10-K 1 form10k.htm FORM 10_K_2012 form10k.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, 2012
 
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 13, 2013
Class A Stock, par value $100
  5,188,471
Class B Stock, par value $100
  8,394,691
 
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
 
 
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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 and quality 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", "eMPF" and "MPF Xtra" are registered trademarks of the Federal Home Loan Bank of Chicago
 
 
3

 
 
 
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 2012, this asset cap was $1.08 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 90 and 91 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 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.
 
Finance Agency regulations require our strategic business plan to include plans for maximizing activities that enhance the carrying out of our mission. The Finance Agency has provided a letter expressing renewed interest in ensuring the FHLBanks remain focused on activities related to their mission, including advances and acquired member assets (AMA), and has requested that we identify an appropriate benchmark for our ratio of mission-related assets to total assets. If the Finance Agency were to require us to maintain a higher ratio of mission-related assets to total assets, it could adversely impact our results of operations.

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 11 FHLBanks at AA+ and one FHLBank 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 all 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.
 
 
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Business Segments
We currently do not manage or segregate our operations by segments.

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 8 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 70 and 71 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. 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

 
Tables 23 and 24 under Item 7 – “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Financial Condition” present information on our five largest borrowers as of December 31, 2012 and 2011 and the interest income associated with the five borrowers with the highest interest income for the years ended December 31, 2012 and 2011.
 
Mortgage Loans
We purchase various mortgage loan products from participating financial institutions (PFIs) under the MPF Program, a secondary mortgage market structure created and maintained by the Federal Home Loan Bank of Chicago (FHLBank Chicago). 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. These traditional mortgage products, along with loans sold under the MPF Xtra product, where the PFI sells a loan through the MPF Program structure to Fannie Mae, collectively provide our members an opportunity to further their cooperative partnership with us.
 
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. Traditional MPF Program mortgage loans are considered 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 mortgage 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 mostly impact credit quality to PFIs. We are responsible for managing the interest rate, prepayment and liquidity risks associated with owning traditional 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 (excluding the MPF Xtra product). 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. As a part of our methodology to determine the amount of CE obligation necessary, we analyze the risk characteristics of each mortgage loan using a model licensed from a Nationally Recognized Statistical Rating Organization (NRSRO). We use the model to evaluate loan data provided by the PFI as well as other relevant information.
 
For traditional MPF products involving conventional loans, 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, or supplemental mortgage insurance (SMI) policy purchased to replace a CE obligation or to in-part reduce the amount of one, 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 or SMI policy 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 traditional 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. As mentioned above, the MPF Xtra product is essentially a loan sale from the PFI to FHLBank Chicago (Fannie Mae seller-servicer), and simultaneously to Fannie Mae. We collect a counterparty fee for our PFI participating in the MPF Xtra product.

The traditional MPF products involving conventional loans are termed credit-enhanced products, in that we share in the credit risk of the loans (as described above) with the PFIs. The MPF Government and Xtra products do not have a first loss and/or credit enhancement structure.
 
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: FHLBank Chicago serves as the MPF Provider for the MPF Program. They maintain the structure of MPF loan products and the eligibility rules for MPF loans, including MPF Xtra loans, which primarily fall under the rules and guidelines provided by Fannie Mae. In addition, the MPF Provider manages the pricing and delivery mechanism for MPF loans and the back-office processing of MPF loans in its role as master servicer and program custodian. We have the capability under the individual bank pricing option to change the pricing offered to our PFIs for all MPF products, 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.
 
 
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The MPF Provider publishes and maintains the MPF Origination, Underwriting and Servicing Guides and the MPF Xtra Guide, all of which detail the requirements PFIs must follow in originating, underwriting or selling and servicing MPF loans. As indicated, under the MPF Xtra product, we are a conduit that PFIs use to sell loans to FHLBank Chicago, then simultaneously to Fannie Mae. We began offering the MPF Xtra product in 2012, primarily to expand our use of balance sheet management tools available to us. MPF Xtra also enhances our list of MPF products so our PFIs can take advantage of the differences between the traditional products and MPF Xtra, primarily the differences between the risk-based capital costs associated with the credit enhancement feature on traditional products compared to loan level price adjustments that exist with MPF Xtra. 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 transaction services fee, which is based upon the unpaid principal balances of MPF loans funded since January 1, 2004.
 
MPF Servicing: PFIs selling MPF loans under the MPF Program may either retain the servicing function or transfer it and the servicing rights to an approved PFI servicer. If a PFI chooses to retain the servicing function, they receive a servicing fee. 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.
 
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 for conventional mortgage loans 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, 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.

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.
 
 
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Table 1 presents a comparison of the different characteristics for each of the MPF products held on balance sheet as of December 31, 2012:
 
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 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
           
MPF Xtra        N/A     N/A     N/A     N/A
    25 bps per year, paid
    monthly
           
MPF Government
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 regulatory requirements relating to loan originator compensation under the Dodd-Frank Act.
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.

Table 2 presents an illustration of the FLA and CE obligation calculation for each conventional MPF product type listed as of December 31, 2012:
 
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.
 
 
8

 
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., 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 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 traditional mortgage products 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.
 
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.
 
 
9

 
Table 3 presents the par value of our consolidated obligations and the combined consolidated obligations of the 12 FHLBanks as of December 31, 2012 and 2011 (in millions):

Table 3
 
   
12/31/2012
   
12/31/2011
 
Par value of consolidated obligations of the FHLBank
  $ 30,458     $ 29,897  
                 
Par value of consolidated obligations of all FHLBanks
  $ 687,902     $ 691,868  

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, 2012 and 2011 (in thousands):
 
Table 4
 
   
12/31/2012
   
12/31/2011
 
Total non-pledged assets
  $ 33,735,216     $ 33,105,379  
Total carrying value of consolidated obligations
  $ 30,642,961     $ 30,145,591  
                 
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 are primarily used to 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.

When consolidated obligations are issued with variable-rate coupon payment terms that use the Federal funds rate, we typically simultaneously enter into derivatives that effectively convert the Federal funds rate to LIBOR. The effective Federal funds rate is based upon transactional data relating to the Federal funds sold market. An increase in commercial bank reserves combined with the rate of interest paid on those reserves has contributed to a decline in the volume of transactions in the overnight Federal funds market. Thus, in the aggregate, the FHLBanks may comprise a significant percentage of the Federal funds sold market at any given point in time; however each FHLBank manages its investment portfolio separately.
 
Consolidated Obligation Discount Notes: The Office of Finance also sells consolidated obligation discount notes on behalf of the FHLBanks that are primarily used 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/or on the funding needs of the FHLBanks. Discount notes are sold at a discount and mature at par.
 
 
10

 
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 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; (2) by acting as an intermediary between members and the capital markets; or (3) in asset/liability management (i.e., economic hedge). Economic hedges are defined as derivatives hedging specific or non-specific underlying assets, liabilities or firm commitments that do not qualify for hedge accounting, but are acceptable hedging strategies under our RMP. 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 or to alter the characteristics of our liabilities to better match the characteristics of our assets, 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 a cost improvement over other funding alternatives and 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 fixed rate 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/or 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 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.
 
 
11

 
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 2012 and 2011 (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)
 
12/31/2012
   
09/30/2012
   
06/30/2012
   
03/31/2012
 
Market Risk (dividend paying capacity)1
  $ -     $ -     $ -     $ -  
Credit Risk
    68,619       69,377       72,905       77,221  
Operations Risk
    20,586       20,813       21,872       23,166  
Derivative Hedging Volatility
    21,325       25,018       27,401       28,300  
Total Retained Earnings Threshold
    110,530       115,208       122,178       128,687  
Actual Retained Earnings as of End of Quarter
    481,282       460,715       440,682       425,872  
Overage
  $ 370,752     $ 345,507     $ 318,504     $ 297,185  
                   
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)
 
12/31/2011
   
09/30/2011
   
06/30/2011
   
03/31/2011
 
Market Risk (dividend paying capacity) 1
  $ -     $ -     $ -     $ -  
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
  $ 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.

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.

 
12

 
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.

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.

