10-K 1 fhlbt12311410k.htm 10-K FHLBT 12.31.14 10K
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C.  20549
 
FORM 10-K
 
x      ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2014
 
OR
 
¨      TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from ________ to ________
 
Commission File Number 000-52004
 
FEDERAL HOME LOAN BANK OF TOPEKA
(Exact name of registrant as specified in its charter)
 
Federally chartered corporation
 
48-0561319
(State or other jurisdiction of
incorporation or organization)
 
(I.R.S. Employer
Identification No.)
 
One Security Benefit Pl. Suite 100
Topeka, KS
 
 
66606
(Address of principal executive offices)
 
(Zip Code)
 
Registrant’s telephone number, including area code: 785.233.0507

Securities registered pursuant to Section 12(b) of the Act: None

Securities registered pursuant to Section 12(g) of the Act:
Class A Common Stock, $100 per share par value

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  ¨ Yes  x No

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  ¨ Yes  x No

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  x Yes  ¨ No
 
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  x  Yes  ¨  No
 
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  x

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. ¨ Large accelerated filer  ¨ Accelerated filer  x Non-accelerated filer  ¨ Smaller reporting company
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).  ¨ Yes  x No
 
Indicate the number of shares outstanding of each of the registrant’s classes of common stock, as of the latest practicable date.
 
 
Shares outstanding as of
March 10, 2015
Class A Stock, par value $100 per share
1,748,745
Class B Stock, par value $100 per share
10,029,930

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 30, 2014, the aggregate par value of stock held by current and former members of the registrant was $882,110,700, and 8,821,107 total shares were outstanding as of that date.

Documents incorporated by reference:  None





.FEDERAL HOME LOAN BANK OF TOPEKA
TABLE OF CONTENTS
PART I 
 
Item 1.
Business
Item 1A.
Risk Factors
Item 1B.
Unresolved Staff Comments
Item 2.
Properties
Item 3.
Legal Proceedings
Item 4.
Mine Safety Disclosures
PART II
 
Item 5.
Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Item 6.
Selected Financial Data
Item 7.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 7A.
Quantitative and Qualitative Disclosures About Market Risk
Item 8.
Financial Statements and Supplementary Data
Item 9.
Changes in and Disagreements With Accountants on Accounting and Financial Disclosure
Item 9A.
Controls and Procedures
Item 9B.
Other Information
PART III
 
 
Item 10.
Directors, Executive Officers and Corporate Governance
Item 11.
Executive Compensation
Item 12.
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
Item 13.
Certain Relationships and Related Transactions, and Director Independence
Item 14.
Principal Accounting Fees and Services
PART IV
 
 
Item 15.
Exhibits, Financial Statement Schedules




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 risks or uncertainties 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;
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 FHLBank products and services or consolidated obligations of the FHLBank System;
Effects of derivative accounting treatment, other-than-temporary impairment (OTTI) accounting treatment, and other accounting rule requirements, or changes in such 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, counterparties, 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;
The ability of the FHLBank to keep pace with technological changes and the ability to develop and support technology and information systems, including the ability to securely 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).


1 "Mortgage Partnership Finance," "MPF," "eMPF" and "MPF Xtra" are registered trademarks of FHLBank Chicago.


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Readers of this report should not rely solely on the forward-looking statements and should consider all risks and uncertainties addressed throughout this report, as well as those discussed under Item 1A – “Risk Factors.”

All forward-looking statements contained in this Form 10-K are expressly qualified in their entirety by reference to 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 to reflect events or circumstances after the date of this report.


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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 2014, 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 five 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 2014 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.

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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 (including FHLB Topeka) 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.

On September 25, 2014, the boards of directors of the FHLBank of Des Moines and the FHLBank of Seattle executed a definitive merger agreement after receiving unanimous approval from their boards of directors. On October 31, 2014, these FHLBanks submitted a joint merger application to the Finance Agency. The Finance Agency approved the merger application on December 19, 2014, subject to the satisfaction of specific closing conditions set forth in the Finance Agency's approval letter, including the ratification of the merger by members of both FHLBanks.

On January 12, 2015, these FHLBanks mailed a joint merger disclosure statement, voting ballots, and related materials to their respective members and requested that ballots be returned by the close of business on February 23, 2015. On February 27, 2015, these FHLBanks issued a joint press release announcing the ratification of the merger by members of both FHLBanks.

The consummation of the merger will be effective only after the Finance Agency determines that the closing conditions identified in the approval letter have been satisfied and the Finance Agency determines that the continuing FHLBank's organizational certificate complies with the requirements of the Finance Agency's merger rules. Assuming the Finance Agency makes these determinations, the merger is expected to be effective on May 31, 2015. The continuing FHLBank would be headquartered in Des Moines. 

Business Segments
We do not currently manage or segregate our operations by business or geographical segment.

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 potentially 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;
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 360 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 and amortizing fixed rate advances up to 24 months in advance;
Member option advances are fixed rate advances that provide the member with an option to prepay without a fee at specific intervals throughout the life of the advance and are issued at a discount to reflect the cost of that option;
Structured advances are advances with an embedded cap, floor, or collar; 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.


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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 – 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.

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. 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), at our discretion.

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, Community Development Financial Institutions (CDFI), 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.

Table 11 under Item 7 – "Management’s Discussion and Analysis of Financial Condition and Results of Operations – Results of Operations" presents the amount of total interest income contributed by our advance products. Tables 25 and 26 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, 2014 and 2013 and the interest income associated with the five borrowers who paid the highest amount of interest income for the years ended December 31, 2014 and 2013.


