10-K 1 c878-20131231x10k.htm 10-K 82f7e486a9bb4e6

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C.  20549

 

FORM 10-K

 

  ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2013

 

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   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   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.   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).    Yes    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.  

 

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   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   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 03/12/2014

Class A Stock, par value $100

5,144,160

Class B Stock, par value $100

7,688,835

 

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. As of June 28, 2013, the aggregate par value of stock held by current and former members of the registrant was $1,409,911,000, and 14,099,110 total shares were outstanding as of that date.

 

Documents incorporated by reference:  None

 

 

 

1

 


 

 

.FEDERAL HOME LOAN BANK OF TOPEKA

 

TABLE OF CONTENTS

 

 

 

 

PART I 

 

5

Item 1. 

Business

5

Item 1A. 

Risk Factors

23

Item 1B. 

Unresolved Staff Comments

31

Item 2. 

Properties

32

Item 3. 

Legal Proceedings

32

Item 4. 

Mine Safety Disclosures

32

PART II 

 

32

Item 5. 

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

32

Item 6. 

Selected Financial Data

33

Item 7. 

Management’s Discussion and Analysis of Financial Condition and Results of Operations

35

Item 7A. 

Quantitative and Qualitative Disclosures About Market Risk

92

Item 8. 

Financial Statements and Supplementary Data

99

Item 9. 

Changes in and Disagreements With Accountants on Accounting and Financial Disclosure

100

Item 9A. 

Controls and Procedures

101

Item 9B. 

Other Information

101

PART III 

 

101

Item 10. 

Directors, Executive Officers and Corporate Governance

101

Item 11. 

Executive Compensation

107

Item 12. 

Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

122

Item 13. 

Certain Relationships and Related Transactions, and Director Independence

123

Item 14. 

Principal Accounting Fees and Services

125

PART IV 

 

125

Item 15. 

Exhibits, Financial Statement Schedules

125

 

 

 

2

 


 

Important Notice about Information in this Annual Report

 

In this annual report, unless the context suggests otherwise, references to the “FHLBank,” “FHLBank Topeka,” “we,” “us” and “our” mean the Federal Home Loan Bank of Topeka, and “FHLBanks” mean the 12 Federal Home Loan Banks, including the FHLBank Topeka.

 

The information contained in this annual report is accurate only as of the date of this annual report and as of the dates specified herein.

 

The product and service names used in this annual report are the property of the FHLBank, and in some cases, the other FHLBanks. Where the context suggests otherwise, the products, services and company names mentioned in this annual report are the property of their respective owners.

 

Special Cautionary Notice Regarding Forward-looking Statements

 

The information contained in this Form 10-K contains forward-looking statements within the meaning of the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements include statements describing the objectives, projections, estimates or future predictions of the FHLBank’s operations. These statements may be identified by the use of forward-looking terminology such as “anticipates,” “believes,” “may,” “is likely,” “could,” “estimate,” “expect,” “will,” “intend,” “probable,” “project,” “should,” or their negatives or other variations of these terms. The FHLBank cautions that by their nature forward-looking statements involve risk or uncertainty and that actual results may differ materially from those expressed in any forward-looking statements as a result of such risks and uncertainties, including but not limited to:

Governmental actions, including legislative, regulatory, judicial or other developments that affect the FHLBank; its members, counterparties or investors; housing government sponsored enterprises (GSE); or the FHLBank System in general;

Regulatory actions and determinations, including those resulting from the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act);

Changes in the FHLBank’s capital structure;

Changes in economic and market conditions, including conditions in the mortgage, housing and capital markets;

Changes in demand for advances or consolidated obligations of the FHLBank and/or of the FHLBank System;

Effects of derivative accounting treatment, other-than-temporary impairment (OTTI) accounting treatment and other accounting rule requirements;

The effects of amortization/accretion;

Gains/losses on derivatives or on trading investments and the ability to enter into effective derivative instruments on acceptable terms;

Volatility of market prices, interest rates and indices and the timing and volume of market activity;

Membership changes, including changes resulting from member failures or mergers, changes in the principal place of business of members or changes in the Federal Housing Finance Agency (Finance Agency) regulations on membership standards;

Our ability to declare dividends or to pay dividends at rates consistent with past practices;

Soundness of other financial institutions, including FHLBank members, nonmember borrowers, and the other FHLBanks;

Changes in the value or liquidity of collateral underlying advances to FHLBank members or nonmember borrowers or collateral pledged by reverse repurchase and derivative counterparties;

Competitive forces, including competition for loan demand, purchases of mortgage loans and access to funding;

The ability of the FHLBank to introduce new products and services to meet market demand and to manage successfully the risks associated with new products and services;

Our ability to keep pace with technological changes and the ability of the FHLBank to develop and support technology and information systems, including the ability to access the internet and internet-based systems and services, sufficient to effectively manage the risks of the FHLBank’s business;

The ability of each of the other FHLBanks to repay the principal and interest on consolidated obligations for which it is the primary obligor and with respect to which the FHLBank has joint and several liability;

Changes in the U.S. government’s long-term debt rating and the long-term credit rating of the senior unsecured debt issues of the FHLBank System;

Changes in the fair value and economic value of, impairments of, and risks associated with, the FHLBank’s investments in mortgage loans and mortgage-backed securities (MBS) or other assets and related credit enhancement (CE) protections; and

The volume 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.”

 

3

 


 

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.

 

4

 


 

PART I

 

Item 1: Business

 

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 for 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 is to ensure that the housing GSEs operate in a safe and sound manner so that they serve as a reliable source of liquidity and funding for housing finance and community investment.

 

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 2013, this asset cap was $1.1 billion.

 

Our members are required to purchase and hold 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 member’s total assets, and each member may be required to purchase activity-based capital stock as it engages in certain business activities with the FHLBank, including advances and Acquired Member Assets (AMA). 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 (January 1 for the FHLBanks) was, one of our directors or executive officers, among others. Information on business activities with related parties is provided in Tables 82 and 83 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 that our strategic business plan describes how our business activities will achieve our mission consistent with the Finance Agency’s core mission asset regulations. Consistent with our 2013 strategic business plan, we focused on increasing advances as a percent of our total assets. Our 2014-2016 strategic business plan includes a balance sheet management strategy consistent with 2013 Finance Agency guidance, to attain core mission benchmarks by the end of 2016. See Item 1A – “Risk Factors” for further information on Finance Agency-suggested benchmarks.

 

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 oversee 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.

5

 


 

 

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 rates all FHLBanks and the FHLBank System’s short-term debt issues at A-1+. S&P’s rating outlook for the FHLBank System’s senior unsecured debt and all 12 FHLBanks is stable. Moody’s has affirmed the long-term Aaa rating on the senior unsecured debt issues of the FHLBank System and the 12 FHLBanks and a short-term issuer rating of P-1, with a rating outlook of stable for senior unsecured debt.

 

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. A brief description of our standard advance product offerings is as follows:

§

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 360 months;

§

Symmetrical fixed rate advances are non-amortizing loans with terms to maturity from 94 days to 360 months, prepayable with a fee but the borrower also has the contractual ability to realize a gain from the market movement of interest rates upon prepayment (we started this product offering in February 2014); 

§

Adjustable rate advances are non-amortizing loans with terms to maturity from 4 to 180 months, which are: (1) prepayable with a 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 a 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, with terms to maturity of 12 to 360 months for fixed rate loans or terms to maturity of 4 to 180 months for variable rate loans;

§

Amortizing advances are fixed rate loans with terms to maturity of 12 to 180 months, prepayable with a 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 with terms to maturity of 12 to 180 months 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 a fee on the initial conversion date or on any interest rate reset date thereafter;

§

Forward settling advance commitments lock in the rate and term of future funding of regular fixed rate advances up to 24 months in advance; and

§

Standby credit facilities are variable rate, non-amortizing, prepayable, revolving standby credit lines that provide the ability to draw advances after normal cutoff times.

 

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 Notes 1 and 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 62 and 63 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 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.

6

 


 

 

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.

 

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, 2013 and 2012 and the interest income associated with the five borrowers with the highest interest income for the years ended December 31, 2013 and 2012.

 

Mortgage Loans

We purchase various residential 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 of 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 portfolio mortgage products, along with residential 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. MPF Program portfolio mortgage loans are considered AMAs, 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 residential 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 residential mortgage loans, whether through retail or wholesale operations, and to retain or acquire servicing of residential mortgage 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 holding residential mortgage loans in portfolio.

 

7

 


 

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 an AA-rated asset. As a part of our methodology to determine the amount of CE obligation necessary, we analyze the risk characteristics of each residential 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 MPF portfolio products involving conventional mortgage 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 conventional 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 three MPF portfolio products from which PFIs currently may choose (see Table 1). Original MPF, MPF 125, and MPF Government are closed loan products in which we purchase loans acquired or closed by the PFI. Under all of the above MPF portfolio products, the PFI performs all traditional retail loan origination functions. As mentioned above, the MPF Xtra product is essentially a loan sale from the PFI to FHLBank of 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 MPF portfolio products involving conventional mortgage 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 of Chicago serves as the MPF Provider for the MPF Program. They maintain the structure of MPF residential 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 utilize the capability under the individual FHLBank pricing option to change the pricing offered to our PFIs for all MPF products, but any changes made affect all delivery commitment terms and loan note rates in the same amount for all PFIs. The MPF Provider has engaged Wells Fargo Bank N.A. as the vendor for master servicing and as the primary custodian for the MPF Program.

