (1) providing liquidity to our members through the offering of advances to finance housing, economic development and community lending; (2) supporting residential mortgage lending through the MPF Program; and (3) providing regional affordable housing programs that create housing opportunities for low- and moderate-income families. In order to effectively accomplish our mission, we must obtain adequate funding amounts at acceptable rate levels. We use derivatives as tools to reduce our funding costs and manage interest rate risk and prepayment risk. We acquire and classify certain investments as trading investments for liquidity and asset-liability management purposes. Although we manage the risks mentioned and utilize these transactions for asset-liability tools, we do not manage the fluctuations in fair value of our derivatives or trading securities. We are essentially a “hold-to-maturity” investor and transact derivatives only for hedging purposes.
 
Adjusted income is a non-GAAP measure used by management to evaluate the quality of our ongoing earnings. We believe that the presentation of income as measured for management purposes enhances the understanding of our performance by highlighting our underlying results and profitability. By removing volatility created by market value fluctuations and items such as prepayment fees, we can compare longer-term trends in earnings that might otherwise be indeterminable. Therefore as part of evaluating our financial performance, we adjust net income reported in accordance with GAAP for the impact of: (1) AHP and REFCORP assessments (assessments for AHP and REFCORP through June 30, 2011 were equivalent to an effective minimum income tax rate of 26.5 percent; and, upon satisfaction of the REFCORP obligation as of June 30, 2011, the assessment for AHP for the second half of 2011 was equivalent to an effective minimum income tax rate of 10 percent); (2) items related to derivatives and hedging activities; and (3) other items excluded because they are not considered a part of our routine operations or ongoing business model, such as prepayment fees, gain/loss on retirement of debt, gain/loss on sale of mortgage loans held for sale and gain/loss on securities. The result is referred to as “adjusted income,” which is a non-GAAP measure of income. Adjusted income is used to compute an adjusted return on equity (ROE) that is then compared to the average overnight Federal funds effective rate, with the difference referred to as adjusted ROE spread. Adjusted income and adjusted ROE spread are used: (1) to measure performance under our incentive compensation plans; (2) as a key measure in determining the level of quarterly dividends; and (3) in strategic planning. While we utilize adjusted income as a key measure in determining the level of dividends, we consider GAAP income volatility caused by gain (loss) on derivatives and trading securities in determining the adequacy of our retained earnings as determined under GAAP. Because the adequacy of GAAP retained earnings is considered in setting the level of our quarterly dividends, gain (loss) on derivatives and trading securities can play a factor when setting the level of our quarterly dividends. Because we are primarily a “hold-to-maturity” investor and do not trade derivatives, we believe that adjusted income, adjusted ROE and adjusted ROE spread are helpful in understanding our operating results and provide a meaningful period-to-period comparison in contrast to GAAP income and ROE based on GAAP income, which can vary significantly from period to period due to derivatives and hedging activities and certain other items that management excludes when evaluating operational performance since the added volatility does not provide a consistent measurement analysis. Derivative and hedge accounting affects the timing of income or expense from derivatives, but not the economic income or expense from these derivatives when held to maturity or call date. For example, interest rate caps are purchased with an upfront fixed cost to provide protection against the risk of rising interest rates. Under derivative accounting guidance, these instruments are then marked to market each month, which can result in having to recognize significant gains and losses from year to year, producing volatility in our GAAP income. However, the sum of such gains and losses over the term of a derivative will equal its original purchase price if held to maturity. Table 10 presents a reconciliation of GAAP income to adjusted income for the years ended December 31, 2011, 2010 and 2009 (in thousands):

Table 10
 
 
   
2011
   
2010
   
2009
 
Net income, as reported under GAAP
  $ 77,326     $ 33,548     $ 236,671  
Total assessments
    20,433       12,153       85,521  
Income (Loss) before assessments
    97,759       45,701       322,192  
Derivative-related and other excluded items1
    72,568       145,674       (111,408 )
Adjusted income (a non-GAAP measure)2
  $ 170,327     $ 191,375     $ 210,784  
                   