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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 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 under 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 sell servicing rights 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.

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 reduce the amount of the CE obligation to some degree, 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 four 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.

Table 11 under Item 7 – "Management’s Discussion and Analysis of Financial Condition and Results of Operations – Results of Operations" presents the amount of total interest income contributed by our mortgage loan products. Table 27 under Item 7 – “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Financial Condition” presents the outstanding balances of mortgage loans sold to us, net of participations, from our top five PFIs and the percentage of those loans to total mortgage loans outstanding.


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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 and cover repurchase risk.
 
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. 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. 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 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.
 
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 servicing‑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.


9


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 potential or pending claim, action, or proceeding asserting that we are liable under these laws. However, there can be no assurance that we will never have any liability under predatory or abusive lending laws.

Table 1 presents a comparison of the different characteristics for each of the MPF products held on our balance sheet as of December 31, 2014:

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
Aggregate sum of the loan level credit enhancements (LLCEs)
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
Aggregate sum of the LLCEs less FLA

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
Aggregate sum of the LLCEs less FLA
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
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 Wall Street Reform and Consumer Protection Act (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, 2014:

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 agreements 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 month-end total regulatory capital, as most recently 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. As of December 31, 2014, the amortized cost of our MBS/CMO portfolio represented 304 percent of our regulatory capital due to some capital redemptions that occurred prior to year end.


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 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 FHLBanks for the payment of principal and interest on the consolidated obligations of all 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, 2014 and 2013 (in millions):

Table 3
 
12/31/2014
12/31/2013
Par value of consolidated obligations of the FHLBank
$
34,381

$
30,931

 
 
 
Par value of consolidated obligations of all FHLBanks
$
847,175

$
766,837


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, 2014 and 2013 (in thousands):

Table 4
 
12/31/2014
12/31/2013
Total non-pledged assets
$
36,767,405

$
33,864,497

Total carrying value of consolidated obligations
$
34,440,614

$
30,946,529

Ratio of non-pledged assets to consolidated obligations
1.07

1.09


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 and manages the FHLBanks’ relationship with the NRSROs with respect to ratings on consolidated obligations. In addition, the Office of Finance administers two tax-exempt government corporations, the Resolution Funding Corporation (REFCORP) and the Financing Corporation (FICO), which were established as a result of the savings and loan crisis of the 1980s.

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.

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.

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.


13


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 – 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 Common Stock is conditionally redeemable on six months’ written notice from the member, and Class B Common 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.

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 five percent minimum leverage capital requirement based on total FHLBank capital, which includes a 1.5 weighting factor applicable to permanent capital, and a four 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.


14


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 a value-at-risk calculation at a 95 percent confidence level for a 60 business day or three calendar month period; 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 included 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 2014 and 2013 (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)
12/31/2014
09/30/2014
06/30/2014
03/31/2014
Market Risk
$
34,441

$
32,528

$
42,053

$
34,414

Credit Risk
53,375

52,782

55,746

53,214

Operations Risk
26,345

25,593

29,340

26,288

Derivative Hedging Volatility
13,807

19,212

18,950

23,729

Total Retained Earnings Threshold
127,968

130,115

146,089

137,645

Actual Retained Earnings as of End of Quarter
627,133

615,192

599,999

581,425

Overage
$
499,165

$
485,077

$
453,910

$
443,780


Table 6
 
 
 
 
 
Retained Earnings Component (based upon prior quarter end)
12/31/2013
09/30/2013
06/30/2013
03/31/2013
Market Risk (dividend paying capacity)1
$
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.

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.


15


Joint Capital Enhancement Agreement (JCE Agreement) – Effective February 28, 2011, we, along with the other 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 an RRE Account and will do so until the balance of the account equals at least 1 percent of that FHLBank’s average balance of outstanding consolidated obligations for the previous quarter.

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

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


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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 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.

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 to finance the purchase, construction, or rehabilitation of very low-, low-, and moderate-income owner occupied or rental housing. In addition to the competitive AHP program funds, a customized homeownership set-aside program called the Homeownership Set-aside Program (HSP) was offered during 2014 under the AHP. The HSP provides down payment, closing cost, or rehabilitation cost assistance to first-time homebuyers in Colorado, Kansas, Nebraska, and Oklahoma.

Community Investment Cash Advance (CICA) Program. CICA loans to members specifically target underserved markets in both rural and urban areas. CICA loans represented 4.8 percent, 5.0 percent and 5.1 percent of total advances outstanding as of December 31, 2014, 2013, and 2012, respectively. Programs offered during 2014 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 slight 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 slight mark-up for administrative costs.


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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 2014, $998,000 in JOBS funds were distributed to assist members in promoting employment growth in their communities. We distributed $995,000 and $998,000 in 2013 and 2012, respectively. A charitable grant program, JOBS funds are allocated annually to support economic development projects. For 2015, 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 directors, employees, members of their households, and any for-profit entity owned by FHLBank directors, employees, or members of their households, are not eligible for JOBS grants. Nonprofit entities at which FHLBank directors, employees, and members of their households volunteer or are employed remain eligible for JOBS grants; and
Rural First-time Homebuyer Education Program – We provide up to $75,000 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 HSP-participating members. We used $75,000, $75,000 and $100,000 of the available funds for this program during 2014, 2013 and 2012, respectively. For 2015, $75,000 has been allocated to this program.