 

The MPF Provider publishes and maintains the MPF Origination, Underwriting and Servicing Guides and 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 of 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. The MPF Xtra product allows our PFIs to take advantage of the differences between the risk-based capital costs associated with the credit enhancement feature on MPF portfolio 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 (UPB) of MPF loans funded since January 1, 2004.

 

8

 


 

MPF Servicing: PFIs selling residential mortgage 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 residential mortgage 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: The MPF Program has adopted ability-to-repay and safe harbor qualified mortgage requirements for all mortgages with loan application dates on or after January 10, 2014. PFIs are required to deliver residential mortgage loans that meet the eligibility requirements in the MPF Guides. The eligibility guidelines in the MPF Guides applicable to the conventional mortgage 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) MPF mortgage loans may have LTVs up to 100 percent. Conventional MPF mortgage 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. MPF mortgage loans are documented using standard Fannie Mae/Freddie Mac uniform instruments.

§

Government loans: Government mortgage loans sold under the MPF Program have substantially the same parameters as conventional MPF mortgage 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 residential 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 a residential mortgage 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 a mortgage 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.

 

9

 


 

Table 1 presents a comparison of the different characteristics for each of the MPF products held on balance sheet as of December 31, 2013:

 

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 based on remaining UPB; 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 based on remaining UPB; performance based after 3 years

Yes; after first 3 years, to the extent recoverable in future periods

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 based on remaining UPB; performance based

Yes; to the extent recoverable in future periods

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 based on remaining UPB

Yes; to the extent recoverable in future periods

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.

 

 

10

 


 

Table 2 presents an illustration of the FLA and CE obligation calculation for each conventional MPF product type listed as of December 31, 2013:

 

Table 2

 

 

 

 

Product Name

FLA

CE Obligation Calculation

Original MPF

4 bps x unpaid principal, annually1

(LLCE2 x PSF3) x Gross Fundings

MPF 100

100 bps x loan funded amount

((LLCE x PSF) – FLA) x Gross Fundings

MPF 125

100 bps x loan funded amount

((LLCE x PSF) – FLA) x Gross Fundings

MPF Plus

5 x variable CE Fee

AA equivalent – FLA-SMI4 = PCE5

                   

 

 

1

Starts at zero and increases monthly over the life of the master commitment.

2

LLCE represents the weighted average loan level credit enhancement score of the loans sold into the pool of loans covered by the master commitment agreement.

3

The S&P Level’s Pool Size Factor (PSF) is applied at the MPF FHLBank level against the total of loans in portfolio. A PSF is greater than one if the number of loans in portfolio is less than 300 in total.

4

SMI represents the coverage obtained from the supplemental mortgage insurer. The initial premium for the insurance is determined based on a sample $100 million loan pool. The final premium determination is made during the 13th month of the master commitment agreement, at which time any premium adjustment is determined based on actual characteristics of loans submitted. The SMI generally covers a portion of the PFI’s CE obligation, which typically ranges from 200 to 250 bps of the dollar amount of loans delivered into a mortgage pool, but the PFI may purchase an additional level of coverage to completely cover the PFI’s CE obligation. The CE fees paid to PFIs for this program are capped at a maximum of 14 bps, which is broken into two components, fixed and variable. The fixed portion of the CE fee is paid to the SMI insurer for the coverage discussed above and is a negotiated rate depending on the level of SMI coverage, ranging from 6 to 8 bps. The variable portion is paid to the PFI, and ranges from 6 to 8 bps, with payments commencing the 13th month following initial loan purchase under the master commitment agreement.

5

PCE represents the CE obligation that the PFI elects to retain rather than covering with SMI. Under this MPF product, the retained amount can range from 0 to 20 bps.

 

Investments

A portfolio of investments is maintained for liquidity and asset-liability management purposes. We maintain a portfolio of short-term investments in highly rated institutions, including overnight Federal funds, term Federal funds, interest-bearing certificates of deposit, commercial paper and securities purchased under agreement to resell (i.e., reverse repurchase agreements). 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 no longer purchase private-label MBS/ABS, although we continue to hold a small percentage in our investment portfolio.

 

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 an 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, as reported to the Finance Agency, on the day we purchase the securities. We generally utilize our MBS authority to maintain a portfolio of MBS investments approximating 300 percent of our total regulatory capital. However, as part of our strategic planning initiatives, we anticipate the level of MBS declining over the next three years.

 

11

 


 

Debt Financing – Consolidated Obligations

Consolidated obligations, consisting of bonds and discount notes, are our primary liabilities and represent the principal source of funding for advances, traditional mortgage products, and 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; however, the capital markets have traditionally considered the FHLBanks’ obligations as “Federal agency” debt. As such, the FHLBanks historically have 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 maturity spectrum and through a variety of debt structures, assists us 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.

 

Table 3 presents the par value of our consolidated obligations and the combined consolidated obligations of the 12 FHLBanks as of December 31, 2013 and 2012 (in millions):

 

Table 3

 

 

 

 

 

 

 

 

   

12/31/2013

12/31/2012

Par value of consolidated obligations of the FHLBank

$

30,931 

 

$

30,458 

 

   

 

 

 

 

 

 

Par value of consolidated obligations of all FHLBanks

$

766,837 

 

$

687,902 

 

 

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 that 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, as described in the Investments section of Item 1 – “Business – Investments.”

 

12

 


 

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, 2013 and 2012 (in thousands):

 

Table 4

 

 

 

 

 

 

 

 

   

12/31/2013

12/31/2012

Total non-pledged assets

$

33,864,497 

 

$

33,735,216 

   

Total carrying value of consolidated obligations

 

30,946,529 

 

 

30,642,961 

 

   

 

 

 

 

 

 

Ratio of non-pledged assets to consolidated obligations

 

1.09 

 

 

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 generally are 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, Constant Maturity Swap (CMS), Prime and Three Month Treasury Bill Auction Yield. 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. The FHLBanks stopped issuing consolidated obligations that use the Federal funds rate in July 2012.

 

Consolidated Obligation Discount Notes: The Office of Finance also sells consolidated obligation discount notes on behalf of the FHLBanks that generally are 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 generally sold at a discount and mature at par.

 

Use of Derivatives

The FHLBank’s Risk Management Policy (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.

 

13

 


 

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, firm commitment, or forecasted transaction; (2) in asset/liability management (i.e. economic hedge); or (3) by acting as an intermediary between members and the capital markets. 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 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 the interest rate sensitivity of 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, to mitigate adverse impacts to earnings from the contraction or extension of certain assets (e.g., advances or mortgage assets) and liabilities, and to reduce funding costs as discussed below.

 

We often execute derivatives concurrently with the issuance of consolidated obligation bonds (collectively referred to as swapped consolidated obligation bond transactions) to reduce funding costs or to alter the characteristics of our liabilities to more closely match the characteristics of our assets. At times, we also execute derivatives concurrently with the issuance of consolidated obligation discount notes in order to create synthetic variable rate debt at a cost that is often lower than funding alternatives and comparable variable rate cash instruments 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 short-term fixed rate assets. It also allows us, in some instances, to offer a wider range of advances at more attractive prices than would otherwise be possible. Swapped consolidated obligation transactions depend 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 adjust the types or terms of the consolidated obligations issued and derivatives utilized to better match assets, meet customer needs, and/or 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 fair value or cash flow hedge accounting. The derivatives are marked to fair value through earnings. We may 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.

  

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, 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.

 

14

 


 

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:

§

Market risk, which effective June 30, 2013 is calculated consistent with the market component of our regulatory riskbased capital value-at-risk requirement using a 95 percent confidence level versus the 99 percent confidence level in the regulatory requirement, recognizing that a dividend period is shorter (60 business days or three months) than the period used in the market component of the regulatory riskbased capital calculation (120 days or six months); prior to June 30, 2013, the market risk component was calculated 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);

§

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);

§

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

§

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 2013 and 2012 (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)

12/31/2013

09/30/2013

06/30/2013

03/31/2013

Market Risk1

$

48,759 

 

$

60,816 

 

$

36,527 

 

$

-

 

Credit Risk

 

62,225 

 

 

65,205 

 

 

69,990 

 

 

68,163 

 

Operations Risk

 

33,295 

 

 

37,806 

 

 

31,955 

 

 

20,449 

 

Derivative Hedging Volatility

 

22,262 

 

 

24,474 

 

 

21,563 

 

 

24,012 

 

Total Retained Earnings Threshold

 

166,541 

 

 

188,301 

 

 

160,035 

 

 

112,624 

 

Actual Retained Earnings as of End of Quarter

 

567,332 

 

 

538,650 

 

 

518,306 

 

 

498,172 

 

Overage

$

400,791 

 

$

350,349 

 

$

358,271 

 

$

385,548 

 

 

                   

1

For March 31, 2013, market risk was zero because we had sufficient income to pay a three-month LIBOR dividend in all scenarios modeled.

 

15

 


 

Table 6

 

 

 

 

 

 

 

 

 

 

 

 

 

 

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.