Key provisions under the JCE Agreement are as follows:
§  
Under the JCE Agreement, each FHLBank will build its RRE Account to a minimum of 1 percent of its total outstanding consolidated obligations through the 20 percent allocation. For this purpose, total outstanding consolidated obligations is based on the most recent quarter's average carrying value of all consolidated obligations for which an FHLBank is the primary obligor, excluding hedging adjustments (Total Consolidated Obligations). Under the JCE Agreement, an FHLBank may make voluntary allocations above 20 percent of its net income and/or above the targeted balance of 1 percent of its Total Consolidated Obligations.
§  
The JCE Agreement provides that any quarterly net losses of an FHLBank may be netted against its net income, if any, for other quarters during the same calendar year to determine the minimum required year-to-date or annual allocation to its RRE Account. Any year-to-date or annual losses must first be allocated to the unrestricted retained earnings of an FHLBank until such retained earnings are reduced to a zero balance. Thereafter, any remaining losses may be applied to reduce the balance of an FHLBank’s RRE Account, but not below a zero balance. In the event an FHLBank incurs a net loss for a cumulative year-to-date or annual period that results in a decrease to the balance of its RRE Account below the balance of the RRE Account as of the beginning of that calendar year, such FHLBank’s quarterly allocation requirement will thereafter increase to 50 percent of quarterly net income until the cumulative difference between the allocations made at the 50 percent rate and the allocations that would have been made at the regular 20 percent rate is equal to the amount of the decrease to the balance of its RRE Account at the beginning of that calendar year.
§  
If the size of an FHLBank’s balance sheet would decrease and consequently, Total Consolidated Obligations would decline, the percent allocated could exceed the targeted one percent of Total Consolidated Obligations. The JCE Agreement provides that if an FHLBank's RRE Account exceeds 1.5 percent of its Total Consolidated Obligations, such FHLBank may transfer amounts from its RRE Account to the unrestricted retained earnings account, but only to the extent that the balance of its RRE Account remains at least equal to 1.5 percent of the FHLBank’s Total Consolidated Obligations immediately following such transfer. Finally, the JCE Agreement provides that during periods in which an FHLBank’s RRE Account is less than one percent of its Total Consolidated Obligations, such FHLBank may pay dividends only from unrestricted retained earnings or from the portion of quarterly net income not required to be allocated to its RRE Account.
§  
The JCE Agreement can be voluntarily terminated by an affirmative vote of two-thirds of the boards of directors of the FHLBanks, or automatically after the occurrence of a certain event after following certain proscribed procedures (Automatic Termination Event). An Automatic Termination Event means: (1) a change in the FHLBank Act, or another applicable statute, that will have the effect of creating a new, or higher, assessment or taxation on net income or capital of the FHLBanks; or (2) a change in the FHLBank Act, or another applicable statute, or relevant regulations that will result in a higher mandatory allocation of an FHLBank’s quarterly net income to any retained earnings account other than the annual amount, or total amount, specified in an FHLBank’s capital plan. An FHLBank’s obligation to make allocations to the RRE Account terminates after it has been determined that an Automatic Termination Event has occurred and one year thereafter the restrictions on paying dividends out of the RRE Account, or otherwise reallocating funds from the RRE Account, are also terminated. Upon the voluntary termination of the JCE Agreement, an FHLBank’s obligation to make allocations to the RRE Account is terminated on the date written notice of termination is delivered to the Finance Agency, and restrictions on paying dividends out of the RRE Account, or otherwise reallocating funds from the RRE Account, terminate one year thereafter.

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 “Capital, Capital Rules and Dividends” under this Item 1. 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.
 
 
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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 competition for AHP funds, customized homeownership set-aside programs offered during 2012 under the AHP included:
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Rural First-time Homebuyer Program (RFHP) – RFHP provides down payment, closing cost or rehabilitation cost assistance to first-time homebuyers in rural areas;
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Rural Disaster-Related Assistance (RDRA) – RDRA provides rehabilitation or rebuilding cost assistance to homeowners in rural federally declared disaster areas; and
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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.

Effective January 1, 2013, we no longer offer the RDRA or TOP.
 
Community Investment Cash Advance (CICA) Program. CICA loans to members specifically target underserved markets in both rural and urban areas. CICA loans represented 5.1 percent, 4.5 percent and 3.8 percent of total advances outstanding as of December 31, 2012, 2011 and 2010, respectively. Programs offered during 2012 under the CICA Program, which is not funded through the AHP, include:
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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;
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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;
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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
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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.

Effective January 1, 2013, we no longer offer the CHP Plus or HELP.
 
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:
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Joint Opportunities for Building Success (JOBS) – In 2012, $998,000, in JOBS funds were distributed to assist members in promoting employment growth in their communities. We distributed $1,225,000 and $1,247,000 in 2011 and 2010, respectively. A charitable grant program, JOBS funds are allocated annually to support economic development projects. For 2013, 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 $17,000 in 2012, $16,000 in 2011 and $9,000 in 2010. Up to $18,000 in funding has been allocated for this program for 2013; 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 $100,000, $75,000 and $78,000 of the available funds for this program during 2012, 2011 and 2010, respectively. For 2013, $75,000 has been allocated to this program.
 
 
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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 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.
 
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 13, 2013, we had 200 employees. The employees are not represented by a collective bargaining unit and we consider our relationship with our employees good.
 
 
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Legislation and Regulatory Developments
The legislative and regulatory environment for the FHLBank has been one of profound change over the past several 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.

Dodd-Frank Act: The Dodd-Frank Act provides for new statutory and regulatory requirements for derivatives transactions, including those utilized by us to hedge our interest rate and other risks. As a result of these requirements, beginning on June 10, 2013, 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. Derivative transactions that are not required to be cleared will be subject to mandatory reporting, documentation, minimum margin and capital and other requirements.

Mandatory Clearing. The Commodity Futures Trading Commission (CFTC) issued its first set of mandatory clearing determinations on November 28, 2012 (first mandatory clearing determination), which will subject four classes of interest rate swaps and two classes of credit default swaps to mandatory clearing beginning in the first quarter of 2013.

Certain of the interest rate swaps in which we engage fall within the scope of the first mandatory clearing determination and, as such, we will be required to clear any such swaps. Implementation of the first clearing determination will be phased in; we are classified as a “category 2 entity” and therefore have to comply with the mandatory clearing requirement for the specified interest rate swaps that we execute on or after June 10, 2013. The CFTC is expected to issue additional mandatory clearing determinations in the future with respect to other types of derivatives transactions, which could include certain interest rate swaps entered into by us that are not within the scope of the first mandatory clearing determination.

The CFTC has approved an end-user exception to mandatory clearing that would exempt derivative transactions that we may enter into with our members that have $10 billion or less in assets; the exception applies only if the member uses the swaps to hedge or mitigate its commercial risk and the reporting counterparty for such swaps complies with certain additional reporting requirements. As a result, any such member swaps would not be subject to mandatory clearing, although such swaps may be subject to applicable new requirements for derivatives transactions that are not subject to mandatory clearing requirements (uncleared trades). Although our moratorium on intermediating swaps for members currently continues, we have included this discussion relating to member swaps because we might decide to offer intermediated member swaps in the future.

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 derivatives transactions more costly. In addition, mandatory clearing has required us to enter into new relationships and accompanying documentation with clearing members, which we continue to negotiate, and additional documentation with our interest rate swap counterparties.

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, although customer collateral must be segregated on an individual customer basis on the books of a futures commission merchant (FCM) and derivatives clearing organization, it 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 in the event of an FCM insolvency. Accordingly, a major consideration in our decision to establish and maintain a clearing relationship with an FCM is our assessment of the financial soundness of the FCM.

Definitions of Certain Terms under New Derivatives Requirements. The Dodd-Frank Act requires 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. Although we have a substantial portfolio of derivative transactions that are entered into for hedging purposes, and may engage in intermediated swaps with its members in the future, based on the definitions in the final rules jointly issued by the CFTC and the SEC in April 2012, we do not expect to be required to register as either a major swap participant or as a swap dealer.

Based on the final rules and accompanying interpretive guidance jointly issued by the CFTC and the SEC in July 2012 to further define the term “swap,” call and put optionality in certain advances to our members will not be treated as “swaps” so long as the optionality relates solely to the interest rate on the advance and does not result in enhanced or inverse performance or other risks unrelated to the interest rate. Accordingly, our ability to offer these advances to member customers should not be adversely affected by the new derivatives regulations.

Margin for Uncleared Derivatives Transactions. The Dodd-Frank Act will also change the regulatory landscape for derivatives 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, minimum margin and capital, and other requirements. The CFTC, the Finance Agency and other federal bank regulators proposed margin requirements for uncleared trades in 2011. Under the proposed margin rules, we would have to post both initial margin and variation margin to our swap dealer and major swap participant counterparties, but may be eligible in both instances for modest unsecured thresholds as a “low-risk financial end user.” Pursuant to additional Finance Agency provisions, we would 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. Final margin rules are not expected until the second quarter of 2013 at the earliest and, accordingly, it is not likely that we will have to comply with such requirements until the end of 2013.

 
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Documentation for Uncleared Transactions. In February 2012, the CFTC adopted final rules that impose external business conduct standards on swap dealers and major swap participants when dealing with counterparties. The external business conduct standards rules prohibit certain abusive practices and require disclosure of certain material information to counterparties. In addition, swap dealers and major swap participants must conduct due diligence relating to their dealings with counterparties. In order to facilitate compliance with the external business conduct standards, swap dealers and major swap participants have sought to amend their existing swap documentation with counterparties. To facilitate amendment of the agreements, the International Swaps and Derivatives Association (ISDA) has initiated a protocol process, which allows multiple counterparty adherents to the same protocol to amend existing bilateral documentation with other adhering counterparties without having to negotiate changes to individual agreements. The original compliance date for swap dealers and major swap participants to comply with the external business standards was October 14, 2012, but that deadline has been extended twice and is now May 1, 2013. We adhered to an ISDA protocol in September 2012 to address the new documentation requirements under the external business conduct rules. Following adherence to the protocol, we have amended our agreements with 19 swap dealers by completing the required exchange of questionnaires with these parties.

In September 2012, the CFTC finalized rules regarding certain new documentation requirements for uncleared trades, including requirements for new dispute resolution and portfolio valuation and reconciliation provisions, new representations regarding applicable insolvency regimes and possible changes to our existing credit support arrangements with our swap dealer counterparties. ISDA has published a second protocol draft to address these new documentation requirements, and we are currently evaluating the protocol’s provisions. Our swap documentation with swap dealers must comply with certain of the requirements contained in the September 2012 CFTC rules by July 1, 2013. The final rules also impose requirements with respect to when swap dealers and major swap participants must deliver acknowledgments of, and execute confirmations for, uncleared trades with us. These timing requirements will be phased in between December 31, 2012 and March 1, 2014.

Additional changes to our swap documentation are expected to be required by additional Dodd-Frank Act rules, including the margin requirements for uncleared swaps that have not yet been finalized. We will consider adhering to future ISDA protocols to address the foregoing requirements.