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. Members mostly access alternative funding other than advances through the brokered deposit market and through repurchase agreements with commercial customers. Large members may have broader access to funding through repurchase agreements with investment banks and commercial banks as well as access to the national and global credit markets. While the availability of alternative funding sources to members can influence member demand for advances, the cost of the alternative funding relative to advances is the primary consideration when accessing alternative funding. Other considerations include product availability through the FHLBank, the member’s creditworthiness, ease of execution, level of diversification, 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, 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.


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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 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 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 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.

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 of the United States. 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 10, 2015, we had 217 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 Recovery Act and the Dodd-Frank Act. Our business operations, funding costs, rights, obligations, and/or the environment in which we carry out our housing finance, community lending and liquidity mission 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 Developments:

Final Rule on Capital Stock and Capital Plans. On October 8, 2014, the Finance Agency issued a proposed rule that would transfer existing parts 931 and 933 of the Federal Housing Finance Board regulations, which address requirements for FHLBanks’ capital stock and capital plans, to new Part 1277 of the Finance Agency regulations (Capital Proposed Rule). The Capital Proposed Rule did not make any substantive changes to these requirements, but did delete certain provisions that applied only to the one-time conversion of FHLBank stock to the new capital structure required by the GLB Act. The Capital Proposed Rule also made certain clarifying changes so that the rules more precisely reflected long-standing practices and requirements with regard to transactions in FHLBank stock. The Capital Proposed Rule added appropriate references to ‘‘former members’’ to clarify when former FHLBank members can be required to maintain investments in FHLBank capital stock after withdrawal from membership in an FHLBank. On March 11, 2015, the Finance Agency

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approved the Capital Proposed Rule as a final rule without change. The final rule will be effective on April 10, 2015. The final rule is not expected to have an impact on our financial condition, results of operations, or cash flows.

Finance Agency Proposed Rule on FHLBank Membership. On September 12, 2014, the Finance Agency issued a proposed rule that would:
Impose a new test on all FHLBank members that requires them to maintain at least one percent of their assets in long term first-lien home mortgage loans, including MBS backed by such loans, on an ongoing basis, with maturities of five years or more, to maintain their membership in their respective FHLBank. The proposal also suggests the possibility of a two percent or a five percent test as options;
Require all insured depository members (other than Federal Deposit Insurance Corporation (FDIC)-insured depositories with less than $1.1 billion in assets) to maintain, on an ongoing basis (rather than only at the time of application for membership as required by current regulations), at least 10 percent of their assets in a broader range of residential mortgage loans, including those secured by junior liens and MBS, in order to maintain their membership in their respective FHLBank;
Eliminate all currently eligible captive insurance companies from FHLBank membership. Current captive insurance company members would have their memberships terminated five years after the rule is finalized. There would be restrictions on the level and maturity of advances that FHLBanks could make to these members during the sunset period. Under the proposed rule, a captive insurance company is a company that is authorized under state law to conduct an insurance business but whose primary business is not the underwriting of insurance for non-affiliated persons or entities; and
Clarify how an FHLBank should determine the “principal place of business” of an insurance company or Community Development Financial Institution (CDFI) for purposes of membership. The proposed rule would also change the way the principal place of business is determined for an institution that becomes a member of an FHLBank after issuance of the final rule. Current rules define an institution’s principal place of business as the state in which it maintains its home office. The proposal would add a second component requiring an institution to conduct business operations from the home office for that state to be considered its principal place of business. The changes would apply prospectively.

If the proposed rule is adopted in its current form, our financial condition and results of operation may be impacted due to loss of members and potential members. Refer also to discussion included in Item 1A – "Risk Factors" in this Form 10-K.

Margin and Capital Requirements for Covered Swap Entities. On September 24, 2014, the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, the FDIC, the Farm Credit Administration, and the Finance Agency (collectively, the Agencies) jointly proposed a rule to establish minimum margin and capital requirements for registered swap dealers, major swap participants, security-based swap dealers, and major security-based swap participants (collectively, Swap Entities) that are subject to the jurisdiction of one of the Agencies (the Proposed Rule). In addition, the Proposed Rule affords the Agencies discretion to subject other persons to the Proposed Rule’s requirements (such persons, together with Swap Entities, referred to as Covered Swap Entities).

The Proposed Rule would subject non-cleared swaps and non-cleared security-based swaps between Covered Swap Entities and between Covered Swap Entities and financial end users that have material swaps exposure (i.e., an average daily aggregate notional of $3 billion or more in uncleared swaps) to a mandatory two-way initial margin requirement. The amount of the initial margin required to be posted or collected would be either the amount calculated using a standardized schedule set forth in the Proposed Rule, which provides the gross initial margin (as a percentage of total notional exposure) for certain asset classes, or an internal margin model conforming to the requirements of the Proposed Rule that is approved by the applicable Agency. The Proposed Rule specifies the types of collateral that may be posted or collected as initial margin (generally, cash, certain government securities, certain liquid debt, certain equity securities and gold); and sets forth haircuts for certain collateral asset classes. Initial margin must be segregated with an independent, third-party custodian and may not be rehypothecated (i.e., reused for their own collateral purposes).

The Proposed Rule would require variation margin to be exchanged daily for non-cleared swaps and non-cleared security-based swaps between Covered Swap Entities and between Covered Swap Entities and all financial end-users (without regard to the swaps exposure of the particular financial end-user). The variation margin amount is the daily mark-to-market change in the value of the swap to the Covered Swap Entity, taking into account variation margin previously paid or collected. Variation margin may only be paid or collected in cash, is not subject to segregation with an independent, third-party custodian, and may, if permitted by contract, be rehypothecated.