 

Under our retained earnings policy, any shortage of actual retained earnings with respect to the retained earnings threshold is to be met over a period generally not to exceed two years from the quarter-end calculation. The policy also provides that meeting the established retained earnings threshold shall have priority over the payment of dividends, but that the Board of Directors must balance dividends on capital stock against the period over which the retained earnings threshold is met. The retained earnings threshold level fluctuates from period to period because it is a function of the size and composition of our balance sheet and the risks contained therein at that point in time.

 

Joint Capital Enhancement Agreement (JCE Agreement) – Effective February 28, 2011, we, along with the other 11 FHLBanks, entered into a JCE Agreement intended to enhance the capital position of each FHLBank. On August 5, 2011, the FHLBanks also amended the JCE Agreement to reflect differences between the original agreement and capital plan amendments.

 

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.

 

16

 


 

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

We are exempt from all federal, state and local taxation except for real property taxes.

 

Assessments

We are subject to regulatory assessments based on a percentage of our earnings. 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. 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 strengthen communities primarily in Colorado, Kansas, Nebraska and Oklahoma.

17

 


 

 

Affordable Housing Program: Amounts specified by the AHP requirements described in Item 1 – “Business – Assessments” 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, a customized homeownership set-aside program called the Rural First-Time Homebuyers Program (RFHP) was offered during 2013 under the AHP. The RFHP provides down payment, closing cost, or rehabilitation cost assistance to first-time homebuyers in rural areas.

 

Community Investment Cash Advance (CICA) Program. CICA loans to members specifically target underserved markets in both rural and urban areas. CICA loans represented 5.0 percent, 5.1 percent and 4.5 percent of total advances outstanding as of December 31, 2013, 2012 and 2011, respectively. Programs offered during 2013 under the CICA Program, which is not funded through the AHP, include:

§

Community Housing Program (CHP) – CHP makes loans available to members for financing the construction, acquisition, rehabilitation, and refinancing of owner-occupied housing for households whose incomes do not exceed 115 percent of the area’s median income and rental housing occupied by or affordable for households whose incomes do not exceed 115 percent of the area’s median income. For rental projects, at least 51 percent of the units must have tenants that meet the income guidelines, or at least 51 percent of the units must have rents affordable to tenants that meet the income guidelines. We provide advances for CHP-based loans to members at our estimated cost of funds for a comparable maturity plus a mark-up for administrative costs; and

§

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.

 

Other Housing and Community Development Programs. A number of other voluntary housing and community development programs have also been established. These programs are not funded through the AHP and include the following:

§

Joint Opportunities for Building Success (JOBS) – In 2013, $995,000 in JOBS funds were distributed to assist members in promoting employment growth in their communities. We distributed $998,000 and $1,225,000 in 2012 and 2011, respectively. A charitable grant program, JOBS funds are allocated annually to support economic development projects. For 2014, 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; and

§

Rural First-time Homebuyer Education Program – We provide up to $100,000 annually to support rural homeownership education and counseling while actively encouraging participating organizations to seek supplemental funding from other sources. Goals of the program are to support rural education and counseling in all four states in the district, especially in those areas with RFHP-participating stockholders. We used $75,000, $100,000 and $75,000 of the available funds for this program during 2013, 2012 and 2011, respectively. For 2014, $75,000 has been allocated to this program.

 

18

 


 

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 and commercial banks. 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 residential mortgage loans and government-guaranteed residential 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 residential mortgage loans 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 increase, or less debt may be issued. We compete for the issuance of debt primarily on the basis of rate, term, structure and perceived risk of the 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 FHLBanks to promote their safety and soundness so they serve as a reliable source of liquidity and funding for housing finance and community investment. 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 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.

 

Before a government corporation issues and offers obligations to the public, the Government Corporation Control Act provides that 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.

 

19

 


 

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 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 12, 2014, we had 210 employees. The employees are not represented by a collective bargaining unit and we consider our relationship with our employees good.

 

Legislative and Regulatory Developments

The legislative and regulatory environment in which we and our members operate continues to evolve as a result of regulations enacted pursuant to the Housing and Economic Recovery Act of 2008, as amended (Recovery Act) and the Dodd-Frank Act. Our business operations, funding costs, rights, obligations, and/or business environment are likely to continue to be significantly impacted by these changes. Significant regulatory actions and developments for the period covered by this report are summarized below.

 

Significant Finance Agency Regulatory Actions:

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 (“REO”), and Other Assets and Listing Assets for Special Mention (AB 2012-02). 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 establishes a standard and uniform methodology for classifying assets, prescribes the timing of asset charge-offs (excluding investment securities), provides measurement guidance with respect to determining our allowance for credit losses, and fair value measurement guidance for REO (e.g., use of appraisals). We are in the process of determining the financial statement effects of implementing AB 2012-02 on our financial condition, results of operations, and cash flows, although we do not believe the results will materially impact our results of operations. Subsequent to the issuance of AB 2012-02, the Finance Agency issued interpretative guidance clarifying that implementation of the asset classification framework may occur in two phases. The asset classification provisions in AB 2012-02 were implemented on January 1, 2014. The charge-off provisions have been extended and should be implemented no later than January 1, 2015.

 

Finance Agency Issues Final Rule on Removal of References to Credit Ratings. On November 8, 2013, the Finance Agency issued a final rule implementing Section 939A of the Dodd-Frank Act, which requires Federal agencies to remove provisions from their regulations that require the use of ratings issued by NRSROs. The final rule amends Finance Agency regulations on investments, standby letters of credit and liabilities. The final rule will require us to make our own determination of credit quality with respect to investments, but does not prevent us from using NRSRO ratings or other third party analytics in our credit determinations. The final rule will become effective on May 7, 2014.

 

Finance Agency Issues Final Rule on Information Sharing Among FHLBanks. On December 6, 2013, the Finance Agency issued a final rule implementing a provision of the Recovery Act requiring the Finance Agency to make available to each FHLBank information relating to the financial condition of all other FHLBanks. The final rule provides that the Finance Agency will distribute to each FHLBank and the Office of Finance, or shall require each FHLBank to distribute directly to each other FHLBank and the Office of Finance, certain categories of information, including information from the Finance Agency’s call report system information regarding FHLBank liquidity, membership and unsecured credit exposure, and information contained in the “Summary and Conclusions” portion of each FHLBank’s final report of examination. The final rule became effective on January 6, 2014.

 

20

 


 

Finance Agency Issues Final Guidance on Collateralization of Advances and Other Credit Products to Insurance Company Members.

On December 23, 2013, the Finance Agency published a final Advisory Bulletin that provides guidance on credit risk management practices to ensure FHLBank advances remain fully secured when lending to insurance company members. The guidance identifies differing risks in lending to insurance companies versus federally-insured depository institutions. The guidance notes that in assessing an FHLBank’s lending to insurance companies and collateral position with respect to insurance company members, the Finance Agency will evaluate, among other things:

§

An FHLBank’s control of pledged collateral and ensuring it has a first-priority perfected security interest;

§

An FHLBank’s communication with the state insurance regulator in each appropriate state;

§

An FHLBank’s legal analysis with respect to state insurance laws;

§

If funding agreements between an FHLBank and an insurance company member are used to document advances, whether the FHLBank would be recognized as a secured creditor with a first-priority perfected security interest in the collateral;

§

The FHLBank’s documented framework, procedures, methodologies and standards to evaluate an insurance company member's creditworthiness and financial condition, and the value of the pledged collateral; and

§

Whether an FHLBank has a written plan for the liquidation of insurance company member collateral.

The Advisory Bulletin was effective upon issuance.

 

Finance Agency Issues Final Rule on Executive Compensation. On January 28, 2014, the Finance Agency issued a final rule setting forth requirements and processes with respect to compensation provided to executive officers by FHLBanks and the Office of Finance. The final rule addresses the authority of the Director of the Finance Agency to review the compensation arrangements of executive officers and to prohibit FHLBanks or the Office of Finance from providing compensation to any executive officer that the Director determines is not reasonable and comparable with compensation for employment in other similar businesses involving similar duties and responsibilities. The final rule also addresses the Director’s authority to approve, in advance, agreements or contracts of executive officers that provide compensation in connection with termination of employment. The final rule became effective on February 27, 2014.

 

Finance Agency Issues Final Rule on Golden Parachute Payments. On January 28, 2014, the Finance Agency issued a final rule setting forth the standards that the Director of the Finance Agency will take into consideration when determining whether to limit or prohibit golden parachute payments. The final rule generally prohibits an FHLBank from making or agreeing to make a golden parachute payment unless an FHLBank is not subject to certain triggering events such as insolvency, appointment of a conservator or receiver, or an FHLBank is in a troubled condition such that it is subject to a cease and desist order, assigned a composite rating of 4 or 5, or has been informed by the Finance Agency that it is in a troubled condition. The final rule became effective on February 27, 2014.

 

Finance Agency Issues Final Guidance on Operational Risk Management. On February 18, 2014, the Finance Agency published a final Advisory Bulletin setting forth its expectations for FHLBanks’ operational risk management programs, including the duties and responsibilities of management and the board with respect to operational risk management. The Advisory Bulletin states that the scope of an FHLBank’s operational risk management program should encompass:

§

Risk identification – including defining operational risk;

§

Risk assessment – including analysis of the severity and likelihood of operational events given the effectiveness of controls in place;

§

Measurement – including the direction and magnitude of changes in risk profile and may include modeling – including the treatment of diverse loss types in a common and analytical framework;

§

Reporting – including operational event reporting that provides timely and actionable information to management; and

§

Risk management decision-making – including evidence that management decisions about operational risk mitigation strategies are informed by data and information gathered in the other processes of the program.