Recordkeeping and Reporting. Compliance dates for the new recordkeeping and reporting requirements for all of our cleared and uncleared swaps have now been established. We currently comply with recordkeeping requirements for our swaps that were in effect on or after July 21, 2010 and, beginning on April 10, 2013, we will have to comply with new record-keeping requirements for swaps entered into on or after April 10, 2013. For interest rate swaps that we enter into with swap dealers, the swap dealers are currently required to comply with reporting requirements applicable to such swaps, including real-time reporting requirements. We will be required to comply with reporting requirements, including real-time reporting requirements, for any swaps that we may intermediate for our members beginning on April 10, 2013.

We, together with the other FHLBanks, will continue to monitor the Dodd-Frank Act rulemakings and the overall regulatory process to implement the derivatives reforms prescribed by that legislation. We will also continue to work with the other FHLBanks to implement the processes and documentation necessary to comply with the Dodd-Frank Act's new requirements for derivatives.

Significant Finance Agency Regulatory Actions:
Finance Agency Issues Final Rule on Private Transfer Fee Covenants. On March 16, 2012, the Finance Agency issued a final rule prohibiting Fannie Mae, Freddie Mac and the FHLBanks (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 were required to comply with the final rule by July 16, 2012.

Finance Agency Issues Advisory Bulletin on Classification of Assets. On April 9, 2012, the Finance Agency issued Advisory Bulletin 2012-02, Framework for Adversely Classifying Loans, Other Real Estate Owned, and Other Assets and Listing Assets for Special Mention (AB 2012-02). The guidance establishes a standard and uniform methodology for classifying assets and prescribes the timing of asset charge-offs, excluding investments. The guidance in AB 2012-02 is generally consistent with the Uniform Retail Credit Classification and Account Management Policy issued by the federal banking regulators in June 2000. AB 2012-02 states that it was effective upon issuance. However, the Finance Agency issued additional guidance that extends the effective date to January 1, 2014. We are currently assessing the provisions of AB 2012-02 in coordination with the Finance Agency and have not yet determined its effect on our operating activities, results of operation or financial condition.

Finance Agency Issues Final Rule on Prudential Management and Operations Standards. On June 8, 2012, the Finance Agency issued a final 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 they are consistent with the purposes of the Safety and Soundness Act and the Regulated Entities’ authorizing statutes, 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 final rule establishes the standards as guidelines. In the event the Finance Agency determines that a Regulated Entity has failed to meet one or more of the standards, the Finance Agency may require the Regulated Entity to submit a corrective plan, which shall describe the actions the Regulated Entity will take to correct its failure to meet any one or more of the standards, and the time within which each action will be taken. If a Regulated Entity fails to submit an acceptable corrective plan, or fails in any material respect to implement or otherwise comply with an approved corrective plan, the Finance Agency may limit certain activities of the Regulated Entity. The final rule became effective on August 7, 2012.

 
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Finance Agency Establishes Suspended Counterparty Program. On June 18, 2012, the Finance Agency issued a notice regarding the establishment of a Suspended Counterparty Program to help address the risk to the Regulated Entities presented by individuals and entities with a history of fraud or other financial misconduct. As part of the Suspended Counterparty Program, each Regulated Entity is required to establish a process to notify the Finance Agency on a timely basis of individuals or institutions which have been convicted of an action relating to fraud or other fraudulent conduct or have been suspended or debarred by any Federal agency for such conduct. The Finance Agency will then inform all Regulated Entities when a decision has been made to suspend a counterparty, including the basis for the scope of the suspension, and the Finance Agency will direct the Regulated Entities to take appropriate action. Regulated Entities were required to implement a process for reporting to the Finance Agency the identity of any individual or entity meeting certain reporting criteria by no later than August 15, 2012.

Finance Agency Issues Notice on the Examination Rating System. On November 13, 2012, the Finance Agency issued a notice on its new Examination Rating System. The final examination rating system, which will be used for examining the Enterprises and the FHLBanks, will require an assessment of seven individual components dealing with capital, asset quality, management, earnings, liquidity, sensitivity to market risk and operational risk. Under the new rating system, each Regulated Entity will be assigned a composite numerical rating from “1” to “5,” with a “1” rating indicating the lowest degree of supervisory concern and a “5” rating indicating the highest level of supervisory concern. The composite rating will reflect the ratings of the underlying components, which will also be rated on a scale of “1” to “5.” The new rating system will replace the examination rating system developed by the Finance Agency’s predecessor agencies. The Finance Agency intends to use the new ratings system for examinations that commence after January 1, 2013.

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 Proposed Order on Qualified Financial Contracts (QFCs). On August 9, 2012, the Finance Agency circulated a proposed order on QFCs that would be applicable to the Regulated Entities. The Finance Agency has indicated that the proposed order is intended to permit the Finance Agency to comply with certain statutory requirements for the transfer of QFCs in the event of the receivership of a Regulated Entity. The proposed order sets forth certain recordkeeping and reporting requirements for a Regulated Entity's QFCs. If the order is issued as proposed, each FHLBank will have to, among other things, establish and maintain infrastructure sufficient to meet the recordkeeping and reporting requirements and engage external personnel to audit its compliance with the order on an annual basis. Comments were due by October 10, 2012.

Finance Agency Issues White Paper on Building a New Infrastructure for the Secondary Mortgage Market. On October 4, 2012, the Finance Agency issued, and requested public input on, its white paper on Building a New Infrastructure for the Secondary Mortgage Market. The purpose of the white paper is to describe a proposed framework for both a new securitization infrastructure and a contractual framework supporting the new infrastructure. The proposed infrastructure would replace the proprietary infrastructures of the Enterprises with a common model, and establish a framework that is consistent with multiple versions of housing finance reform, including greater participation of private capital in assuming credit risk. Public input on the white paper was due by December 3, 2012.

Finance Agency Issues Notice on a Proposed Advisory Bulletin on Collateralization of Advances and Other Credit Products Provided by FHLBanks to Insurance Company Members. On October 5, 2012, the Finance Agency issued a notice with request for comment on a proposed advisory bulletin which would set forth standards to guide Finance Agency staff in its supervision of secured lending to insurance company members by the FHLBanks. The advisory bulletin would set forth a series of considerations that the Finance Agency proposes to use in monitoring transactions between FHLBanks and their insurance company members, with a focus on principles that would be used by the Finance Agency supervisory staff to assess each FHLBank’s ability to evaluate the financial health of its insurance company members and the quality of their eligible collateral, as well as the extent to which the FHLBank has a first-priority security interest in that collateral. Comments on the proposed advisory bulletin were due by December 4, 2012.

Finance Agency Issues Notice of Proposed Rulemaking on Stress Testing of Regulated Entities. On October 5, 2012, the Finance Agency issued a notice of proposed rulemaking on Stress Testing of Regulated Entities. The purpose of the proposed rule is to ensure stronger regulation of the Regulated Entities by providing the Finance Agency with additional, forward-looking information that will allow it to assess capital adequacy under various scenarios at the Regulated Entities. Section 165(i)(2)(c) of the Dodd-Frank Act requires the Finance Agency, as a primary federal financial regulatory agency, in coordination with other Federal financial regulators, to issue consistent and comparable regulations for annual stress testing of financial companies with assets over $10 billion. The proposed rule would require each Regulated Entity to complete an annual stress test of itself based on scenarios provided by the Finance Agency that reflect a minimum of three sets of economic and financial conditions, including a baseline, adverse and severely adverse scenario using a planning horizon of at least nine quarters over which the impact of the specified scenarios must be assessed. The proposed rule would require the Regulated Entities to report the results of the stress tests to the Finance Agency by January 5 of each year and then to provide certain public disclosure of the results of the stress tests within 90 days of the submission of the report to the Finance Agency. Comments on the proposed rulemaking were due by December 4, 2012.

Finance Agency Issues Notice of Proposed Rulemaking on Information Sharing Among FHLBanks. On January 29, 2013, the Finance Agency issued a notice of proposed rulemaking on Information Sharing Among FHLBanks. The proposed rule would implement Section 1207 of the Recovery Act, which requires the Finance Agency to make available to each FHLBank information relating to the financial condition of all other FHLBanks and to promulgate regulations to facilitate the sharing of such information among the FHLBanks. The Finance Agency published a proposed rule to implement the foregoing Recovery Act provisions in late 2012, but has re-issued the proposed rule after reviewing the comments and reconsidering the proposed means of information sharing. Pursuant to the proposed rule, the Director of the Finance Agency would distribute to the FHLBanks and the Office of Finance a proposed order identifying the categories of financial and supervisory information regarding each FHLBank and the FHLBank System that the Finance Agency would share with each FHLBank and the Office of Finance. Upon finalizing the order, the Finance Agency would routinely distribute certain categories of information to the FHLBanks and the Office of Finance. Comments on the proposed rule are due by April 1, 2013.
 
 
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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 which 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 Fannie Mae and Freddie Mac as holders of mortgages on properties subject to PACE obligations, as well as MBS 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 were due by March 26, 2012.

Other Significant Regulatory Actions:
Financial Stability Oversight Council (FSOC) Issues Final Rule and Interpretive Guidance on Authority to Require Supervision and Regulation of Certain Nonbank Financial Companies. On April 11, 2012, the FSOC issued a final rule to 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. Under the final rule, the FSOC has established 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 billion 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 borrowings 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 builds 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. The final rule became effective on May 11, 2012.

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.

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 were due by April 30, 2012.