Under the Proposed Rule, the variation margin requirement would become effective on December 1, 2015 and the initial margin requirement would be phased in over a four-year period commencing on that date. For entities that have less than a $1 trillion notional amount of non-cleared derivatives, the Proposed Rule’s initial margin requirement would not come into effect until December 1, 2019.

We would not be a Covered Swap Entity under the Proposed Rule, although the Finance Agency has discretion to designate us as a Covered Swap Entity. Rather, we would be a financial end-user under the Proposed Rule, and we would likely have material swaps exposure upon the effective date of the Proposed Rule’s initial margin requirement.


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Since we are currently posting and collecting variation margin on non-cleared swaps, it is not anticipated that the Proposed Rule’s variation margin requirement, if adopted, would have a material impact on our costs. However, if the Proposed Rule’s initial margin requirement is adopted, it is anticipated that our cost of engaging in non-cleared swaps would increase.

Finance Agency Proposed Rule on Responsibilities of Boards of Directors; Corporate Practices and Corporate Governance Matters. On January 28, 2014, the Finance Agency published 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, and the FHLBanks (each a "regulated entity"). 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 each regulated entity adopt an enterprise wide risk management program and appoint a chief risk officer with certain enumerated responsibilities;
Require each regulated entity to maintain a compliance program headed by a compliance officer who reports directly to the chief executive officer and must regularly report to the board of directors (or a board committee);
Require each regulated entity’s board to establish committees specifically responsible for the following matters: (a) risk management; (b) audit; (c) compensation; and (d) corporate governance;
Require each FHLBank to designate in its bylaws a body of law to follow for its corporate governance practices and procedures 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 a regulated entity’s indemnification policies, procedures and practices and may limit or prohibit indemnification payments in support of the safe and sound operations of the regulated entity.

Finance Agency Final Rule on Executive Compensation. On January 28, 2014, the Finance Agency issued a final rule, effective February 27, 2014, setting forth requirements and processes with respect to compensation provided to executive officers of the FHLBanks and the Office of Finance. The final rule addresses the authority of the Director of the Finance Agency to: (1) approve executive officer agreements that provide for compensation in connection with termination of employment; and (2) review the compensation arrangements of executive officers of the FHLBanks and to prohibit an FHLBank 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.

Finance Agency Final Rule on Golden Parachute Payments. On January 28, 2014, the Finance Agency issued a final rule, effective February 27, 2014, setting forth the standards that the Director of the Finance Agency will consider when determining whether to limit or prohibit golden parachute payments. The primary impact of this final rule is to better conform existing Finance Agency regulations on golden parachutes with FDIC golden parachute regulations and to further limit golden parachute payments made by an FHLBank or the Office of Finance that is assigned a less than satisfactory composite Finance Agency examination rating.

Other Significant Developments:

National Credit Union Administration (NCUA) Risk-Based Capital Proposed Rule. On January 27, 2015, the NCUA issued a second proposed rule for comment that would amend NCUA’s current regulations regarding prompt corrective action to require that credit unions, with assets greater than $100 million, taking certain risks hold capital commensurate with those risks. We are currently evaluating the potential impact of the proposed rule.

Basel Committee on Bank Supervision - Liquidity Coverage Ratio. On September 3, 2014, the Board of Governors of the Federal Reserve System, the Office of the Comptroller of the Currency, and the FDIC finalized the liquidity coverage ratio (LCR) rule, applicable to: (i) U.S. banking organizations with $250 billion or more in total consolidated assets or $10 billion or more in total consolidated on-balance sheet foreign exposure, and their consolidated subsidiary depository institutions with $10 billion or more in total consolidated assets; and (ii) certain other U.S. bank or savings and loan holding companies having at least $50 billion in total consolidated assets, which will be subject to less stringent requirements under the LCR rule. The LCR rule requires such covered companies to maintain investments of “high quality liquid assets” (HQLA) that are no less than 100 percent of their total net cash outflows over a prospective 30-day stress period. Among other things, the final rule defines the various categories of HQLA, called Levels 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.


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Under the final rule, collateral pledged to an FHLBank but not securing existing borrowings may be considered eligible HQLA to the extent the collateral itself qualifies as eligible HQLA; qualifying FHLBank System consolidated obligations are categorized as Level 2A HQLAs; and the amount of a covered company’s funding that is assumed to run-off includes 25 percent of FHLBank advances maturing within 30 days, to the extent such advances are not secured by Level 1 or Level 2A HQLA, where 0 percent and 15 percent run-off assumptions apply, respectively. At this time, the impact of the final rule is uncertain. The final rule became effective January 1, 2015 and requires that all covered companies be fully compliant by January 1, 2017.

Money Market Mutual Fund Reform. On July 23, 2014, the SEC approved final regulations governing money market mutual funds. The final regulations, among other things, will:
Require institutional prime money market funds (including institutional municipal money market funds) to sell and redeem shares based on their floating net asset value, which would result in the daily share prices of these money market funds fluctuating along with changes in the market-based value of the funds’ investments;
Allow money market fund boards of directors to directly address a run on a fund by imposing liquidity fees or suspending redemptions temporarily; and
Include enhanced diversification, disclosure and stress testing requirements, as well as provide updated reporting by money market funds and private funds that operate like money market funds.

The final regulations do not change the existing regulatory treatment of FHLBank consolidated obligations as liquid assets. FHLBank consolidated discount notes continue to be included in the definition of “daily liquid assets,” and the definition of “weekly liquid assets” continues to include FHLBanks' consolidated discount notes with a remaining maturity of up to 60 days. The future impact of these regulations on demand for FHLBank consolidated obligations is unknown.