 

The Advisory Bulletin also sets forth the expectation that the FHLBanks’ operational risk management processes will include an operational risk policy, board oversight, executive and senior management leadership, operational risk officer implementation, and business unit management and staff commitment. The Advisory Bulletin states that Finance Agency examiners will evaluate the FHLBanks’ operational risk management practices as part of the annual examination. The Advisory Bulletin was effective upon issuance.

 

21

 


 

Finance Agency Issues Proposed Rule on Responsibilities of Boards of Directors; Corporate Practices and Corporate Governance Matters. On January 28, 2014, the Finance Agency issued a proposed rule to relocate and consolidate existing Federal Housing Finance Board and Office of Federal Housing Enterprise Oversight regulations pertaining to director responsibilities, corporate practices and corporate governance matters for Fannie Mae, Freddie Mac (together, the Enterprises) and the FHLBanks. The proposed rule would make certain amendments or additions to the corporate governance rules currently applicable to the FHLBanks, including provisions to:

§

Revise existing risk management provisions to better align them with more recent proposals of the Federal Reserve Board, including requirements that the FHLBanks adopt an enterprise wide risk management program and have a Chief Risk Officer (CRO) with certain enumerated responsibilities;

§

Require each FHLBank to maintain a compliance program headed by a compliance officer who reports directly to the chief executive officer (CEO);

§

Require each FHLBank’s board to establish committees specifically responsible for the following matters: (a) risk management, (b) audit, (c) compensation, and (d) corporate governance; and

§

Require each FHLBank to designate in its bylaws a body of law to follow for its corporate governance practices and governance issues that may arise for which no federal law controls, choosing from: (a) the law of the jurisdiction in which the FHLBank maintains its principal office; (b) the Delaware General Corporation Law; or (c) the Revised Model Business Corporation Act. The proposed rule states that the Finance Agency has the authority to review an FHLBank’s indemnification policies, procedures and practices and may limit or prohibit indemnification payments in furtherance of the safe and sound operations of the FHLBank.

Comments on the proposed rule are due by May 15, 2014.

 

Other Significant Developments:

Consumer Financial Protection Bureau (CFPB) Issues Final Rule on Qualified Mortgages. In January 2013, the CFPB issued a final rule with an effective date of January 10, 2014, that establishes new standards for mortgage lenders to follow during the loan approval process to determine whether a borrower can afford to repay certain types of loans, including mortgages and other loans secured by a dwelling. The final rule provides for a “safe harbor” or a “rebuttable presumption,” depending on loan pricing, from consumer claims that a lender did not adequately consider whether a consumer can afford to repay the lender's mortgage, provided that the mortgage meets the requirements of a Qualified Mortgage loan (QM). QMs are home loans that are either eligible for purchase by Fannie Mae or Freddie Mac or otherwise satisfy certain underwriting standards. On May 6, 2013, the Finance Agency announced that Fannie Mae and Freddie Mac will no longer purchase a loan that is not a QM under those underwriting standards starting January 10, 2014. The underwriting standards require lenders to consider, among other factors, the borrower's current income, current employment status, credit history, monthly mortgage payment, monthly payment for other loan obligations, and total debt-to-income ratio. Further, the QM underwriting standards generally prohibit loans with excessive points and fees, interest-only or negative-amortization features (subject to limited exceptions), or terms greater than 30 years. On the same date it issued the final Ability to Repay/final QM standards, the CFPB also issued a proposal that would allow small creditors (generally those with assets under $2 billion) in rural or underserved areas to treat first lien balloon mortgage loans that they offer as QM mortgages. Comments were due by February 25, 2013.

 

The QM liability safe harbor could provide incentives to lenders, including our members, to limit their mortgage lending to QMs or otherwise reduce their origination of mortgage loans that are not QMs. This approach could reduce the overall level of members' mortgage lending and, in turn, reduce demand for our advances. 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.

 

Financial Crimes Enforcement Network (FinCEN) Issues Final Rule on Anti-Money Laundering Program and Suspicious Activity Report Filing Requirements for Housing Government Sponsored Enterprises. On February 25, 2014, FinCEN, a bureau of the Department of the Treasury, issued a final rule defining certain housing government sponsored enterprises, including the FHLBanks, as financial institutions pursuant to 31 U.S.C. 5312(a)(2)(Y) for the purpose of requiring FHLBanks to establish anti-money laundering programs and report suspicious activities as well as allow the FHLBanks to participate in special information sharing procedures to deter money laundering and terrorist activity. As amended by the USA PATRIOT Act, the Bank Secrecy Act 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 the programs. The final rule requires the FHLBanks to develop and implement a written anti-money laundering program that is reasonably designed to prevent the FHLBanks from being used to facilitate money laundering or the financing of terrorist activities, and other financial crimes. The final rule also requires the FHLBanks to file suspicious activity reports directly with FinCEN in the event certain suspicious transactions are conducted or attempted by, at, or through an FHLBank. The FHLBanks are currently subject to Finance Agency regulations and guidance on the Reporting of Fraudulent Financial Instruments, which is expected to be amended to avoid conflicts with FinCEN’s regulations. The final rule is effective April 28, 2014, with a compliance date of August 25, 2014.

 

22

 


 

Basel Committee on Banking Supervision – Proposed Liquidity Coverage Ratio. In October 2013, the Federal Reserve, Office of the Comptroller of the Currency and Federal Deposit Insurance Corporation issued a proposed rule for a minimum liquidity coverage ratio (LCR) applicable to all internationally active banking organizations; bank holding companies; systemically important, non-bank financial institutions designated for Federal Reserve supervision; certain savings and loan holding companies; depository institutions with $250 billion or more in total assets or $10 billion or more in consolidated total on-balance sheet foreign exposure; and to such depository institutions’ consolidated subsidiaries that are depository institutions with $10 billion or more in total consolidated assets. Among other things, the proposed rule would require the foregoing entities to maintain a sufficient amount of high-quality liquid assets (HQLAs) to meet their obligations and other liquidity needs that are forecasted to occur during a 30-calendar day stress scenario. The proposed rule defines various categories of HQLAs for purposes of satisfying the LCR, and these HQLAs are further categorized as Level 1, 2A, or 2B. The treatment of HQLAs for the LCR is most favorable under the Level 1 category, less favorable under the Level 2A category, and least favorable under the Level 2B category. As proposed, FHLBank consolidated obligations would be categorized as Level 2A HQLAs, meaning that their value would be reduced by 15 percent for purposes of the LCR and, when combined with the Level 2B category, cannot exceed 40 percent of the total HQLAs maintained by the institution. The categorization of consolidated obligations as a Level 2A HQLA could adversely impact investor demand for consolidated obligations because their treatment will be less favorable than the treatment of Level 1 HQLAs, potentially resulting in increased funding costs and, in turn, adversely impacting the results of our operations. Comments on the proposed rule were due January 31, 2014.

 

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.

 

Item 1A: Risk Factors

 

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. In response to the economic downturn and the recession that ended in 2010, the U.S. government established certain governmental lending programs that adversely impacted our business. 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.

 

Key legislation in response to disruptions in the financial markets includes the Dodd-Frank Act, which was signed into law in July 2010. 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 also requires federal regulatory agencies to establish regulations to implement the legislation. For example, regulations on the over-the-counter derivatives market already issued, and others still to be issued, under the Dodd-Frank Act could materially affect our ability to hedge our interest rate risk exposure from advances and mortgage loan purchases, achieve our risk management objectives, and act as an intermediary between our members and counterparties. Regulatory actions taken by the Commodity Futures Trading Commission (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. Additionally, initial and variation margin are currently required to be posted for cleared derivatives. Such regulatory actions also have the potential to impact the costs of certain transactions between us and our members.

 

23

 


 

In addition, the CFPB, which was created under the authority of the Dodd-Frank Act, issued a final rule effective in January, 2014, which: (1) establishes lending requirements including the requirement to consider a borrower’s ability to repay: and (2) provides a safe harbor for meeting QM requirements. See Item 1 – “Business – Legislation and Regulatory Developments” for further discussion. These qualified mortgage standards, along with legislation in many states that imposes stricter foreclosure requirements, could provide incentives to lenders, including our members, to limit their mortgage lending to QMs or otherwise reduce their origination of mortgage loans that are not QMs. This approach could reduce the overall level of members' mortgage lending and, in turn, reduce demand for our advances. 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. This could result in increased losses on delinquent mortgage loans and lower the value of our MBS investments as well as mortgage loans we hold in portfolio under the MPF Program and mortgage loans pledged to us as collateral.

 

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. Both the U.S. House and Senate considered legislation in 2013 that would reform the GSEs. We do not know how or to what extent GSE reform legislation will impact the business or operations of the FHLBank or the FHLBank System.

 

To the extent that 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 – Legislative and Regulatory Developments” for more information on potential future legislation and other regulatory activity affecting us.

 

We are subject to a complex body of laws and regulatory requirements 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 regulatory requirements 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. We are, or may also become, subject to regulations promulgated by the SEC, CFTC, Federal Reserve Board, Financial Crimes Enforcement Network, or other regulatory agencies.