National Credit Union Administration Issues Proposed Rule on Access to Emergency Liquidity. On July 30, 2012, the National Credit Union Administration (NCUA) published a proposed rule requiring, among other things, that federally-insured credit unions of $100 million or larger must maintain access to at least one federal liquidity source for use in times of financial emergency and distressed circumstances. This access must be demonstrated through direct or indirect membership in the Central Liquidity Facility (a U.S. government corporation created to improve the general financial stability of credit unions by serving as a liquidity lender to credit unions) or by establishing access to the Federal Reserve’s discount window. The proposed rule does not include FHLBank membership as an emergency liquidity source. If the rule is issued as proposed, it may adversely impact our results of operations if it causes our federally-insured credit union members to favor these federal liquidity sources over FHLBank membership or advances. Comments were due by September 28, 2012.

FSOC Issues Proposed Recommendations Regarding Money Market Mutual Fund Reform. On November 19, 2012, the FSOC issued proposed recommendations pursuant to Section 120 of the Dodd-Frank Act, which authorizes the FSOC to issue recommendations to a primary financial regulatory agency to apply new or heightened standards and safeguards for a financial activity or practice conducted by bank holding companies or nonbank financial companies. Pursuant to Section 120, the FSOC proposes to determine that money market funds’ activities and practices could create or increase the risk of significant liquidity, credit and other problems spreading among bank holding companies, nonbank financial companies and U.S. financial markets. Based on the proposed determination, the FSOC proposed three alternative approaches for addressing the concerns: (1) require money market funds to have a floating net asset value per share; (2) require money market funds to have a net asset value buffer with a tailored amount of assets of up to one percent to absorb day-to-day fluctuations in the value of the funds’ portfolio securities and allow the funds to maintain a stable net asset value; or (3) require money market funds to have a risk-based net asset value buffer of three percent to provide explicit loss-absorption capacity that could be combined with other measures to enhance the effectiveness of the buffer. Actions by the FSOC or other regulators in response to the FSOC’s proposed recommendations could result in money market funds being less attractive to investors, thereby shrinking demand for FHLBank debt by money market funds and potentially hindering our ability to obtain the liquidity needed to meet certain obligations. Comments on the proposed recommendations were due by February 15, 2013.

Additional Developments:
Basel Committee on Banking Supervision Capital and Liquidity 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. In January 2013, the Basel Committee approved a revised liquidity framework, including a revised liquidity coverage ratio which revises the definition of high-quality liquid assets and net cash outflows, which are used to determine the amount and type of high quality, unencumbered liquid assets an organization should have at hand in the event of a liquidity crisis.

 
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On June 7, 2012, the Board of Governors, the Office of the Comptroller of the Currency (OCC) and the Federal Deposit Insurance Corporation (FDIC) (collectively, the Agencies) concurrently published three joint notices of proposed rulemaking (the NPRs) seeking comments on comprehensive revisions to the Agencies’ capital framework to incorporate the Basel Committee’s new capital framework. These revisions would, among other things:
§  
Implement the Basel Committee’s capital standards related to minimum requirements, regulatory capital, and additional capital buffers;
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Revise the methodologies for calculating risk-weighted assets in the general risk-based capital rules; and
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Revise the approach by which large banks determine their capital adequacy.

The NPRs do not incorporate the reforms related to liquidity risk management published in Basel III, which the Agencies are expected to propose in a separate rulemaking. If the new NPRs are adopted as proposed and depending on the liquidity framework expected to be proposed by the Agencies, some of our members could need to divest assets in order to comply with the more stringent capital and liquidity requirements, thereby tending to decrease their need for advances. The requirements may also adversely impact investor demand for consolidated obligations to the extent that affected institutions divest or limit their investments in consolidated obligations. On the other hand, any new liquidity requirements could motivate our members to borrow term advances from us to create and maintain balance sheet liquidity. Comments were due on the proposed rulemakings by October 22, 2012.

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 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.

Expiration of Unlimited Insurance on Noninterest-Bearing Transaction Accounts. As a result of the Dodd-Frank Act, the Federal Deposit Insurance Act and the Federal Credit Union Act were amended to require that the FDIC and NCUA fully insure the net amount that any depositor at an insured depository institution maintains in a noninterest-bearing transaction account. The amendments provided an alternative source of funds to many of our members, which competed with our advance business. The provisions of the Dodd-Frank Act which authorized unlimited insurance on noninterest-bearing transaction accounts included a prospective repeal of such authority, with such repeal occurring effective January 1, 2013.
 
Consumer Financial Protection Bureau (CFPB) Issues Final Qualified Mortgage Rule. In January 2013, the CFPB issued a final rule with an effective date of January 10, 2014 establishing new standards for mortgage lenders to follow during the loan approval process to determine whether a borrower can afford to repay the mortgage. Qualified mortgage loans (QMs) are home loans that are either eligible for Fannie Mae or Freddie Mac to purchase or otherwise satisfy certain underwriting standards. The standards require lenders to consider, among other factors, the borrower's current income, current employment status, credit history, monthly payment for mortgage loans, monthly payment for other loan obligations, and the borrower's total debt-to-income ratio. Further, the underwriting standards prohibit loans with excessive points and fees, interest-only or negative-amortization features (subject to limited exceptions), or terms greater than 30 years.

The final rule provides for a safe harbor from certain liability for QMs, which could incent lenders, including our members, to limit their mortgage lending to QMs or otherwise reduce their origination of mortgage loans that are not QMs. This could reduce the overall level of members’ mortgage loan lending and, in turn, reduce demand for our advances. In January 2013, the CFPB also issued a proposal that would generally allow first lien balloon mortgage loans made by small creditors (generally those with assets under $2 billion) in rural or underserved areas, and retained in portfolio for at least three years, to be treated as QM mortgages. However, we believe that many of the balloon mortgage loans made by our CFI members may not be made in areas that fit the narrow criteria for “rural or underserved areas.” If such balloon mortgages are not treated as QM mortgages under final CFPB regulations, this is likely to reduce mortgage lending by our CFI members and lead to increased concentration in the mortgage market. Additionally, the value and marketability of mortgage loans that are not QMs, including those pledged as collateral to secure member advances, may be adversely affected. Comments were due February 25, 2013.

HARP, HAMP and Other Foreclosure Prevention Efforts. In 2012, the Finance Agency, Fannie Mae, and Freddie Mac announced a series of changes that were intended to assist more eligible borrowers who can benefit from refinancing their home mortgages. The changes include lowering or eliminating certain risk-based fees, removing the current 125 percent LTV ceiling on fixed rate mortgages that are purchased by Fannie Mae and Freddie Mac, waiving certain representations and warranties, eliminating the need for a new property appraisal and extending the end date for the program until December 31, 2013 for loans originally sold to Fannie Mae and Freddie Mac on or before May 31, 2009.

Other federal agencies have also implemented other programs during the past few years intended to prevent foreclosure. These programs focus on lowering a home owner's monthly payments through mortgage modifications or refinancings, providing temporary reductions or suspensions of mortgage payments, and helping homeowners transition to more affordable housing. Other proposals such as expansive principal writedowns or principal forgiveness (including new short-sale/deed in lieu of foreclosure programs recently discussed), or converting delinquent borrowers into renters and conveying the properties to investors, have gained some popularity as well. If the Finance Agency requires us to offer a similar refinancing option for our investments in mortgage loans, our income from those investments could decline.

Further, settlements announced in 2013 and 2012 with the banking regulators, the federal government and the nation’s largest mortgage servicers and states’ attorneys general are also likely to focus on loan modifications and principal writedowns. In late January, 2013 the Treasury department announced that it is expanding refinancing programs for homeowners whose mortgages are greater than their home value to include mortgages underlying private-label MBS. These programs, proposals and settlements could ultimately impact investments in MBS, including the timing and amount of cash flows we realize from those investments. We monitor these developments and assess the potential impact of relevant developments on investments, including private-label MBS as well as on our securities and loan collateral and on the creditworthiness of any members that could be impacted by these issues. We continue to update models, including the models we use to analyze investments in private-label MBS, based on these types of developments. Additional developments could result in further increases to loss projections from these investments.

Additionally, these developments could result in a significant number of prepayments on mortgage loans underlying investments in Agency MBS. If that should occur, these investments would be paid off in advance of original expectations subjecting us to resulting premium acceleration and reinvestment risk.

 
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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 website at www.sec.gov. Additionally, on our website at www.fhlbtopeka.com, you can find a link to the SEC’s website 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 since 2008 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 has 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. Such regulatory actions also have the potential to impact the costs of certain transactions between us and our members.

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.

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.

 
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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 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. 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 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. 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 in-district state HFAs and one out-of-district HFA 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.
 
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 GSEs and the public perception that the FHLBank System would be likely to receive U.S. government support in the event of a crisis. The U.S. government’s fiscal challenges, including the debt ceiling, sequestration and budgeting could impact the credit standing or credit rating of the U.S. government, which could in turn 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 or more 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 Aaa with a negative outlook by Moody’s while 11 of the FHLBanks are rated AA+ with a negative outlook and one of the FHLBanks is rated AA with a negative outlook by S&P. 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, which may negatively affect our cost of funds and our ability to issue consolidated obligations for our benefit.

 
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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 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 increases.
 
The yield on or value of our MBS/ABS investments may be adversely affected by increased delinquency rates and credit losses related to mortgage loans that back our MBS/ABS 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. Although residential property values started to increase or at least stabilize in mid-2012, residential property values in many states declined over the previous five years 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/ABS investments. Furthermore, market illiquidity has, from time to time, increased the amount of management judgment required to value private-label MBS/ABS and certain other securities. Subsequent valuations may result in significant changes in the value of private-label MBS/ABS 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.
 
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.
 
 
23

 
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/ABS 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.
 