1
The excluded items are “Prepayment fees on terminated advances,” “Net gain (loss) on trading securities,” “Net gain (loss) on derivatives and hedging activities” and “Net gain (loss) on mortgage loans held for sale” directly from our Statements of Income.
2
Non-GAAP financial measures have inherent limitations, are not required to be uniformly applied and are not audited. To mitigate these limitations, we have procedures in place to calculate these measures using the appropriate GAAP components. Although these non-GAAP measures are frequently used by our stakeholders in the evaluation of our performance, they have limitations as analytical tools, and should not be considered in isolation, or as a substitute for analyses of results as reported under GAAP.
 
 
 
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Table 11 presents adjusted ROE compared to the average Federal funds rate, which we use as a key measure of effective use and management of members’ capital (amounts in thousands):
 
 
Table 11
 
 
   
2011
   
2010
   
2009
 
Average GAAP capital for the period
  $ 1,745,252     $ 1,873,427     $ 2,105,594  
ROE, based upon GAAP income before assessments
    5.60 %     2.44 %     15.30 %
Adjusted ROE, based upon adjusted income1
    9.76 %     10.22 %     10.01 %
Average overnight Federal funds effective rate
    0.10 %     0.18 %     0.16 %
Adjusted ROE income as a spread to average Federal funds rate1
    9.66 %     10.04 %     9.85 %
                   
1
Non-GAAP financial measures have inherent limitations, are not required to be uniformly applied and are not audited. To mitigate these limitations, we have procedures in place to calculate these measures using the appropriate GAAP components. Although these non-GAAP measures are frequently used by our stakeholders in the evaluation of our performance, they have limitations as analytical tools, and should not be considered in isolation, or as a substitute for analyses of results as reported under GAAP.
 
 
Earnings Analysis: Table 12 presents changes in the major components of our earnings for the past three years (in thousands):
 
 
Table 12
 
 
   
Increase (Decrease) In Earnings Components
   
   
Dollar Change
   
Percent Change
   
   
2011 vs. 2010
   
2010 vs. 2009
   
2011 vs. 2010
   
2010 vs. 2009
   
Total interest income
  $ (83,524 )   $ (204,165 )     (13.3 )%     (24.5 )%
Total interest expense
    (64,574 )     (195,030 )     (17.0 )     (33.9 )
Net interest income
    (18,950 )     (9,135 )     (7.6 )     (3.5 )
Provision for (reversal of) credit losses on mortgage loans
    (524 )     328       (33.1 )     26.2  
Net interest income after mortgage loan loss provision
    (18,426 )     (9,463 )     (7.4 )     (3.7 )
Net gain (loss) on trading securities
    6,347       26,762       44.0       216.9  
Net gain (loss) on derivatives and hedging activities
    65,931       (286,136 )     37.7       (256.7 )
Other non-interest income
    3,687       (3,150 )     64.2       (35.4 )
Total non-interest income (loss)
    75,965       (262,524 )     49.2       (243.0 )
Operating expenses
    2,252       2,586       5.6       6.9  
Other non-interest expense
    3,229       1,918       41.0       32.2  
Total other expense
    5,481       4,504       11.4       10.3  
AHP assessments
    4,845       (22,587 )     128.7       (85.7 )
REFCORP assessments
    3,435       (50,781 )     41.0       (85.8 )
Total assessments
    8,280       (73,368 )     68.1       (85.8 )
NET INCOME
  $ 43,778     $ (203,123 )     130.5 %     (85.8 )%
 
 
Net Interest Income: Net interest income decreased from 2010 to 2011, despite improvements in our net interest spread and net interest margin, due primarily to the decrease in average interest-earning assets. Some key factors in the improvements in our net interest spread and net interest margin were: (1) improvements in the funding cost of consolidated obligation discount notes, consolidated obligation bonds and deposits; (2) active management of the debt used to fund long-term assets by calling higher cost callable debt and replacing it with lower cost callable and/or bullet debt; and (3) an increase in the proportion of higher earning assets (primarily mortgage loans) to total average interest-earning assets as short-term money market investments and advance balances, on average, declined.
 