 

We cannot predict whether new regulatory requirements 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 regulatory requirements or legislation on our operations. Changes in regulatory or statutory requirements could result in, among other things, an increase in our cost of funding and the cost of operating our business, a change in our permissible business activities, or a decrease in the size, scope or nature of our membership or our lending, investment or MPF Program activities, which could negatively affect our financial condition and results of operations.

 

We 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.

 

An increase in required AHP contributions could adversely affect our results of operations, our ability to pay dividends, or our ability to redeem or repurchase capital stock. The FHLBank Act requires each FHLBank to contribute to its AHP the greater of: (1) ten percent of the FHLBank’s net earnings for the previous year; or (2) that FHLBank’s pro rata share of an aggregate of $100 million, the proration of which is made on the basis of the net earnings of the FHLBanks for the previous year. A failure of the FHLBanks to make the minimum $100 million annual AHP contribution in a given year could result in an increase in our AHP contribution, which could adversely affect our results of operations, our ability to pay dividends, or our ability to redeem or repurchase capital stock. 

24

 


 

 

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. In addition, 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

 

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. During 2013, as market interest rates increased in response to the Federal Reserve’s announced intention to begin tapering its Quantitative Easing initiative later in the year,  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. 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 stable outlook by Moody’s and AA+ with a stable 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 bilateral 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 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.

 

25

 


 

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 stable outlook by Moody’s while 11 of the FHLBanks are rated AA+ with a stable outlook and one of the FHLBanks is rated AA with a stable 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.

 

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 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 acquisition of mortgage loans 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. 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. 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. 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 guarantee 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

 

26

 


 

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 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.

 

Changes to our balance sheet management strategies could adversely impact our results of operations. In 2013, the Finance Agency provided a letter to each FHLBank setting forth proposed core mission asset measures and benchmark ratios that seeks to ensure each FHLBank maintains a balance sheet structured to achieve its mission. The Finance Agency proposed a two-tier set of mission assets benchmarks whereby the Tier 1 benchmark will measure average advances as a percentage of average consolidated obligations and the Tier 2 benchmark will measure all core mission assets (advances plus AMA) as a percentage of average consolidated obligations. The Finance Agency proposed the long-term balance sheet targets be comprised of a minimum Tier 1 ratio of 65 percent and a minimum Tier 2 ratio of 80 percent. In response to the letter, we have implemented a balance sheet management strategy that would adjust our asset mix to meet the ratios by the end of 2016. These balance sheet strategies may result in lower net income than we are currently projecting and therefore, adversely impact our financial condition and results of operations as we implement and maintain a core mission asset balance sheet.

 

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 bilateral 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.

 

27

 


 

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) bilateral 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 require all clearable derivatives transactions to be cleared through a derivatives clearinghouse. As a result of such statutes and regulations, we are 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 jeopardize the effectiveness of derivatives hedging transactions, and could adversely affect our operations as we may be unable to enter into certain derivatives transactions or do so 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, and 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.

 

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.

28

 


 

 

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.

 

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 guarantee 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 guarantee that a member’s purchase of our capital stock would not effectively become an illiquid investment.

 

The application of new accounting standards relevant to us, 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 there were a change in standards and we were unable to 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

 

29

 


 

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 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.

 

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, but to a much smaller extent, 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.

 

30

 


 

Reliance on FHLBank of Chicago as MPF Provider could have a negative impact on our business if 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, operational support and the maintenance of investor relations for the MPF Program and is also 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, or investors that purchase mortgages under the MPF Program, were to experience operational or other difficulties that prevent the fulfillment of their contractual obligations.

 

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, which may occur as a result of various factors including adjustments in business strategies and increasing expense and compliance burdens. 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. Periodically, we experience member failures and out-of-district consolidations that can 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 the value of our membership.

 

Item 1B: Unresolved Staff Comments

 

Not applicable.

 

31

 


 

Item 2: Properties

 

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. We have also acquired 942,578 square feet of land in Topeka, Kansas to be utilized as a potential future building site, if needed.

 

Item 3: Legal Proceedings

 

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.

 

Item 4: Mine Safety Disclosures

 

Not applicable.

 

PART II

 

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 advance and mortgage loan activity executed 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 12, 2014, we had 813 stockholders of record and 5,144,160 shares of Class A Common Stock and 7,688,835 shares of Class B Common Stock outstanding, including 45,564 shares of Class A Common Stock and 1,126 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, 2013 and 2012, which excludes dividends treated as interest expense for mandatorily redeemable shares. Dividends paid on capital stock are outlined in Table 7 (dollar amounts in thousands):

 

32

 


 

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

12/31/2013

 

0.25 

%

$

40 

 

$

253 

 

$

293 

 

 

3.75 

%

$

37 

 

$

7,966 

 

$

8,003 

 

09/30/2013

 

0.25 

 

 

40 

 

 

289 

 

 

329 

 

 

3.50 

 

 

33 

 

 

7,873 

 

 

7,906 

 

06/30/2013

 

0.25 

 

 

41 

 

 

233 

 

 

274 

 

 

3.50 

 

 

32 

 

 

8,393 

 

 

8,425 

 

03/31/2013

 

0.25 

 

 

40 

 

 

238 

 

 

278 

 

 

3.50 

 

 

28 

 

 

7,452 

 

 

7,480 

 

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 

 

                   

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.

 

Dividends may be paid in cash or Class B Common Stock as authorized under our capital plan and approved by our Board of Directors. Finance Agency regulation prohibits any FHLBank from paying a stock dividend if excess stock outstanding will exceed one percent of its total assets after payment of the stock dividend. We were able to manage our excess capital stock position in the past two years in order to pay stock dividends.

 

We anticipate paying a 0.25 percent dividend on Class A Common Stock and a 4.00 percent dividend on Class B Common Stock for the first quarter of 2014. Historically, dividend levels have been influenced by several factors: (1) an objective of moving dividend rates gradually over time; (2) an objective of having dividends reflective of the level of current short-term interest rates; and (3) an objective of managing the balance of retained earnings to appropriate levels as set forth in the retained earnings policy. 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.

 

Our retained earnings balances have been significantly above the threshold set forth in the retained earnings policy and were not a factor in determining dividend declarations in 2013 and 2012. There is a possibility that the threshold level could change and be a greater consideration for dividend levels in the future because the threshold is a function of the size and composition of our balance sheet.

 

With retained earnings significantly exceeding the threshold amount and expected to grow in the future, we are analyzing potential changes to our capital management practices. Changes may include: (1) repurchasing some or all of our excess capital stock outstanding; (2) paying cash dividends; (3) reducing the advance activity-based stock purchase requirement; and (4) increasing the percentage of current income we pay out in dividends through higher dividends on Class A Common Stock and/or Class B Common Stock. Depending on the results of our analysis, we may move forward with none, some or all of these potential changes.

 

Item 6: Selected Financial Data

 

Table 8 presents Selected Financial Data for the periods indicated (dollar amounts in thousands):

 

33

 


 

Table 8

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

   

12/31/2013

12/31/2012

12/31/2011

12/31/2010

12/31/2009

Statement of Condition (as of year end):

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total assets

$

33,950,304 

 

$

33,818,627 

 

$

33,190,182 

 

$

38,706,067 

 

$

42,631,611 

 

Investments1

 

8,704,552 

 

 

10,774,411 

 

 

10,576,537 

 

 

14,845,941 

 

 

16,347,941 

 

Advances

 

17,425,487 

 

 

16,573,348 

 

 

17,394,399 

 

 

19,368,329 

 

 

22,253,629 

 

Mortgage loans, net2

 

5,949,480 

 

 

5,940,517 

 

 

4,933,332 

 

 

4,293,431 

 

 

3,333,784 

 

Total liabilities

 

32,149,084 

 

 

32,098,146 

 

 

31,488,735 

 

 

36,922,589 

 

 

40,685,701 

 

Deposits

 

961,888 

 

 

1,181,957 

 

 

997,371 

 

 

1,209,952 

 

 

1,068,757 

 

Consolidated obligation bonds, net3

 

20,056,964 

 

 

21,973,902 

 

 

19,894,483 

 

 

21,521,435 

 

 

27,524,799 

 

Consolidated obligation discount notes, net3

 

10,889,565 

 

 

8,669,059 

 

 

10,251,108 

 

 

13,704,542 

 

 

11,586,835 

 

Total consolidated obligations, net3

 

30,946,529 

 

 

30,642,961 

 

 

30,145,591 

 

 

35,225,977 

 

 

39,111,634 

 

Mandatorily redeemable capital stock

 

4,764 

 

 

5,665 

 

 

8,369 

 

 

19,550 

 

 

22,437 

 

Total capital

 

1,801,220 

 

 

1,720,481 

 

 

1,701,447 

 

 

1,783,478 

 

 

1,945,910 

 

Capital stock

 

1,252,249 

 

 

1,264,456 

 

 

1,327,827 

 

 

1,454,396 

 

 

1,602,696 

 

Total retained earnings

 

567,332 

 

 

481,282 

 

 

401,461 

 

 

351,754 

 

 

355,075 

 

Accumulated other comprehensive income (loss) (AOCI)

 

(18,361)

 

 

(25,257)

 

 

(27,841)

 

 

(22,672)

 

 

(11,861)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Statement of Income (for the year ended):

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net interest income

 

217,773 

 

 

219,680 

 

 

230,926 

 

 

249,876 

 

 

259,011 

 