Default by a derivatives clearinghouse on its obligations could adversely affect our results of operations or financial condition. The Dodd-Frank Act and implementing CFTC regulations will require all clearable derivatives transactions to be cleared through a derivatives clearinghouse. As a result of such statutes and regulations, we will be required to centralize our risk with the derivatives clearinghouse as opposed to the pre-Dodd-Frank Act methods of entering into derivatives transactions which allowed us to distribute our risk among various counterparties. The default by a derivatives clearinghouse could adversely affect our financial condition in the event we are owed money by the derivatives clearinghouse and jeopardizing the effectiveness of derivatives hedging transactions, and could adversely affect our operations as we may be unable to enter into certain derivatives transactions or unable to enter into such transactions at cost-effective rates.
 
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 or other transactions. 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.
 
 
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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 primarily 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) and to a much lesser degree 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. 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. If key technology platforms become obsolete, or if we experience disruptions, including difficulties in our ability to process transactions, our revenue or results of operations could be materially adversely affected. 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. Additionally, a failure in or breach of our operational or security systems or infrastructure, or those of third parties with which we do business, including as a result of cyber attacks, could disrupt our business and result in the disclosure or misuse of confidential or proprietary information. While we have implemented disaster recovery, business continuity and legacy software reduction 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. A failure to maintain current technology, systems and facilities or an operational 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 and credit 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.
 
 
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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 FHLBank of Chicago. In its role as MPF Provider, 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 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 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, 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 13, 2013, we had 826 stockholders of record and 5,188,471 shares of Class A Common Stock and 8,394,691 shares of Class B Common Stock outstanding, including 47,875 shares of Class A Common Stock and 3,000 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, 2012 and 2011, 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
 
12/31/2012
    0.25 %   $ 40     $ 261     $ 301       3.50 %   $ 30     $ 7,694     $ 7,724  
09/30/2012
    0.25       42       251       293       3.50       31       7,564       7,595  
06/30/2012
    0.25       43       300       343       3.50       29       7,113       7,142  
03/31/2012
    0.25       41       314       355       3.50       29       6,708       6,737  
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  
                   
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 2012 and 2011, 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 2013. 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 2012 was 0.25 percent per annum, well above short-term interest rates such as overnight Federal funds (average of 0.14 percent for 2012), 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.
 
 
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Table 8
 
Selected Financial Data (dollar amounts in thousands):
 
   
12/31/2012
   
12/31/2011
   
12/31/2010
   
12/31/2009
   
12/31/2008
 
Statement of Condition (as of year end)
                             
Total assets
  $ 33,818,627     $ 33,190,182     $ 38,706,067     $ 42,631,611     $ 58,556,231  
Investments1
    10,774,411       10,576,537       14,845,941       16,347,941       19,435,809  
Advances
    16,573,348       17,394,399       19,368,329       22,253,629       35,819,674  
Mortgage loans, net2
    5,940,517       4,933,332       4,293,431       3,333,784       3,023,805  
Deposits
    1,181,957       997,371       1,209,952       1,068,757       1,703,531  
Consolidated obligation discount notes, net3
    8,669,059       10,251,108       13,704,542       11,586,835       26,261,411  
Consolidated obligation bonds, net3
    21,973,902       19,894,483       21,521,435       27,524,799       27,421,634  
Total consolidated obligations, net3
    30,642,961       30,145,591       35,225,977       39,111,634       53,683,045  
Mandatorily redeemable capital stock
    5,665       8,369       19,550       22,437       34,806  
Capital stock
    1,264,456       1,327,827       1,454,396       1,602,696       2,240,335  
Total retained earnings
    481,282       401,461       351,754       355,075       156,922  
Accumulated other comprehensive income (loss)
    (25,257 )     (27,841 )     (22,672 )     (11,861 )     (2,012 )
Total capital
    1,720,481       1,701,447       1,783,478       1,945,910       2,395,245  
                                         
Statement of Income (for the year ended)
                                       
Net interest income
    219,680       230,926       249,876       259,011       247,287  
Provision for credit losses on mortgage loans
    2,496       1,058       1,582       1,254       196  
Other income (loss)
    (42,916 )     (78,328 )     (154,694 )     108,021       (168,312 )
Other expenses
    51,696       53,781       47,899       43,586       40,002  
Income before assessments
    122,572       97,759       45,701       322,192       38,777  
Assessments
    12,261       20,433       12,153       85,521       10,338  
Net income
    110,311       77,326       33,548       236,671       28,439  
                                         
Ratios and Other Financial Data
                                       
Dividends paid in cash4
    285       362       316       367       345  
Dividends paid in stock4
    30,205       27,257       36,553       41,500       79,935  
Weighted average dividend rate5
    2.26 %     1.99 %     2.36 %     2.29 %     3.64 %
Dividend payout ratio6
    27.64 %     35.72 %     109.90 %     17.69 %     282.29 %
Return on average equity
    6.23 %     4.43 %     1.79 %     11.24 %     1.17 %
Return on average assets
    0.32 %     0.21 %     0.08 %     0.48 %     0.05 %
Average equity to average assets
    5.13 %     4.73 %     4.46 %     4.31 %     4.15 %
Net interest margin7
    0.64 %     0.63 %     0.60 %     0.53 %     0.43 %
Total capital ratio8
    5.09 %     5.13 %     4.61 %     4.56 %     4.09 %
Regulatory capital ratio9
    5.18 %     5.24 %     4.72 %     4.64 %     4.15 %
Ratio of earnings to fixed charges10
    1.45       1.31       1.12       1.56       1.02  
                   
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 $5,416,000, $3,473,000, $2,911,000, $1,897,000 and $884,000 as of December 31, 2012, 2011, 2010, 2009 and 2008, respectively.
3
Consolidated obligations are bonds and discount notes that we are primarily liable to repay. See Note 10 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 $41,000, $174,000, $346,000, $504,000 and $609,000 for the years ended December 31, 2012, 2011, 2010, 2009 and 2008, 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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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 limited other financial services to our member 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 if a member’s advances or mortgage loan balances decline. We believe it is important to manage our business and the associated risks so that we can always meet the following objectives: (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 through other products; (2) repurchase excess capital stock in order to appropriately manage the size of our balance sheet; and (3) pay appropriate dividends.
 
Net income (loss) for the year ended December 31, 2012 was $110.3 million compared to $77.3 million for the year ended December 31, 2011. The increase was primarily attributable to the following:
§
$11.2 million decrease in net interest income (decrease income);
§
$48.8 million decrease related to net gain (loss) on trading securities (decrease income);
§
$87.3 million increase related to net gain (loss) on derivatives and hedging activities (increase in income);
§  
$3.1 million decrease in net other-than-temporary impairment losses on held-to-maturity securities (increase in income);
§  
$4.4 million decrease related to net gain (loss) on mortgage loans held for sale (decrease income);
§
$2.1 million decrease in other expenses (increase income); and
§
$8.2 million decrease in assessments (increase income).
 
The smaller net loss on derivatives and hedging activities for 2012 is primarily the result of a smaller relative decline in interest rates and steepness of the yield curve in 2012 compared to 2011. The market value of our trading securities portfolio decreased in value in 2012 compared to 2011. Net interest income, which does not include market value fluctuations, has primarily declined as a result of a smaller average balance sheet over the periods since net interest margin increased at the same time. Detailed discussion relating to the fluctuations in net gain (loss) on derivatives and hedging activities, net gain (loss) on trading securities and net interest income can be found under this Item 7 – “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Results of Operations.” For additional information relating to OTTI, see Item 7 – “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Financial Condition – Investments.” For additional information relating to the 2011 net gain (loss) on mortgage loans held for sale, see Note 6 of the Notes to the Financial Statements under Item 8. The decrease in other expenses and the decrease in total assessments, which is related to the satisfaction of our REFCORP obligation in June 2011, are discussed in this Item 7 – “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Results of Operations.”

Total assets increased by less than two percent from December 31, 2011 to December 31, 2012 but had several compositional changes. We experienced a significant increase in the amount of mortgage loans outstanding in 2012. The primary factors impacting the growth in mortgage loans include: (1) the increased number of new and delivering PFIs; (2) the mortgage loan origination volume of current PFIs; (3) refinancing activity; (4) the level of interest rates and the shape of the yield curve; and (5) the relative competitiveness of the MPF Program compared to other purchasers of mortgage loans. Advance balances declined, with a majority of the decline due to net pay downs by large borrowers, particularly insurance company borrowers. Among specific advance products, the balance on line of credit borrowings increased significantly from December 31, 2011 to December 31, 2012, which partially offset significant declines in balances of other advance products over the same period. Although investment balances (see Table 8) did not change much between December 31, 2012 and 2011, the composition of the investments did change. As of December 31, 2012, we had significant balances in secured reverse repurchase agreements backed by high quality collateral; however, we had no reverse repurchase agreements outstanding as of December 31, 2011. We decreased our investments in Federal funds sold, marketable certificates of deposit and commercial paper to further reduce exposure to unsecured investments with counterparties in Europe and with those having credit ratings below certain thresholds. The total balance of MBS increased slightly during 2012 as we attempted to maintain balances at approximately 300 percent of regulatory capital. For additional information relating to changes in investment balances, see Item 7 – “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Financial Condition – Investments.”

 
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Over the last two years, total average assets decreased $2.4 billion, or 6.4 percent, from 2011 to 2012. This reduction in average assets was due to a strategic decision near the end of 2011 to reduce our allocation of unsecured money market investments and slightly de-lever the balance sheet.