The decreases in average yields on advances from December 31, 2010 to December 31, 2011 (see Table 13) are primarily attributable to the decline in short-term rates combined with the relative short-term nature of our advance portfolio. As discussed under this Item 7 – “Financial Condition – Advances,” a significant portion of our advance portfolio either matures or effectively re-prices within three months by product design or through the use of derivatives. Because of the relatively short nature of the advance portfolio, including the impact of any interest rate swaps qualifying as fair value hedges, the average yield in this portfolio typically responds quickly to changes in the general level of short-term interest rates.
 
The average yield on investments decreased from December 31, 2010 to December 31, 2011 (see Table 13) due primarily to declining market interest rates and compositional changes in our investment portfolio as balances of higher yielding long-term investments, both fixed and variable rate, declined.
 
As discussed under this Item 7 – “Financial Condition – Investments,” we expanded our MBS portfolio in April 2008 under temporary authority granted by Finance Agency Resolution 2008-08. In the first quarter of 2010, we further expanded our MBS portfolio by $2.4 billion in Agency variable rate CMOs with embedded caps, but we have not purchased any additional MBS since that time. Over the last several years, our investment strategy focused more on the purchase of Agency variable rate CMOs with embedded interest rate caps because these securities generally had a higher overall risk-adjusted return relative to our cost of funds than comparable fixed rate CMOs. Included in this strategy was the purchase of interest rate caps that effectively offset a portion of the negative effect of the caps embedded in the CMOs. See additional discussion on the impact of interest rate caps under this Item 7 – “Net Gain (Loss) on Derivatives and Hedging Activities.”
 
 
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The average yields on the MPF portfolio declined during 2011 compared to 2010 (see Table 13) due to several factors including: (1) borrowers refinancing their mortgages in order to take advantage of lower average residential mortgage rates experienced throughout much of the last nine months of 2011; (2) the growth in MPF balances with new mortgage loans placed into our portfolio at average rates below existing mortgage loans in the portfolio; and (3) increased write-offs of premiums associated with mortgage loan prepayments.
 
The average rate paid on all deposits decreased from 2010 to 2011 (see Table 13). The average rate paid on deposits generally fluctuates in tandem with the movement in short-term interest rates. The level of short-term interest rates is primarily driven by the FOMC decisions on the target rate for overnight Federal funds, but is also influenced by the expectations of capital market participants. However, because of the current extremely low interest rate environment, we established a floor of 5 bps on demand deposits and 15 bps on overnight deposits in June 2009. The floor on overnight deposits was decreased even further from 15 bps to 10 bps in October 2011.
 
The average yield on consolidated obligation discount notes declined from 2010 to 2011 (see Table 13). Some key factors in the decline were the decrease in short-term market rates, including repo rates, caused by a reduced supply of alternative short-term investments, and increased flight-to-quality demand for Agency discount notes in response to the European debt crisis and other geopolitical events, especially in the second, third and fourth quarters of 2011.
 
The average yield on consolidated obligation bonds also declined from 2010 to 2011 (see Table 13). Important factors in the decline in consolidated obligation bond yields were: (1) generally lower intermediate and longer-term market interest rates; and (2) refinancing of a portion of the callable debt funding our fixed rate mortgage loan, fixed rate MBS and fixed rate advance portfolios.
 
As discussed above, throughout much of 2010 and 2011, we have been able to lower our long-term, consolidated obligation funding costs by calling previously issued callable debt and replacing it with new lower-cost fixed rate, callable, and to a lesser extent, non-callable bonds. Over the past several years, we have used callable debt with short lockouts (primarily three to six months) as a primary funding tool for mortgage assets and as a secondary funding tool for amortizing and other fixed rate advances. This has provided an opportunity to take advantage of lower debt costs in 2010 and during periods of time in 2011, particularly in the third and fourth quarters of 2011. We continued to maintain a sizable portfolio of unswapped callable bonds in 2011. Unswapped callable bonds increased from $3.7 billion as of December 31, 2010 to $4.4 billion as of December 31, 2011. Callable bonds are an effective instrument for funding fixed rate mortgage-related assets because they provide a way to offset the prepayment risk. For a further discussion of how we use callable bonds see Item 7 – “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Financial Condition – Consolidated Obligations.”
 