Provision for credit losses on mortgage loans

 

1,926 

 

 

2,496 

 

 

1,058 

 

 

1,582 

 

 

1,254 

 

Other income (loss)

 

(30,818)

 

 

(42,916)

 

 

(78,328)

 

 

(154,694)

 

 

108,021 

 

Other expenses

 

52,762 

 

 

51,696 

 

 

53,781 

 

 

47,899 

 

 

43,586 

 

Income before assessments

 

132,267 

 

 

122,572 

 

 

97,759 

 

 

45,701 

 

 

322,192 

 

Assessments

 

13,229 

 

 

12,261 

 

 

20,433 

 

 

12,153 

 

 

85,521 

 

Net income

 

119,038 

 

 

110,311 

 

 

77,326 

 

 

33,548 

 

 

236,671 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Selected Financial Ratios and Other Financial Data (for the year ended):

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Dividends paid in cash4

 

291 

 

 

285 

 

 

362 

 

 

316 

 

 

367 

 

Dividends paid in stock4

 

32,697 

 

 

30,205 

 

 

27,257 

 

 

36,553 

 

 

41,500 

 

Weighted average dividend rate5

 

2.42 

%

 

2.26 

%

 

1.99 

%

 

2.36 

%

 

2.29 

%

Dividend payout ratio6

 

27.71 

%

 

27.64 

%

 

35.72 

%

 

109.90 

%

 

17.69 

%

Return on average equity

 

6.37 

%

 

6.23 

%

 

4.43 

%

 

1.79 

%

 

11.24 

%

Return on average assets

 

0.33 

%

 

0.32 

%

 

0.21 

%

 

0.08 

%

 

0.48 

%

Average equity to average assets

 

5.24 

%

 

5.13 

%

 

4.73 

%

 

4.46 

%

 

4.31 

%

Net interest margin7

 

0.61 

%

 

0.64 

%

 

0.63 

%

 

0.60 

%

 

0.53 

%

Total capital ratio8

 

5.31 

%

 

5.09 

%

 

5.13 

%

 

4.61 

%

 

4.56 

%

Regulatory capital ratio9

 

5.37 

%

 

5.18 

%

 

5.24 

%

 

4.72 

%

 

4.64 

%

Ratio of earnings to fixed charges10

 

1.59 

 

 

1.45 

 

 

1.31 

 

 

1.12 

 

 

1.56 

 

                   

1

Includes trading 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 was $6,748,000, 5,416,000, $3,473,000, $2,911,000 and $1,897,000 as of December 31, 2013, 2012, 2011, 2010 and 2009, 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 dividends recorded in accordance with GAAP were $25,000, $41,000, $174,000, $346,000, and $504,000 for the years ended December 31, 2013, 2012, 2011, 2010, and 2009, respectively.

5

Dividends paid in cash and stock on both classes of stock as a percentage of average capital stock eligible for dividends.

6

Ratio disclosed represents dividends declared and paid during the year as a percentage of net income for the calendar year presented, although the Finance Agency regulation requires dividends be paid out of known income prior to declaration date.

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).

 

34

 


 

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

 

The following Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) is intended to assist the reader in understanding our business and assessing our operations both historically and prospectively. This discussion should be read in conjunction with our audited financial statements and related notes presented under Item 8 of this annual report on Form 10-K. Our MD&A includes the following sections:

§

Executive Level Overview – a general description of our business and financial highlights;

§

Financial Market Trends – a discussion of current trends in the financial markets and overall economic environment, including the related impact on our operations;

§

Critical Accounting Policies and Estimates – a discussion of accounting policies that require critical estimates and assumptions;

§

Results of Operations – an analysis of our operating results, including disclosures about the sustainability of our earnings;

§

Financial Condition – an analysis of our financial position;

§

Liquidity and Capital Resources – an analysis of our cash flows and capital position;

§

Risk Management – a discussion of our risk management strategies; and

§

Recently Issued Accounting Standards.

 

Executive Level Overview

We are a regional wholesale bank that makes advances (loans) to, purchases mortgages from, and provides 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 is to ensure that the housing GSEs operate in a safe and sound manner so that they serve as a reliable source of liquidity and funding for housing finance and community investment.

 

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 based on the member’s total assets. Each member may be required to purchase activity-based capital stock (Class B Common Stock) as it engages in certain business activities with the FHLBank, including advances and AMA, at levels determined by management with the Board of Director’s approval and within the ranges stipulated in the Capital Stock Plan. Currently, 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. In the past, capital stock also increased when members sold additional mortgage loans to us; however, members are no longer required to purchase capital stock for AMA activity (see additional information under this Item 7 – “Financial Condition – Capital”). At our discretion, we may repurchase excess Class B Common Stock if there is a decline in a member’s advances. We believe it is important to manage our business and the associated risks so that we can always strive to 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.

 

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 purchases of MBS; 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 interest rates. One way we do this is through the use of derivatives to reduce our funding costs and manage interest rate and prepayment risk. We also acquire and classify certain investments as trading securities for liquidity and asset-liability management purposes. Although we manage the risks mentioned and utilize these transactions for asset-liability tools, we do not actively trade these positions. While we actively manage our net exposure to derivative counterparties, we do not attempt to manage the fluctuations in the fair value of our derivatives or trading securities. We are essentially a “hold-to-maturity” investor and transact derivatives only for hedging purposes, even though some derivative hedging relationships do not qualify for hedge accounting under accounting principles generally accepted in the United States of America (GAAP) (referred to as economic hedges) and therefore can add significant volatility to our GAAP income.

 

35

 


 

Net income for the year ended December 31, 2013 was $119.0 million compared to $110.3 million for the year ended December 31, 2012. The $8.7 million increase was due to a decrease in net losses from: (1) derivative and hedging activities; and (2) fair value changes on trading securities. We also had a slight decrease in the provision for loan losses, which added to 2013 net income. These positive impacts on net income were partially offset by a decrease in net interest income before loan loss provision primarily due to a decrease of 27 bps in the weighted average yield on long-term investments and a decrease of 19 bps in the weighted average yield on advances, largely driven by a $2.4 million decrease in prepayment fees. The decline in asset yields in 2013 has been greater than the decline in funding costs, which had been significantly reduced in prior years through our callable debt refinancing. Although we continued to refinance our debt in 2013, we were not able to keep pace with falling asset yields until the fourth quarter, at which time we were able to replace some high cost debt at rates over 200 bps lower, which resulted in an increase in net interest margin for the quarter.

 

The net gain on derivatives and hedging activities for the year ended December 31, 2013 compared to the net loss in 2012 is primarily the result of the gain on economic hedges resulting from an increase in market rates and a steepening of the yield curve. The increase in net loss on trading securities in 2013 compared to 2012 was primarily attributable to a loss on our fixed rate GSE debentures due to increasing interest rates and widening GSE credit spreads relative to the Overnight Indexed Swap (OIS) curve. Detailed discussion relating to the fluctuations in net interest income, net gain (loss) on derivatives and hedging activities and net gain (loss) on trading securities can be found under this Item 7 – “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Results of Operations.”

 

Total assets remained relatively flat year over year. The increase of $131.7 million, or 0.4 percent, from December 31, 2012 to December 31, 2013 was primarily attributable to an $852.1 million, or 5.1 percent increase in advances, offset by a $655.3 million, or 27.7 percent, net decrease in cash and reverse repurchase agreements. In 2013, we began executing an asset composition strategy to increase advances so that they comprise a majority of our total assets through targeted sales and marketing activities while continuing the use of tools implemented in 2012 to control the MPF mortgage loan portfolio volume retained on our balance sheet (see Item 7 – “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Financial Condition – MPF Program”). This strategy also entails maintaining a smaller allocation of money market securities and other investments than we have in the past. However, the shift to large cash balances from money market securities at year-end was due to low yields and a general shortage of suitable investments in the market. We had $2.0 billion outstanding in reverse repurchase agreements at the end of 2012; however, the yields on these secured investments were extremely low in the latter half of 2013 and remained low at year-end. Thus, we had no reverse repurchase agreements at December 31, 2013. Not only were yields low on unsecured investments (Federal funds sold, commercial paper and certificates of deposit) at year-end, but it was difficult to invest because counterparties were out of the market.

 

Total liabilities increased by 0.2 percent from December 31, 2012 to December 31, 2013. This increase was primarily attributable to the $2.2 billion increase in consolidated obligation discount notes, partially offset by a $1.9 billion decrease in consolidated obligation bonds. The increase in discount notes from December 31, 2012 to December 31, 2013 was primarily a result of funding the increase in short-term advances during that time period. The decrease in bonds was due primarily to declines in bonds swapped or indexed to LIBOR during 2013 due to waning concern over the “fiscal cliff” and debt ceiling concerns of late 2012. For additional information, see Item 7 – “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Financial Condition.”

 

Although dividend rates were unchanged in 2012, the Class B dividend rate increased to 3.75 percent in the fourth quarter of 2013, while the Class A dividend rate remained unchanged. Changes in the weighted average dividend rates over the periods ended December 31, 2013 (2.42 percent) and 2012 (2.26 percent) occurred due to changes in the mix of Class A and Class B stock. Factors impacting the stock class mix and average dividend rates include: (1) a reduction in our membership capital stock (Class A) purchase requirement in mid-2012; (2) a reduction in our activity stock (Class B) requirement for AMA in the third quarter of 2013; (3) weekly exchanges of excess Class B stock to Class A; and (4) periodic repurchases of excess Class A stock.