On the liability side of the balance sheet, from December 31, 2011 to December 31, 2012, consolidated obligation bonds and member deposits increased and consolidated obligation discount notes decreased. The increase in bonds, both in absolute dollars and as a percentage of total consolidated obligations, was primarily due to increased issuance of unswapped callable bonds used to fund the growth in our fixed rate mortgage assets. We also increased our use of non-callable floating rate bonds to enhance our liquidity position in response to potential market disruptions related to Congressional fiscal cliff and debt ceiling debates. This desire to lengthen the maturity of our liabilities was also the primary reason discount notes decreased both in absolute dollars and as a percentage of total consolidated obligations from December 31, 2011 to December 31, 2012.
 
The increase in our weighted average dividend rate paid during 2012 compared to 2011 can be attributed to the combination of a dividend rate change in the middle of 2011 and a change in the capital requirements in 2012. In September 2011, we lowered the dividend rate on Class A shares by 15 bps and increased the dividend rate on Class B Common Stock by 50 bps as a way to better compensate the users of our products. The average dividend rate was also affected by a reduction in the membership stock requirement initiated in mid-2012 which resulted in the issuance of additional Class B Common Stock to members to replace the excess membership Class A Common Stock created by the reduced requirement and previously used to support their advance and mortgage loan activity (Class A Common Stock up to the amount of a member’s membership stock purchase requirement can be used to support advance and mortgage loan activity, but excess Class A Common Stock cannot).
 
Financial Market Trends
The primary external factors that affect net interest income are market interest rates and the general state of the economy.

General discussion of the level of market interest rates:
Table 9 presents selected market interest rates as of the dates or for the periods shown.
 
Table 9
 
Market Instrument
 
Average Rate
for 2012
   
Average Rate
for 2011
   
December 31, 2012
Ending Rate
   
December 31, 2011
Ending Rate
 
Overnight Federal funds effective/target rate1
    0.14 %     0.10 %  
0.0 to 0.25
 %  
0.0 to 0.25
 %
Federal Open Market Committee (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
    0.08       0.05       0.02       0.01  
Three-month LIBOR1
    0.43       0.34       0.31       0.58  
Two-year U.S. Treasury note1
    0.27       0.44       0.25       0.25  
Five-year U.S. Treasury note1
    0.75       1.51       0.71       0.85  
Ten-year U.S. Treasury note1
    1.78       2.76       1.74       1.88  
30-year residential mortgage note rate2
    3.84       4.53       3.52       4.07  
                   
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 January 30, 2013 meeting, the FOMC reaffirmed the significant accommodation that it announced in September and December 2012 that it will “...continue purchasing additional agency mortgage-backed securities at a pace of $40 billion per month and longer-term Treasury securities at a pace of $45 billion per month.” The FOMC believes that these actions, including continuing its policies of reinvesting principal payments from its agency debt and agency MBS into agency MBS and rolling over maturing U.S. Treasury securities at auction, will “...maintain downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative.” The January 2013 statement also reiterated the open-ended nature of its accommodation, initially added in the September 2012 statement, that if the outlook for labor market does not “improve substantially” it will continue “...purchases of Treasury and agency mortgage-backed securities, and employ its other policy tools as appropriate, until such improvement is achieved in a context of price stability.” At the January 30, 2013 meeting, the Committee also maintained the Federal funds target rate at a range of zero to 0.25 percent and stated that it anticipated that this range “...will be appropriate at least as long as the unemployment rate remains above 6.5 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be anchored.” In its December 2012 assessments of appropriate monetary policy, 14 of the 19 FOMC participants judged that the appropriate time for increasing the target rate was 2015 or greater. The majority of the participants believed that over the longer run four percent or greater was the appropriate level for the target Federal funds rate.

The daily average of three-month LIBOR increased from 2011 to 2012, primarily in response to the European debt crisis which began in the spring of 2010 but became more acute in the fall of 2011and persisted through the spring and summer of 2012. Three-month LIBOR peaked on January 5, 2012 at 0.5825 percent and began declining gradually throughout the year in response to actions taken by the European Central Bank (ECB) and the International Monetary Fund (IMF) to address the crisis. The decline in three-month LIBOR accelerated in the summer of 2012 declining from 0.4606 percent on June 30, 2012 to 0.3060 percent on December 31, 2012 with most of the declines occurring through October 2012. The daily average one-month LIBOR also increased slightly from 2011 to 2012 for the same reasons. 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 impact net interest income. While other short-term rates such as those for U.S. Treasury bills, repo rates and our consolidated obligation discount notes have remained relatively low throughout most of 2012, they did increase from the end of 2011 likely due, in part, to the impact of sales of shorter-term U.S. Treasuries under the FOMC’s maturity extension program (“Operation Twist”).

 
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Both long and short-term U.S. Treasury rates have been significantly influenced by Federal Reserve policy over the last several years. In November 2010, the Federal Reserve initiated a second round of quantitative easing by announcing that it would expand its holding of longer-term securities by purchasing an additional $600 billion in long-term U.S. Treasury securities which was completed as scheduled in June 2011. In September 2011, the Federal Reserve announced additional measures by introducing Operation Twist by which it would extend the average maturity of its holdings of securities. As mentioned above, while still relatively low, short-term U.S. Treasury rates out to, and including, the one-year point of the curve increased in 2012 from the extremely low levels at the end of 2011 likely reflecting increased supply and the impact of sales of shorter-term U.S. Treasuries from the FOMC’s Operation Twist. The portion of the U.S. Treasury rate curve beyond one year declined from December 30, 2011 to December 31, 2012. In general longer-term U.S. Treasury rates increased in the first quarter of 2012 before falling significantly through the end of July 2012. Rates moved higher from these lows but generally stayed relatively low for the remainder of 2012. For some portions of the yield curve, the shape of the yield curve flattened from December 31, 2011 to December 31, 2012. During this period of time, the spread between the two-year U.S. Treasury note and the 10-year U.S. Treasury note decreased by 13.6 bps likely reflecting the market’s cautious outlook for economic growth and employment for much of 2012 and the impact of additional monetary actions taken by the FOMC and potential for additional monetary actions in the future. However, over the same period, the spread between the two-year U.S. Treasury note and the 30-year U.S. Treasury bond increased 4.2 bps as improving economic data resulted in increasing rates in the latter part of 2012. 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 advances to our members.

Other factors impacting FHLBank consolidated obligations:
Investors continue to view short-term FHLBank consolidated obligations as carrying a relatively strong credit profile, even after the ratings downgrade by S&P in August 2011. This has resulted in steady investor demand for FHLBank discount notes and short-term bonds. Because of this demand and other factors (some of which are listed below), the overall cost to issue short-term consolidated obligations remained low throughout 2012. However, while remaining relatively low, yields on discount notes increased from December 31, 2011 to December 31, 2012 likely because of an increase in supply of competing instruments, such as U.S. Treasury bills, repurchase agreements and short-term U.S. Treasury securities sold as a part of Operation Twist, and as a result of higher rates on these alternative short-term investments, despite mixed economic data and continuing, although lessened, concerns about the European sovereign debt crisis. Several factors might result in lower short-term rates in 2013, including discount notes, such as the expiration of the Transaction Account Guarantee (TAG) program (unlimited deposit insurance on non-interest bearing checking accounts) program on December 31, 2012, the end of the sales of short-term U.S. Treasuries from Operation Twist, and the FOMC commitments to keep rates “exceptionally low” and continue unsterilized asset purchases until the job market improves significantly. The expiration of Operation Twist sales might result in lower short-term rates as the supply of U.S. Treasury securities in the market declines, capacity on dealer balance sheets that was dedicated to purchases of Operation Twist securities is freed up making room for purchases of other investments, like discount notes, and repurchase agreement rates might decline due to the reduction of net supply of U.S. Treasury securities from the market, increasing demand for alternative investments, like FHLBank discount notes or other short-term consolidated obligations. The expiration of the TAG program could result in a significant amount of money moving from commercial bank deposits into money market funds or direct investments resulting in an increase in demand for discount notes or other short-term consolidated obligations.

Indicative spreads of fixed rate, non-callable FHLBank debt relative to similar term U.S. Treasury instruments have decreased from December 31, 2011 to December 31, 2012 for maturities greater than one year. For example, the spread between the on-the-run FHLBank two-year bullet debenture and the two-year U.S. Treasury note decreased from 15.0 bps on December 31, 2011 to 5.5 bps on December 31, 2012. The spread between the on-the-run FHLBank five-year bullet debenture and the five-year U.S. Treasury note decreased from 28.2 bps on December 31, 2011 to 11.5 bps as of December 31, 2012. Indicative FHLBank three-month lockout callable bond spreads to U.S. Treasuries for all tenors two years and greater decreased significantly from December 30, 2011 to December 31, 2012, which suggests improved investor demand for these structures over the period. We fund a large portion of our fixed rate mortgage assets and some fixed rate 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.” Likely an important factor in the improved spreads to U.S. Treasuries for non-callable and callable fixed rate bonds was FOMC accommodation throughout 2012 and particularly its actions announced in its September and December meetings (see previous discussion). In response to these actions, demand for investments with yields higher than U.S. Treasuries likely increased as investors were anticipating low yields for a longer period of time.