Joint Final Rule on Credit Risk Retention for Asset-Backed Securities. On October 22, 2014, the Finance Agency and other U.S. federal regulators jointly approved a final rule requiring sponsors of ABS to retain credit risk in those transactions. The final rule largely retains the risk retention framework contained in the proposal issued by the agencies in August 2013 and generally requires sponsors of ABS to retain a minimum five percent economic interest in a portion of the credit risk of the assets collateralizing the ABS, unless all the securitized assets satisfy specified qualifications. The final rule specifies criteria for qualified residential mortgage (QRM), commercial real estate, auto, and commercial loans that would make them exempt from the risk retention requirement. The definition of QRM is aligned with the definition of “qualified mortgage” (QM) as provided in Section 129C of the Truth in Lending Act, and its implementing regulations, as adopted by the Consumer Financial Protection Bureau. The QM definition requires, among other things, full documentation and verification of consumers’ debt and income and a debt-to-income ratio that does not exceed 43 percent; and restricts the use of certain product features, such as negative amortization and interest-only and balloon payments.

Other exemptions from the credit risk requirement include certain owner-occupied mortgage loans secured by three-to-four unit residential properties that meet the criteria for QM and certain types of community-focused residential mortgages (including extensions of credit made by CDFIs). The final rule also includes a provision that requires the agencies to periodically review the definition of QRM, the exemption for certain community-focused residential mortgages, and the exemption for certain three-to-four unit residential mortgage loans and consider whether they should be modified.

The final rule exempts Agency MBS from the risk retention requirements as long as the sponsoring agency is operating under the conservatorship or receivership of the Finance Agency and fully guarantees the timely payment of principal and interest on all assets in the issued security. Further, MBS issued by any limited-life regulated entity succeeding to either Fannie Mae or Freddie Mac operating with capital support from the U.S. would be exempt from the risk retention requirements. The final rule became effective February 23, 2015. Compliance with the rule with respect to asset-backed securities collateralized by residential mortgages is required beginning December 24, 2015 and compliance with the rule with regard to all other classes of asset-backed securities is required beginning December 24, 2016. We have not yet determined the effect, if any, that this rule, may have on our operations.

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). 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 were extended and were implemented on January 1, 2015. The implementation of the charge-off provisions of AB 2012-02 did not have a material impact on our financial condition, results of operations, or cash flows.


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Where to Find Additional Information
We file our annual, quarterly and current reports and other information with the SEC. You may read and copy such material at the public reference facilities maintained by the SEC at 100 F Street, NE, Washington, DC 20549. Please call the SEC at 1-800-732-0330 for more information on the public reference room. You can also find our SEC filings at the SEC’s website at www.sec.gov. Additionally, on our website at www.fhlbtopeka.com, you can find a link to the SEC’s website which can be used to access our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 (Exchange Act), as soon as reasonably practicable after we electronically file such material with, or furnish it to, the SEC.

Item 1A: Risk Factors
 
Our business has been and may continue to be adversely impacted by 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. Despite an improvement in the housing and mortgage markets, there continue to be challenges to the ongoing economic recovery due to uncertainty about the U.S. fiscal situation and the U.S. housing market due to the lack of real wage growth and tight credit standards. Although previous government lending programs are no longer active, 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 adversely affected by provisions contained in 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 adversely 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) have subjected us to increased regulatory requirements which have made and will continue to make 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 and are anticipated to be required for uncleared derivative transactions. The proposed CFTC regulation on uncleared derivatives will increase the amount of collateral we are required to deliver to our counterparties. Such regulatory actions also have the potential to impact the costs of certain transactions between us and our members.

In addition, the Consumer Financial Protection Bureau (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 qualified mortgage (QM) requirements. See Item 1 – “Business – Legislative 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 any mortgage loans pledged to us as collateral.

Our primary regulator, the Finance Agency, also continues to issue proposed and final regulatory and other requirements as a result of the Recovery Act, the Dodd-Frank Act and other mandates. We cannot predict the effect of any new regulations or other regulatory guidance 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 membership base, 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 2014 that would reform the GSEs. We do not know how, when, or to what extent GSE reform legislation will impact the business or operations of the FHLBank or the FHLBank System.

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To the extent that any actions by the U.S. government in response to an economic downturn or recession 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 and other 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 or other requirements or other guidance 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 further regulations promulgated by the SEC, CFTC, Federal Reserve Board, Financial Crimes Enforcement Network, or other regulatory agencies.
 
We cannot predict whether new regulatory or other 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, statutory or other 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 mortgage loan activities, which could negatively affect our financial condition and results of operations.

We share a regulator with Fannie Mae and Freddie Mac. The Finance Agency currently serves as the federal regulator of the FHLBanks and the Office of Finance, Fannie Mae and Freddie Mac. Because the business models of Fannie Mae and Freddie Mac are significantly different from that of the FHLBanks, there is a risk that actions by the Finance Agency toward Fannie Mae and Freddie Mac may have an unfavorable impact on the FHLBanks’ operations and/or financial condition. 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.
 
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 FHLBanks are in ongoing discussions with the Finance Agency regarding the core mission asset measures and benchmark ratios, which have not yet been finalized. Any adjustments to our balance sheet to meet core mission asset ratios may result in lower net income and, therefore, adversely impact our financial condition and results of operations as we implement and maintain a core mission asset balance sheet.

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 required AHP contribution, which could adversely affect our results of operations, our ability to pay dividends, or our ability to redeem or repurchase capital stock. 

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 or other requirements by the Finance Agency that would require higher levels of required or restricted 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 accounting guidance 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 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.


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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 accounting guidance 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 capital stock necessary for membership and/or lending activities with us.