 

As noted previously, our balance sheet management strategies for the period of 2014-2016 will focus on improving our core mission asset ratios and include the establishment of benchmark ratios of: (1) advances to consolidated obligations (Tier 1 ratio); and (2) advances plus AMA to consolidated obligations (Tier 2 ratio). See Item 1A – “Risk Factors” for further information on Finance Agency-suggested benchmarks. Benchmarks established for 2014 will likely entail a reduced allocation to MBS, money market and other investments over time through paydowns and maturities, but without the sale of any assets. We also anticipate changes to our management of capital levels, which could include reducing our activity-based stock purchase requirement (see “Financial Condition – Capital” under this Item 7), establishing periodic repurchases of some or all of our excess stock and increasing our dividend payout ratio among other practices (see Item 5 – “Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities”), while maintaining sufficient levels of liquidity to fulfill our mission. Although we project lower net income as a result of the balance sheet management strategies compared to prior years, we expect that the effect of any changes to our capital management will offset the impact of lower net income and potentially increase our stockholders’ profitability from ownership of our capital stock.

 

36

 


 

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 2013

Average Rate for 2012

December 31, 2013

Ending Rate

December 31, 2012

Ending Rate

Overnight Federal funds effective/target rate1

 

0.11 

%

 

0.14 

%

 

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

 

3-month U.S. Treasury bill1

 

0.05 

 

 

0.08 

 

 

0.07 

 

 

0.02 

 

3-month LIBOR1

 

0.27 

 

 

0.43 

 

 

0.25 

 

 

0.31 

 

2-year U.S. Treasury note1

 

0.30 

 

 

0.27 

 

 

0.38 

 

 

0.25 

 

5-year U.S. Treasury note1

 

1.16 

 

 

0.75 

 

 

1.73 

 

 

0.71 

 

10-year U.S. Treasury note1

 

2.34 

 

 

1.78 

 

 

3.00 

 

 

1.74 

 

30-year residential mortgage note rate2

 

4.20 

 

 

3.84 

 

 

4.72 

 

 

3.52 

 

                   

1

Source is Bloomberg (overnight Federal funds rate is the effective rate for the averages and the target rate for the ending rates).

2

Mortgage Bankers Association weekly 30-year fixed rate mortgage contract rate obtained from Bloomberg.

 

Most U.S. Treasury rates increased through much of 2013, driven by the expectation of reductions in U.S. Treasury and MBS purchases by the Federal Reserve Bank as economic conditions improved. In January 2014, the tapering of asset purchases began, with continued economic progress cited as justification for the reduction. However, the FOMC is maintaining accommodative monetary policy based on the weakness of certain economic indicators, which means a continued low target for the Federal funds rate and a less significant decrease in the quantitative easing asset purchase program than originally anticipated. While market participants assume that the Federal Reserve Bank will complete tapering in the first half of 2014, the Federal Reserve Governors have stated that there is no set schedule and that speed and timing of asset purchase reductions would be data dependent. Initial response to the Federal Reserve Bank’s tapering announcement was minimal, but the 10-year Treasury rate rose upon the release of additional positive economic data. We issue debt at a spread above U.S. Treasury securities, so higher interest rates increase the cost of issuing FHLBank consolidated obligations and increase the cost of advances to our members and housing associates.

 

As interest rates rose significantly and market volatility increased in the latter half of 2013, demand for our longer-term debt was negatively impacted as investors were hesitant to buy bonds with the possibility of continued increases in market rates. Dealers also reduced their willingness to hold additional inventories of new Agency debt as the debt they held earlier in the year decreased in value and extended in duration. These factors have increased the spread over U.S. Treasuries at which we can issue longer-term bullet and callable bonds. 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.”

 

Other factors impacting FHLBank consolidated obligations:

Investors continue to view short-term FHLBank consolidated obligations as carrying a relatively strong credit profile. Historically our strong credit profile has resulted in steady investor demand for FHLBank discount notes and short-term bonds, which allowed the overall cost to issue short-term consolidated obligations to remain relatively low throughout the first half of 2013. Political uncertainty over increasing the debt ceiling and funding the Federal government resulted in tighter market conditions and a temporary increase in short-term funding costs across all instruments in late 2013, which caused us to increase our issuance of term discount notes and non-callable variable rate bonds indexed or swapped to LIBOR in anticipation of potential market disruptions related to this uncertainty. The U.S. government reached an agreement to suspend the nation's borrowing limit through March 15, 2015; therefore, concerns over the federal debt ceiling limit, which could result in increased liquidity concerns for market participants and a move back into cash or other short-term investments, have been delayed for the time being. Non-callable variable rate consolidated obligation bonds indexed or swapped to LIBOR generally have fixed terms from 10 to 24 months and are issued in lieu of issuing callable fixed rate consolidated obligation bonds that are swapped to LIBOR. If swapped callable bonds have to be replaced and re-swapped during a market disruption, it is uncertain whether we will be able to issue fixed rate callable debt at favorable LIBOR levels.

 

37

 


 

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 hedged assets or liabilities are recognized simultaneously. 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 seek to utilize 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 risk but do not meet hedge accounting requirements, either because it was more cost effective to use a derivative hedge compared to a non-derivative hedging alternative, or because a non-derivative hedging alternative was not 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.

 

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.

 

38

 


 

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, 2013 and 2012, we held a portfolio of derivatives that are marked to market with no offsetting qualifying hedged item. This portfolio of economic derivatives consisted primarily of: (1) interest rate swaps hedging fixed rate non-MBS trading investments; (2) interest rate caps hedging adjustable rate MBS with embedded caps; and (3) interest rate swaps hedging 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 fair 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 fair value of trading securities being hedged by economic hedges because the amount of economic hedges exceeds the amount of swapped trading securities. See Tables 62 and 63 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 $1.1 billion as of December 31, 2013, which matches the notional amount of interest rate swaps hedging the GSE debentures in trading securities on that date. For asset/liability management purposes, approximately half 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 13 through 15 under this Item 7, which show the relationship of gains/losses on economic 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, 2013 and 2012, 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 17 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.

 

39

 


 

As of December 31, 2013, 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 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. We record private-label MBS at fair value at the time it is determined to have OTTI. Due to the lack of trades in the market for these securities, 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 in past years 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.

 

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; or (3) 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.

 

40

 


 

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 UPB. 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 UPBs 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 UPB 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 financial market conditions.

 

Allowance for Credit Losses: We have established an allowance methodology for each of our portfolio segments to estimate the allowance for credit losses, if necessary, to provide for probable losses inherent in our portfolio segments.

 

41

 


 

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 our conventional mortgage loan portfolio but have not been realized.

§

Collectively Evaluated Mortgage Loans – The assessment of loan loss for the pools of loans entails segmenting 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 held in our mortgage loan portfolio 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 been individually evaluated for impairment, 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 SMI). 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. Based upon the collateral held as security, our credit extension and collateral policies, credit analysis and repayment history, we currently do not anticipate any credit losses on advances and have not recorded an allowance for losses on advances. 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 discussion of collateral.

 

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.

 

Term Federal Funds Sold and Term Securities Purchased Under Agreements to Resell – There were no investments in term Federal funds sold or in term securities purchased under agreements to resell outstanding as of December 31, 2013 and 2012, and all such investments acquired during the years ended December 31, 2013 and 2012 were repaid according to their contractual terms.

 

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.”

 

42

 


 

Results of Operations (Years Ended December 31, 2013, 2012 and 2011)

Earnings Analysis: Table 10 presents changes in the major components of our earnings (dollar amounts in thousands):

 

Table 10

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Increase (Decrease) in Earnings Components

 

Dollar Change

Percent Change

 

2013 vs. 2012

2012 vs. 2011

2013 vs. 2012

2012 vs. 2011

Total interest income

$

(51,718)

 

$

(51,704)

 

 

(10.5)

%

 

(9.5)

%

Total interest expense

 

(49,811)

 

 

(40,458)

 

 

(18.1)

 

 

(12.8)

 

Net interest income

 

(1,907)

 

 

(11,246)

 

 

(0.9)

 

 

(4.9)

 

Provision for credit losses on mortgage loans

 

(570)

 

 

1,438 

 

 

(22.8)

 

 

135.9 

 

Net interest income after mortgage loan loss provision

 

(1,337)

 

 

(12,684)

 

 

(0.6)

 

 

(5.5)

 

Net gain (loss) on trading securities

 

(22,937)

 

 

(48,820)

 

 

(81.8)

 

 

(235.0)

 

Net gain (loss) on derivatives and hedging activities

 

31,585 

 

 

87,265 

 

 

147.1 

 

 

80.2 

 

Other non-interest income

 

3,450 

 

 

(3,033)

 

 

52.2 

 

 

(31.5)

 

Total other income (loss)

 

12,098 

 

 

35,412 

 

 

28.2 

 

 

45.2 

 

Operating expenses

 

1,080 

 

 

(364)

 

 

2.6 

 

 

(0.9)

 

Other non-interest expenses

 

(14)

 

 

(1,721)

 

 

(0.1)

 

 

(15.2)

 

Total other expenses

 

1,066 

 

 

(2,085)

 

 

2.1 

 

 

(3.9)

 

AHP assessments

 

968 

 

 

3,650 

 

 

7.9 

 

 

42.4 

 

REFCORP assessments

 

 

 

(11,822)

 

 

0.0 

 

 

(100.0)

 

Total assessments

 

968 

 

 

(8,172)

 

 

7.9 

 

 

(40.0)

 

Net income

$

8,727 

 

$

32,985 

 

 

7.9 

%

 

42.7 

%

 

Net income for the year ended December 31, 2013 was $119.0 million compared to $110.3 million for the year ended December 31, 2012. The $8.7 million increase was due primarily to a decrease in net losses from: (1) derivative and hedging activities; and (2) fair value changes on trading securities. We also had a slight decrease in the provision for loan losses, which added to 2013 net income. These positive impacts on net income were partially offset by a decrease in net interest income principally due to a decrease in the weighted average yield on assets that exceeded the decrease in the weighted average cost of interest bearing liabilities. Return on equity (ROE) was 6.37 percent and 6.23 percent for the year ended December 31, 2013 and 2012, respectively. Dividends paid to members totaled $33.0 million for the year ended December 31, 2013 compared to $30.5 million for the prior year.