The spreads on FHLBank fixed rate, non-callable debentures relative to the LIBOR swap curve deteriorated notably for all maturities out to seven years from December 31, 2011 to December 31, 2012 while spreads relative to LIBOR for maturities greater than seven years improved over the same period of time. An important factor in the deterioration of some of the theoretical spreads relative to LIBOR was the narrowing of market spreads between the LIBOR swap curve and our debt likely in response to easing concerns about the European sovereign debt crisis primarily in the second half of 2012. The theoretical swap level of the on-the-run FHLBank two-year bullet deteriorated significantly from three-month LIBOR minus 32.0 bps on December 31, 2011 to three-month LIBOR minus 7.4 bps on December 31, 2012. The theoretical swap level of the on-the-run FHLBank five-year bullet also deteriorated from three-month LIBOR minus 9.1 bps on December 31, 2011 to three-month LIBOR plus 1.6 bps on December 31, 2012. Because we issue a large amount of liabilities swapped to both one-month and three-month LIBOR, the deterioration in these spreads indicate deterioration in our funding costs for structures indexed or swapped to LIBOR. In 2012, we substantially increased our issuance of longer-term swapped and, to a lesser extent, unswapped, non-callable floating rate bonds in anticipation of future maturities of swapped liabilities and to increase our liquidity position in anticipation of potential year-end financial market disruptions resulting from the “fiscal cliff” and possible disruptions in early 2013 from political events around the increase of the debt ceiling. For additional information, see Item 7 – “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Financial Condition – Consolidate Obligations.” Many of the concerns over the impact of the fiscal cliff were addressed and eliminated in the American Taxpayer Relief Act of 2012 that was signed by President Obama on January 2, 2013. Additionally, the statutory debt ceiling was temporarily suspended for three months in early February 2013 which, according to some estimates, will allow issuance of U.S. Treasury securities until the summer of 2013. However, in addition to another debt ceiling debate later in 2013, there are several events in 2013 that could result in disruptions in financial markets and/or the economy including spending sequestration and the expiration of continuing budget resolution.

 
32

 
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 26, 2012 from the week ended December 28, 2011. Foreign investor holdings of U.S. Treasury securities increased significantly over the same periods. 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 Agency debt, excluding floating rate notes, and the percentage of total money market fund assets allocated to this category declined overall in 2012, but increased notably in the fourth quarter of 2012 likely reflecting the expiration of the FDIC’s TAG program on December 31, 2012. Taxable money market fund holdings of FHLBank debt increased in 2012 and ended 2012 at its highest levels of the year. On November 19, 2012, the FSOC released for public comment money market reform proposals which include significant changes to money market funds and include capital buffers, redemption limits and floating net asset value proposals. Public comments on the proposals were due on February 15, 2013. Because money market funds are such a large and important investor base for FHLBank consolidated obligations, typically short-term obligations, including discount notes, variable rate consolidated obligation bonds and short-term consolidated obligation bonds, changes in demand from money market funds for these consolidated obligations or changes to the overall structure of money market funds could result in changes in costs to issue our short-term consolidated obligations which will typically impact the cost of advances for our members.

Economic and other factors potentially impacting net interest income:
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 8 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 2013. Additional downgrades could increase the likelihood and/or the severity of the impacts detailed above.

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.
 
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 hedge 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 hedge 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.
 
 
33

 
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, 2012 and 2011, we held a portfolio of derivatives that are marked to market with no offsetting qualifying hedged item. This portfolio of economic hedges consisted primarily of: (1) fixed rate non-MBS trading investments; (2) adjustable rate MBS with embedded caps; and (3) variable rate consolidated obligation bonds. 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. See Tables 70 and 71 under Item 7A: Quantitative and Qualitative Disclosures About Market Risk, which present the notional amount and fair value amount (fair value includes net accrued interest receivable or payable on the derivative) for derivative instruments by hedged item, hedging instrument, hedging objective and accounting designation. The total par value of trading securities related to economic hedges was $1.0 billion as of December 31, 2012, 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 fixed rate 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
 
Fair Value: As of December 31, 2012 and 2011, 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 Comprehensive Income, Statements of Capital and Statements of Cash Flows as well as risk-based capital, duration of equity (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.
 
We made a change in market observable inputs used to value our derivatives at December 31, 2012. Prior to December 31, 2012, the FHLBank utilized the LIBOR Swap Curve to estimate the fair value of its interest-related derivatives. During the fourth quarter of 2012, the FHLBank observed an increasing trend in the use of the Overnight Indexed Swap (OIS) Curve by other market participants to value collateralized derivative contracts. The FHLBank performed an assessment of market participants and determined the OIS Curve was the appropriate curve to be used for valuation of its collateralized interest rate derivatives. As such, effective December 31, 2012, the FHLBank utilized the OIS Curve to estimate the fair value of its interest-related derivatives.

As of December 31, 2012, 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 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 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 that occurred from 2007 through mid-2012 and difficult conditions in the credit markets for the early part of that period, 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.
 
 
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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 4 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.
 
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 recent disruption in the financial market, tight credit and declining home prices, consumer mortgage refinancing behavior has also been 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.
 
 
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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 traditional 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.
 
For additional information regarding allowances for credit losses, see Note 7 of the Notes to Financial Statements included under Item 8 – “Financial Statements and Supplementary Data.”

Results of Operations (Years Ended December 31, 2012, 2011 and 2010)
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 2011 to 2012 can primarily be attributed to a decrease in average interest-earning assets along with a slight deterioration in our net interest spread. Interest income on advances declined as a result of both lower average advance balances and average rate. The impact on interest income from the growth in the size of the mortgage loan portfolio, both nominally and relative to other assets, was offset by a decline in the average rate on this portfolio as borrowers refinanced their mortgages in order to take advantage of lower average residential mortgage rates experienced throughout much of 2012 and from the growth in balances with new mortgage loans placed into our portfolio at average rates below existing mortgage loans in the portfolio. Interest income on our total investment portfolio, which consists of interest-bearing deposits, Federal funds sold, reverse repurchase agreements and investment securities decreased due to compositional changes in the portfolio. 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 it with lower cost callable and/or bullet debt. Consequently, our 2012 interest expense declined as a result of both a decrease in the average balances and a decrease in average rate. See Tables 13 and 14 for further information.
 
Although net interest income decreased during 2011 and 2012, due primarily to a shrinking balance sheet, falling interest rates and asset mix changes, net income has improved in both years due to significant changes in the market value of various derivatives. See “Net Gain (Loss) on Derivative and Hedging Activities” 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.

 
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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 is equivalent to an effective minimum income tax rate of 10 percent); (2) market value changes on derivatives (excludes net interest settlements related to derivatives not qualifying for hedge accounting); 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 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, ROE based on GAAP income and ROE spread based on GAAP income, which can vary significantly from period to period because of market value changes on derivatives 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 of a purchased cap if held to maturity.

In addition to impacting the timing of income and expense from derivatives, derivative accounting also impacts the presentation of net interest settlements on derivatives and hedging activities. This presentation differs under GAAP for economic hedges compared to hedges that qualify for hedge accounting. Net interest settlements on economic hedges are included with the market value changes and recorded in net gain (loss) on derivatives and hedging activities while the net interest settlements on qualifying fair value or cash flow hedges are included in net interest margin. Therefore, only the market value changes included in the net gain (loss) on derivatives and hedging activities are removed to arrive at adjusted income (i.e., net interest settlements on economic hedges, which represent actual cash inflows or outflows and do not create market value volatility, are not removed).

Table 10 presents a reconciliation of GAAP income to adjusted income for the years ended December 31, 2012, 2011 and 2010 (in thousands):

Table 10
 
   
2012
   
2011
   
2010
 
Net income, as reported under GAAP
  $ 110,311     $ 77,326     $ 33,548  
Total assessments
    12,261       20,433       12,153  
Income before assessments
    122,572       97,759       45,701  
Derivative-related and other excluded items1
    7,824       32,079       92,502  
Adjusted income (a non-GAAP measure)2
  $ 130,396     $ 129,838     $ 138,203  
                   
1
Consists of market value changes on derivatives (excludes net interest settlements on derivatives not qualifying for hedge accounting) and trading securities as well as prepayment fees on terminated advances and net gain (loss) on mortgage loans held for sale.
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.
 
Table 11 presents adjusted ROE (a non-GAAP measure) 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
 
   
2012
   
2011
   
2010
 
Average GAAP total capital for the period
  $ 1,771,641     $ 1,745,252     $ 1,873,427  
ROE, based upon GAAP net income
    6.23 %     4.43 %     1.79 %
Adjusted ROE, based upon adjusted income1
    7.36 %     7.44 %     7.38 %
Average overnight Federal funds effective rate
    0.14 %     0.10 %     0.18 %
Adjusted ROE as a spread to average Federal funds rate1
    7.22 %     7.34 %     7.20 %
                   
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.
 