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, the Finance Agency, and the Federal Deposit Insurance Corporation (FDIC) have been focused on maintaining home mortgage rates at relatively low levels. These actions may increase the rate of mortgage prepayments which may adversely affect the earnings on our mortgage investments.

Changes in our credit ratings may adversely affect our business operations. As of March 10, 2015. we are rated Aaa with a stable outlook by Moody’s and AA+ with a stable outlook by S&P. Adverse 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 could impact the credit standing or credit rating of the U.S. government, which could in turn result in a revision of the rating assigned to us or the consolidated obligations of the FHLBank System.

The FHLBanks issue consolidated obligations that are the joint and several liability of all FHLBanks. Significant developments affecting the credit standing of one or more of the other 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 adversely affect our cost of funds and negatively affect our financial condition. As of March 10, 2015, 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 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 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.


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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. Trends in unemployment, home price growth, and foreclosure inventory have been moving in a positive direction for the past several years, which has supported the underlying health of our MBS/ABS investments. However, if one or more of these macroeconomic variables deteriorates noticeably, delinquency and/or default rates on the underlying collateral supporting these investments will likely increase, and we could experience reduced yields or losses on our MBS/ABS investments. Any increase in 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 potential 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 collateral losses exceed the coverage ability of the insurance company, the MBS/CMO or HFA bondholders could experience losses of principal. Furthermore, market illiquidity has, from time to time, increased the amount of management judgment required to value private-label MBS/ABS and certain other securities. Subsequent valuations may result in significant changes in the value of private-label MBS/ABS and other investment securities. If we decide to sell securities due to credit deterioration, the price we may ultimately realize will depend on the demand and liquidity in the market at that time and may be materially lower than the fair value reflected in our financial statements.
 
Loan modification and liquidation programs could have an adverse impact on the value of our MBS investments. Efforts of mortgage servicers to modify delinquent loans in order to mitigate losses 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 delinquent mortgage loans 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 may result in higher losses than we may have expected or experienced to date being allocated to our MBS investments backed by such loans, which may have an adverse impact on our results of operations and financial condition.
 
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.
 
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, the majority of which are located within the United States, Canada, Australia, and Europe. 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; (5) third-party custodians and futures commission merchants associated with cleared derivatives; and (6) unsecured money market and Federal funds investment transactions. 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 and 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 that allowed us to distribute our risk among various counterparties. A default by a derivatives clearinghouse: (1) could adversely affect our financial condition in the event we are owed money by the derivatives clearinghouse; (2) jeopardize the effectiveness of derivatives hedging transactions; and (3) adversely affect our operations as we may be unable to enter into certain derivatives transactions or do so at cost-effective rates.

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.

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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. Our counterparties in the capital markets are also subject to additional regulation following the financial crisis that ended in 2010. These regulations could alter the balance sheet composition, market activities and behavior of our counterparties in a way that could be detrimental to our access to the capital markets and overall financial market liquidity, which could have a negative impact on our funding costs and results of operations. Further, we rely on the Office of Finance for the issuance of consolidated obligations, and a failure or interruption of services provided by the Office of Finance could hinder our ability to access the capital markets. 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, economic, or other 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 and debt positions 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.

We rely on 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 or through derivative clearinghouses, 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 or at all, 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.

Lack of a public market and restrictions on transferring our stock could result in an illiquid investment for the holder. Under the GLB Act, Finance Agency regulations and our capital plan, our Class A Common Stock may be redeemed upon the expiration of a six-month redemption period and our Class B Common Stock after a five-year redemption period following our receipt of a redemption request. Only capital stock in excess of a member’s minimum investment requirement, capital stock held by a member that has submitted a notice to withdraw from membership or capital stock held by a member whose membership has been terminated may be redeemed at the end of the redemption period. Further, we may elect to repurchase excess capital stock of a member at any time at our sole discretion.
 
We cannot guarantee, however, that we will be able to redeem capital stock even at the end of the redemption periods. The redemption or repurchase of our capital stock is prohibited by Finance Agency regulations and our capital plan if the redemption or repurchase of the capital stock would cause us to fail to meet our minimum regulatory capital requirements. Likewise, under such regulations and the terms of our capital plan, we could not honor a member’s capital stock redemption request if the redemption would cause the member to fail to maintain its minimum capital stock investment requirement. Moreover, since our capital stock may only be owned by our members (or, under certain circumstances, former members and certain successor institutions), and our capital plan requires our approval before a member may transfer any of its capital stock to another member, we can provide no assurance that a member would be allowed to sell or transfer any excess capital stock to another member at any point in time.
 

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We may also suspend the redemption of capital stock if we reasonably believe that the redemption would prevent us from maintaining adequate capital against a potential risk, or would otherwise prevent us from operating in a safe and sound manner. In addition, approval from the Finance Agency for redemptions or repurchases is required if the Finance Agency or our Board of Directors were to determine that we have incurred, or are likely to incur, losses that result in, or are likely to result in, charges against our capital. Under such circumstances, we cannot 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 to 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.

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 market 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 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 rely heavily on information systems and other technology. We rely heavily on 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 and 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.


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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.

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 include 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 loan assets 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.

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 an increase in brokered deposits, may significantly decrease the demand for our advances. Any change we might make in pricing our advances, in order to compete more effectively with 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, and other GSEs, as well as corporate, sovereign and supranational entities for funds raised through the issuance of consolidated obligations and other debt instruments. 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.
 
Member mergers or consolidations, failures, or other changes in member business with us may adversely affect our financial condition and results of operations. 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. Member failures and out-of-district consolidations also 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. 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.