Additionally, a significant portion of our bonds are comprised of long-term callable bonds adjusting or swapped to LIBOR which are used to fund LIBOR-based and other short-term assets. When assets and liabilities are based upon different indices, such as when the discount note curve is used to set rates for some advances and LIBOR-based debt is used to fund those advances, we are exposed to basis risk. We maintained a relatively balanced basis position throughout much of 2010 and 2011. However, during certain times over these periods we increased our allocation to LIBOR-based debt or fixed rate debt, including discount notes, in order to attempt to take advantage of market opportunities to issue debt at more advantageous rates. At times we also increased our position in LIBOR-based debt in preparation for large maturities of liabilities funding LIBOR-based assets (assets adjusting to or swapped to LIBOR) and/or to enhance liquidity.
 
Derivative and hedging activities impacted our net interest spread as well. The assets and liabilities hedged with derivative instruments designated under fair value hedging relationships are adjusted for changes in fair values even as other assets and liabilities continue to be carried on a historical cost basis. The result is that positive basis adjustments on: (1) advances reduce the average annualized yield; and (2) consolidated obligations decrease the average annualized cost. The positive basis adjustments on advances have exceeded those on consolidated obligations over the last three years. Therefore, the average net interest spread has been negatively affected by the basis adjustments included in the asset and liability balances and is not necessarily comparable between years. Additionally, 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. However, net interest payments or receipts on derivatives that do not qualify for hedge accounting (economic hedges) flow through Net Gain (Loss) on Derivatives and Hedging Activities and not Net Interest Income (net interest received/paid on economic derivatives is identified in Tables 15 through 17 under this Item 7), which distorts yields especially for trading investments that are swapped.
 
As explained in more detail in Item 7A – “Quantitative and Qualitative Disclosure About Market Risk – Interest Rate Risk Management – Duration of Equity,” our DOE is relatively short. The historically short DOE is the result of the short maturities (or short reset periods) of the majority of our assets and liabilities. Accordingly, our net interest income is quite sensitive to the level of short-term interest rates. The fact that the yield on assets and the cost of liabilities can change quickly makes it crucial for management to tightly control and minimize any duration mismatch of short-term assets and liabilities to lessen any adverse impact on net interest income from changes in short-term rates.
 
 
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Table 13 presents average balances and yields of major earning asset categories and the sources funding those earning assets (in thousands):
 
Table 13
 
 
   
12/31/2011
   
12/31/2010
   
12/31/2009
 
   
Average
Balance
   
Interest
Income/
Expense
   
Yield
   
Average
Balance
   
Interest
Income/
Expense
   
Yield
   
Average
Balance
   
Interest
Income/
Expense
   
Yield
 
Interest-earning assets:
                                                     
Interest-bearing deposits
  $ 206,898     $ 204       0.10 %   $ 122,380     $ 230       0.19 %   $ 2,837,565     $ 7,095       0.25 %
Federal funds sold
    1,928,804       2,219       0.12       2,519,690       4,826       0.19       1,537,489       3,950       0.26  
Investments1
    11,912,420       180,482       1.52       14,331,632       239,107       1.67       15,052,637       311,386       2.07  
Advances2,3
    17,847,711       165,514       0.93       21,179,801       209,453       0.99       25,935,734       348,123       1.34  
Mortgage loans2,4,5
    4,612,061       195,828       4.25       3,661,819       173,756       4.75       3,205,757       160,585       5.01  
Other interest-earning assets
    35,272       2,240       6.35       41,024       2,639       6.43       48,780       3,037       6.23