 
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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
   
   
2012 vs. 2011
   
2011 vs. 2010
   
2012 vs. 2011
   
2011 vs. 2010
   
Total interest income
  $ (51,704 )   $ (83,524 )     (9.5 )%     (13.3 )%
Total interest expense
    (40,458 )     (64,574 )     (12.8 )     (17.0 )
Net interest income
    (11,246 )     (18,950 )     (4.9 )     (7.6 )
Provision for credit losses on mortgage loans
    1,438       (524 )     135.9       (33.1 )
Net interest income after mortgage loan loss provision
    (12,684 )     (18,426 )     (5.5 )     (7.4 )
Net gain (loss) on trading securities
    (48,820 )     6,347       (235.0 )     44.0  
Net gain (loss) on derivatives and hedging activities
    87,265       65,931       80.2       37.7  
Other non-interest income
    (3,033 )     4,088       (31.5 )     73.6  
Total non-interest income (loss)
    35,412       76,366       45.2       49.4  
Operating expenses
    (364 )     2,252       (0.9 )     5.6  
Other non-interest expense
    (1,721 )     3,630       (15.2 )     47.2  
Total other expense
    (2,085 )     5,882       (3.9 )     12.3  
AHP assessments
    3,650       4,845       42.4       128.7  
REFCORP assessments
    (11,822 )     3,435       (100.0 )     41.0  
Total assessments
    (8,172 )     8,280       (40.0 )     68.1  
NET INCOME
  $ 32,985     $ 43,778       42.7 %     130.5 %
 
Net Interest Income: Net interest income decreased from 2011 to 2012, primarily as a result of a decrease in average interest-earning assets as well as a slight deterioration in our net interest spread. Despite the small decrease in net interest spread, our net interest margin, which is net interest income as a percentage of average interest-earning assets, increased slightly as a result of an increase in retained earnings and non-interest bearing liabilities, which has the effect of increasing net interest income relative to interest-earning assets. Despite the slight decrease in net interest spread and slight improvement in net interest margin in 2012, both of these measures improved since 2010. Some key factors in the improvement or stability in our net interest margin and net interest spread since 2010, were: (1) improvements in the funding cost of bonds and deposits; (2) active management of the debt used to fund long-term assets by calling higher cost callable debt and replacing with lower cost callable and/or bullet debt; and (3) an increase in the proportion of higher earning assets, including mortgage loans and advances, to total average interest-earning assets as short-term money market investments, on average, declined. Some key factors in the small decline in our net interest spread for the year ending December 31, 2012 were: (1) lower yields on average earning assets as declining average yields on mortgage loans and advances more than offset the higher average yields on Federal funds sold, securities purchased under agreements to resell and investment securities; and (2) a smaller decline in the average yield of interest-bearing liabilities relative to the decline in the average yield on interest-earning assets. Over the last several years, active management of our debt has been an important factor in the improvements in and stability of our net interest spread and margin. However if we stay in the current historically low interest rate environment for a prolonged period of time, it is unlikely that we will be able to maintain this trend of refinancing our debt costs faster than the decline in mortgage yields, which could result in a lower net interest spread and margin in the future.

The average yields on advances decreased from 2011 to 2012 (see Table 13). The average advance yield is impacted by the interplay between advance product pricing, product mix changes, interest rate changes and changes in the average maturity of various advances. In 2012, an important compositional change pushing overall advance portfolio yields lower was an increase in line of credit advances, which are typically lower yielding advances, as a percentage of the total 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.

Our investment portfolio is comprised of interest-bearing deposits, Federal funds sold, reverse repurchase agreements and investment securities. The average yield on each of these components in our investment portfolio increased in 2012 relative to 2011, with the increase in the yield on our investment securities primarily due to compositional changes in this portfolio. The compositional change was the result of management’s decision to reduce non-MBS investments as a percentage of total assets which had the effect of increasing the balances of higher yielding longer term investments, both fixed and variable rate, as a percentage of the total investment securities portfolio. The resulting higher yields from the compositional changes were at least partially offset by the impact of prepayments of higher rate MBS/CMOs (higher fixed rates plus higher spreads over LIBOR) and the acquisition of new lower rate MBS/CMOs (lower spreads over LIBOR plus lower fixed rates).

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. As a result, the balances of these higher yielding MBS/CMOs remained elevated relative to capital throughout 2011. We did not purchase any additional MBS until February 2012. Since mid-2006, and prior to this year, our primary MBS investment strategy focused more on variable rate Agency MBS/CMOs because we believed they generally had a higher overall risk-adjusted return relative to our cost of funds than comparable fixed rate MBS. Many of these floating-rate securities have coupons that are capped at certain levels, and we have generally purchased interest rate caps to offset some of this risk. 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 mortgage loan portfolio declined notably during 2012 compared to 2011 (see Table 13) due to several factors including: (1) borrowers refinancing their mortgages in order to take advantage of lower average residential mortgage rates; (2) the growth in mortgage loan 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. Although the growth of this portfolio appears to be slowing in recent months, we expect the portfolio yield to continue to decline for the next several quarters due to these factors.

The average rate paid on all deposits decreased from 2011 to 2012 (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 low interest rate environment at the time (and which has continued), 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, thus contributing to the decrease from 2011 to 2012 in the average rate paid on all deposits.

The average yield on consolidated obligation discount notes increased slightly from 2011 to 2012 (see Table 13). An important factor pushing discount note yields higher for 2012 when compared to 2011 was the sale of short-term U.S. Treasury securities as a part of the FOMC’s maturity extension program. The maturity extension program, commonly referred to as Operation Twist, offset factors that resulted in lower average yields on discount notes in the first part of 2012, including the flight-to-quality demand for Agency discount notes in response to the European debt crisis and other geopolitical events that occurred or carried over into the fourth quarter of 2011. Many of the discount notes issued during this period of low rates had maturity dates throughout the first half of 2012. Because the U.S. government and FOMC programs that were likely a factor in pushing short-term rates higher expired on December 31, 2012 (Operation Twist and TAG), we anticipate that average yields on discount notes could actually decline in 2013.

The average yield on bonds declined from 2011 to 2012 (see Table 13). Some important factors in the decline in consolidated obligation bond yields were: (1) generally lower intermediate and longer-term term market interest rates; and (2) our ability to refinance a large portion of our longer-term unswapped callable bonds.

As discussed above, during 2011 and 2012 we were able to lower our long-term consolidated obligation funding costs by calling previously issued callable debt and replacing it with new lower-cost debt with similar characteristics. Replacing this debt usually increases costs in the short term due to the acceleration of unamortized concessions on the debt when it is called because we amortize concession costs to contractual maturity. However, this increase is offset by the lower rate on the debt and by funding benefits from timing differences between the date the debt is called and the settlement date of the new debt. We use unswapped callable debt with short lockouts (primarily three months to one year) as a primary funding tool for long-term amortizing assets. This provided us with the opportunity to take advantage of lower debt costs at various times during 2012. We also increased the size of our portfolio of unswapped callable bonds in 2012 from $4.4 billion as of December 31, 2011 to $5.3 billion as of December 31, 2012, which because of lower interest rates during 2012 than interest rates on the existing funding portfolio, also decreased the cost of consolidated obligation bonds from 2011 to 2012. The biggest reason why our portfolio of callable bonds increased was because of the increase in our mortgage loan portfolio. Callable bonds are an effective instrument for funding fixed rate mortgage-related assets because they provide a way to effectively manage the prepayment risk on these assets. This is especially true for callable bonds with short lockouts because they allow us to react quickly to mortgage prepayments attributable to a drop in interest rates. 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.”

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 at historical cost. 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 hedging adjustments on advances exceeded those on consolidated obligations over the last three years. Therefore, the average net interest spread has been negatively affected by the hedging 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 instead of 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 to a variable rate.

As explained in more detail in Item 7A – “Quantitative and Qualitative Disclosure About Market Risk – Interest Rate Risk Management – Duration of Equity,” our DOE remains within both the RMP limits and the operating rates and continues to remain 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
 
   
12/31/2012
   
12/31/2011
   
12/31/2010
 
   
Average
Balance
   
Interest
Income/
Expense
   
Yield
   
Average
Balance
   
Interest
Income/
Expense
   
Yield
   
Average
Balance
   
Interest
Income/
Expense
   
Yield
 
Interest-earning assets:
                                                     
Interest-bearing deposits
  $ 353,494     $ 513       0.15 %   $ 206,898     $ 204       0.10 %   $ 122,380     $ 230       0.19 %
Federal funds sold and securities purchased under agreements to resell
    2,226,596       4,027       0.18       1,928,804       2,219       0.12       2,519,690       4,826       0.19  
Investment securities1
    8,880,851       139,488       1.57       11,912,420       180,482       1.52       14,331,632       239,107       1.67  
Advances2,3
    17,348,927       154,560       0.89       17,847,711       165,514       0.93       21,179,801       209,453       0.99  
Mortgage loans2,4,5
    5,526,009       194,363       3.52       4,612,061       195,828       4.25       3,661,819       173,756       4.75  
Other interest-earning assets
    29,305       1,832       6.25       35,272       2,240       6.35       41,024       2,639       6.43  
Total earning assets
    34,365,182       494,783       1.44       36,543,166       546,487       1.50       41,856,346       630,011       1.51  
Other non interest-earning assets
    166,083                       343,859                       189,916                  
Total assets
  $ 34,531,265                     $ 36,887,025                     $ 42,046,262                  
                                                                         
Interest-bearing liabilities:
                                                                       
Deposits
  $ 1,601,019     $ 1,511       0.09 %   $ 1,951,644     $ 2,594       0.13 %   $ 1,932,023     $ 2,805       0.15 %
Consolidated obligations2:
                                                                       
Discount Notes
    9,674,078       9,237       0.10       11,051,415       9,591       0.09       13,839,192       21,017       0.15  
Bonds
    20,698,141       264,134       1.28       21,474,224       302,765       1.41       23,578,262       355,164       1.51  
Other borrowings
    13,818       221       1.60       26,022       611       2.35       41,070       1,149       2.80  
Total interest-bearing liabilities
    31,987,056       275,103       0.86       34,503,305       315,561       0.91       39,390,547       380,135       0.97  
Capital and other non-interest-bearing funds
    2,544,209                       2,383,720                       2,655,715                  
Total funding
  $ 34,531,265                     $ 36,887,025                     $ 42,046,262                  
                                                                         
Net interest income and net interest spread6
          $ 219,680       0.58 %           $ 230,926       0.59 %           $ 249,876       0.54 %
                                                                         
Net interest margin7
                    0.64 %                     0.63 %                     0.60 %
                   
1
The non-credit portion of the other-than-temporary impairment discount on held-to-maturity securities is excluded from the average balance for calculations of yield since the change runs through equity.
2
Interest income/expense and average rates include the effect of associated derivatives.
3
Advance income includes prepayment fees on terminated advances.