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Further, while member failures may cause us to liquidate pledged collateral if the outstanding advances are not repaid, historically, failures 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 by us 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.

In September 2014, the Finance Agency issued a proposed rule on FHLBank membership. This rule, among other things, imposes new and ongoing membership requirements and eliminates all currently eligible captive insurance companies from FHLBank membership. If this proposed rule is adopted in its current form, it may materially affect certain FHLBanks' business activities, financial condition, and results of operations. The full effect of this rule on each of the FHLBanks and their respective members will be uncertain until after the final membership rule is issued.

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 25) 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.

Item 1B: Unresolved Staff Comments
 
Not applicable.
 
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. 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.
 

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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 10, 2015, we had 795 stockholders of record and 1,748,745 shares of Class A Common Stock and 10,029,930 shares of Class B Common Stock outstanding, including 40,288 shares of Class A Common Stock and 500 shares of Class B Common Stock subject to mandatory redemption by members or former members. "Classes" of stock are not registered 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 voluntarily registered one of our classes of stock pursuant to section 12(g)(1) of the Exchange Act.
 
We paid quarterly stock dividends during the years ended December 31, 2014 and 2013, 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):
 
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
12/31/2014
1.00
%
$
40

$
431

$
471

6.00
%
$
34

$
14,087

$
14,121

09/30/2014
1.00

41

398

439

6.00

34

12,958

12,992

06/30/2014
1.00

39

436

475

5.00

32

9,498

9,530

03/31/2014
0.25

39

256

295

4.00

40

7,840

7,880

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

                   
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 shares of 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 1.00 percent dividend on Class A Common Stock and a 6.00 percent dividend on Class B Common Stock for the first quarter of 2015. 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 – Financial Condition – 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 2014 and 2013. 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.

Item 6: Selected Financial Data

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


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Table 8
 
12/31/2014
12/31/2013
12/31/2012
12/31/2011
12/31/2010
Statement of Condition (as of period end):
 
 
 
 
 
Total assets
$
36,853,977

$
33,950,304

$
33,818,627

$
33,190,182

$
38,706,067

Investments1
9,620,399

8,704,552

10,774,411

10,576,537

14,845,941

Advances
18,302,950

17,425,487

16,573,348

17,394,399

19,368,329

Mortgage loans, net2
6,230,172

5,949,480

5,940,517

4,933,332

4,293,431

Total liabilities
35,268,710

32,149,084

32,098,146

31,488,735

36,922,589

Deposits
595,775

961,888

1,181,957

997,371

1,209,952

Consolidated obligation bonds, net3
20,221,002

20,056,964

21,973,902

19,894,483

21,521,435

Consolidated obligation discount notes, net3
14,219,612

10,889,565

8,669,059

10,251,108

13,704,542

Total consolidated obligations, net3
34,440,614

30,946,529

30,642,961

30,145,591

35,225,977

Mandatorily redeemable capital stock
4,187

4,764

5,665

8,369

19,550

Total capital
1,585,267

1,801,220

1,720,481

1,701,447

1,783,478

Capital stock
974,041

1,252,249

1,264,456

1,327,827

1,454,396

Total retained earnings
627,133

567,332

481,282

401,461

351,754

Accumulated other comprehensive income (loss) (AOCI)
(15,907
)
(18,361
)
(25,257
)
(27,841
)
(22,672
)
Statement of Income (for the year ended):
 
 
 
 
 
Net interest income
225,165

217,773

219,680

230,926

249,876

Provision (reversal) for credit losses on mortgage loans
(1,615
)
1,926

2,496

1,058

1,582

Other income (loss)
(55,850
)
(30,818
)
(42,916
)
(78,328
)
(154,694
)
Other expenses
53,143

52,762

51,696

53,781

47,899

Income before assessments
117,787

132,267

122,572

97,759

45,701

AHP assessments
11,783

13,229

12,261

20,433

12,153

Net income
106,004

119,038

110,311

77,326

33,548

Selected Financial Ratios and Other Financial Data (for the year ended):
 
 
 
 
 
Dividends paid in cash4
299

291

285

362

316

Dividends paid in stock4
45,904

32,697

30,205

27,257

36,553

Weighted average dividend rate5
4.22
%
2.42
%
2.26
%
1.99
%
2.36
%
Dividend payout ratio6
43.59
%
27.71
%
27.64
%
35.72
%
109.90
%
Return on average equity
6.29
%
6.37
%
6.23
%
4.43
%
1.79
%
Return on average assets
0.30
%
0.33
%
0.32
%
0.21
%
0.08
%
Average equity to average assets
4.82
%
5.24
%
5.13
%
4.73
%
4.46
%
Net interest margin7
0.64
%
0.61
%
0.64
%
0.63
%
0.60
%
Total capital ratio8
4.30
%
5.31
%
5.09
%
5.13
%
4.61
%
Regulatory capital ratio9
4.36
%
5.37
%
5.18
%
5.24
%
4.72
%
Ratio of earnings to fixed charges10
1.58

1.59

1.45

1.31

1.12

                   
1 
Includes trading securities, held-to-maturity securities, interest-bearing deposits, securities purchased under agreements to resell and Federal funds sold.
2 
The allowance for credit losses on mortgage loans was $4,550,000, $6,748,000, $5,416,000, $3,473,000 and $2,911,000 as of December 31, 2014, 2013, 2012, 2011, and 2010, respectively.
3 
Consolidated obligations are bonds and discount notes that we are primarily liable to repay. See Note 17 to the financial statements for a description of the total consolidated obligations of all FHLBanks for which we are jointly and severally liable.
4 
Dividends reclassified as interest expense on mandatorily redeemable capital stock and not included as dividends recorded in accordance with GAAP were $40,000, $25,000, $41,000, $174,000 and $346,000 for the years ended December 31, 2014, 2013, 2012, 2011, and 2010, 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 period 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 Common Stock) as a percentage of total assets.
10 
Total earnings divided by fixed charges (interest expense including amortization/accretion of premiums, discounts and capitalized expenses related to indebtedness).