 

Net income for the year ended December 31, 2012 was $110.3 million compared to $77.3 million for the year ended December 31, 2011. The $33.0 million increase was due primarily to a $38.4 million decrease in net losses from: (1) derivative and hedging activities; and (2) fair value changes on trading securities and an $8.2 million decrease in assessments, partially offset by an $11.2 million decrease in net interest income and a slight increase in the 2012 provision for loan losses. The smaller net loss on derivatives and hedging activities between 2011 and 2012 is primarily the result of a smaller relative decline in interest rates and steepness of the yield curve in 2012 compared to 2011, partially offset by a decrease in the fair value of our trading securities portfolio in 2012.

 

Net Interest Income: Net interest income, which includes interest earned on advances, mortgage loans and investments less interest paid on consolidated obligations, deposits, and other borrowings is the primary source of our earnings. The decrease in net interest income for the year ended December 31, 2013 compared to 2012 was due primarily to a decrease in our net interest spread and margin despite an increase in average interest-earning assets (see Table 11). Net interest income decreased from 2011 to 2012 as a result of a smaller balance sheet, a decline in interest rates, and changes in asset composition. The decreases in the average yield on long-term investments and advances had the largest impact on the decrease in interest income between 2012 and 2013, and are discussed in greater detail below.

 

The average yield on investments, which consists of interest-bearing deposits, Federal funds sold, reverse repurchase agreements and investment securities, decreased 21 bps, from 1.26 percent for the year ended December 31, 2012 to 1.05 percent for the current year. The average yield on our investment portfolio increased between 2011 and 2012 primarily due to compositional changes in this portfolio, while the decrease in the average yield on investments between 2012 and 2013 was a result of declining interest rates, including LIBOR. A significant portion of our investment portfolio consists of short-term investments or variable rate investments with short-term indices, such as one- or three-month LIBOR and the Federal funds effective rate. Prepayments of higher rate MBS/CMOs reinvested into lower rate or variable rate MBS/CMOs also factored into the decline in the yield on our investment securities between 2012 and 2013.

 

43

 


 

The average yield on advances decreased 19 bps, from 0.89 percent for the year ended December 31, 2012 to 0.70 percent for the current year. The decrease in the average yield on advances was due to a general shift in composition that began in 2012 and continued into 2013, resulting from growth in our lowest margin advance product, which is line of credit advances, and a decrease in prepayment fees between 2013 and 2012. Further, a significant portion of our advances are swapped to LIBOR so the decrease in the average one month and three-month LIBOR rates during 2013 compared to 2012 also contributed to the decline in advance yields.

 

The average yield on mortgage loans decreased 23 bps, from 3.52 percent in 2012 to 3.29 percent in 2013. Similar to 2012, the decrease in the average yield on the mortgage portfolio was due to: (1) borrowers refinancing their mortgages in order to take advantage of lower average residential mortgage rates experienced throughout much of 2012 and the first half of 2013; and (2) new mortgage loans placed into our portfolio at average rates below existing mortgage loans. During 2013, the increase in the write-offs of premiums associated with mortgage loan prepayments also contributed to the decrease in yield. As residential mortgage rates increased and prepayments declined in the fourth quarter of 2013, the mortgage portfolio yield increased slightly from the low levels of the first and second quarters of 2013. We expect this yield to remain relatively steady for the next several quarters, as mortgage interest rates are not anticipated to fluctuate significantly from current levels.

 

The overall decline in asset yields in 2013 has been greater than the decline in funding costs, which had been significantly reduced in 2012 through our callable debt refinancing. Although we continued to refinance our debt in 2013, we were not able to lower our funding costs to a level commensurate with the decline in our asset yields during 2013. In late 2011 and early 2012, we refinanced most of our unswapped callable debt used to fund predominately fixed rate amortizing assets, which allowed us to significantly increase our net interest margin in the first half of 2012. During the remainder of 2012 and into 2013, our mortgage asset yields decreased significantly due to borrowers refinancing at lower rates, which also increased premium amortization during 2013. We were unable to lower our debt costs as much as our mortgage yields decreased, thus contributing to the lower net interest spread and margin in 2013.

 

The average cost of consolidated obligation bonds decreased 27 bps, from 1.28 percent in 2012 to 1.01 percent in 2013. This decrease was largely a result of the refinance of a large portion of our longer-term unswapped callable bonds throughout 2012, the impact of which was fully realized during 2013. The decrease was also due to relatively low intermediate and long-term market interest rates for the first half of 2013, and lower short-term market interest rates, especially LIBOR. Despite the increase in interest rates during the second half of 2013, we were able to replace some called and matured higher-cost consolidated obligation bonds with debt at a much lower cost in late 2013. Therefore, the average cost of our consolidated obligations decreased further beginning in the fourth quarter of 2013. Replacing callable debt generally increases interest costs in the short term due to the acceleration of the unamortized concessions on the debt when it is called because concession costs are amortized to contractual maturity. However, this increase is offset by the lower rate on the new debt and the funding benefit due to the timing differences between the date the debt is called and the forward settlement date of the new debt (conventionally not exceeding 30 days). For 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.”

 

Our net interest spread is impacted by derivative and hedging activities, as the assets and liabilities hedged with derivative instruments designated under fair value hedging relationships are adjusted for changes in fair values, while other assets and liabilities are carried at historical cost. This causes positive hedging adjustments on advances to reduce the average annualized yield and positive hedging adjustments on consolidated obligations to decrease the average annualized cost. The positive hedging adjustments on advances have exceeded those on consolidated obligations over the last three years, which has negatively affected the average net interest spread and is not necessarily comparable between years. Additionally, net interest payments or receipts on derivatives designated as fair value hedges and 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 13 through 15 under this Item 7), which distorts yields, especially for trading investments that are swapped to a variable rate.

 

44

 


 

Table 11 presents average balances and yields of major earning asset categories and the sources funding those earning assets (dollar amounts in thousands):

 

Table 11

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

12/31/2013

12/31/2012

12/31/2011

 

Average Balance

Interest Income/ Expense

Yield

Average Balance

Interest Income/ Expense

Yield

Average Balance

Interest

Income/

Expense

Yield

Interest-earning assets:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest-bearing deposits

$

272,385 

 

$

311 

 

 

0.11 

%

$

353,494 

 

$

513 

 

 

0.15 

%

$

206,898 

 

$

204 

 

 

0.10 

%

Securities purchased under agreements to resell

 

847,010 

 

 

1,027 

 

 

0.12 

 

 

1,371,914 

 

 

2,742 

 

 

0.20 

 

 

124,164 

 

 

78 

 

 

0.06 

 

Federal funds sold

 

1,259,512 

 

 

1,346 

 

 

0.11 

 

 

854,682 

 

 

1,285 

 

 

0.15 

 

 

1,804,640 

 

 

2,141 

 

 

0.12 

 

Investment securities1

 

8,839,549 

 

 

114,643 

 

 

1.30 

 

 

8,880,851 

 

 

139,488 

 

 

1.57 

 

 

11,912,420 

 

 

180,482 

 

 

1.52 

 

Advances2,3

 

18,278,197 

 

 

128,441 

 

 

0.70 

 

 

17,348,927 

 

 

154,560 

 

 

0.89 

 

 

17,847,711 

 

 

165,514 

 

 

0.93 

 

Mortgage loans2,4,5

 

5,947,390 

 

 

195,644 

 

 

3.29 

 

 

5,526,009 

 

 

194,363 

 

 

3.52 

 

 

4,612,061 

 

 

195,828 

 

 

4.25 

 

Other interest-earning assets

 

26,170 

 

 

1,653 

 

 

6.32 

 

 

29,305 

 

 

1,832 

 

 

6.25 

 

 

35,272 

 

 

2,240 

 

 

6.35 

 

Total earning assets

 

35,470,213 

 

 

443,065 

 

 

1.25 

 

 

34,365,182 

 

 

494,783 

 

 

1.44 

 

 

36,543,166 

 

 

546,487 

 

 

1.50 

 

Other non-interest-earning assets

 

153,265 

 

 

 

 

 

 

 

 

166,083 

 

 

 

 

 

 

 

 

343,859 

 

 

 

 

 

 

 

Total assets

$

35,623,478