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Item 7: Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
The following Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) is intended to assist the reader in understanding our business and assessing our operations both historically and prospectively. This discussion should be read in conjunction with our audited financial statements and related notes presented under Item 8 of this annual report on Form 10-K. Our MD&A includes the following sections:
Executive Level Overview - a general description of our business and financial highlights;
Financial Market Trends - a discussion of current trends in the financial markets and overall economic environment, including the related impact on our operations;
Critical Accounting Policies and Estimates - a discussion of accounting policies that require critical estimates and assumptions;
Results of Operations - an analysis of our operating results, including disclosures about the sustainability of our earnings;
Financial Condition - an analysis of our financial position;
Liquidity and Capital Resources - an analysis of our cash flows and capital position;
Risk Management - a discussion of our risk management strategies; and
Recently Issued Accounting Standards.

Executive Level Overview
We are a regional wholesale bank that makes advances (loans) to, purchases mortgages from, and provides limited other financial services to our member institutions. We are currently 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.

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.

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 (former members previously required to purchase AMA activity-based stock are subject to the prior requirement as long as there are unpaid principal balances outstanding). 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 always strive to provide franchise value by maintaining a core mission asset focus and meeting 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 stable dividends.


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Net income for the year ended December 31, 2014 was $106.0 million compared to $119.0 million for the year ended December 31, 2013. The $13.0 million decrease in net income was due to declines in fair value of derivatives and hedging activities, partially offset by a decrease in negative fair value changes of trading securities, an increase in net interest income, and a decrease in the provision/reversal for credit losses on mortgage loans. The $26.1 million increase in net losses on derivative and hedging activities and trading securities was due largely to the impact of interest rates on the fair values of the derivative instruments or hedged items and trading securities. Net interest income increased by $7.4 million for the year ended December 31, 2014 despite decreases in interest income on investments, advances, and prepayment fees on terminated advances. The increase in net interest income was due primarily to a decrease in the overall cost of borrowing compared to the prior year and an increase of seven basis points in the average yield on mortgage loans. The decrease in the provision/reversal for credit losses on mortgage loans was a result of continued improvement in the housing market, along with refinements to our allowance for credit loss methodology, which increased net income by $3.5 million for the year ended December 31, 2014. 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 increased $2.9 billion, or 8.6 percent, from December 31, 2013 to December 31, 2014. The FHLBank has been actively promoting the impact of the dividend on the effective borrowing cost of advances to increase member awareness of the benefit of higher dividends, which has resulted in increased utilization of advances, especially the line of credit product. The year-over-year increase in total assets was due primarily to an increase in line of credit activity during the latter half of the year, a large portion of which was repaid on the last day of the year and reinvested in cash and investments with overnight maturities. The majority of these line of credit advances were re-drawn shortly after the end of the year. Net advances increased $877.5 million, or 5.0 percent, from December 31, 2013. Mortgage loans held for portfolio increased $280.7 million, or 4.7 percent, as a result of growth in the level of loans funded under the MPF Program relative to the level of prepayments. Additionally, the number of selling PFIs has increased during 2014. These increases were partially offset by a decrease in investment securities of $1.8 billion as a result of prepayments and maturities that were not reinvested as part of a balance sheet initiative that entails maintaining a smaller allocation of money market securities and other investments than we have in the past, described in greater detail below.
Total liabilities increased $3.1 billion, or 9.7 percent, from December 31, 2013 to December 31, 2014. This increase was attributable to the $3.3 billion increase in consolidated obligation discount notes, partially offset by a decrease in deposits. The increase in discount notes from December 31, 2013 to December 31, 2014 was a result of funding the increase in short-term advances during that time period. For additional information, see Item 7 – “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Financial Condition.”

Dividends paid to members totaled $46.2 million for the year ended December 31, 2014 compared to $33.0 million for the same period in the prior year. The dividend rate for Class A Common Stock increased from 0.25 percent to 1.00 percent from December 31, 2013 to December 31, 2014, and the dividend rate for Class B Common Stock increased from 3.75 percent to 6.00 percent for the same period. Capital management changes that have facilitated the increase in our dividend include: (1) a reduction in our membership capital stock (Class A) purchase requirement in 2012; (2) a reduction in our activity stock (Class B) requirement for AMA in 2013; (3) a reduction of our activity stock (Class B) requirement for advances in 2014; (4) weekly exchanges of excess Class B stock to Class A; and (5) periodic repurchases of excess Class A stock.

During 2014, we continued working towards a core mission asset focused balance sheet. Our ratio of average advances and average mortgage loans to average consolidated obligations (core mission assets ratio) was 80 percent for 2014. We intend to manage our balance sheet with an emphasis towards maintaining a core mission assets ratio within the range of 70 to 80 percent during 2015. However, because this ratio is dependent on several variables such as member demand for our advance and mortgage loan products, it is possible that we will be unable to maintain this level throughout 2015.

We have also made changes to our management of capital levels, which included reducing our activity-based stock purchase requirement (see “Financial Condition – Capital under this Item 7), making 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.


34


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
Average Rate for
12/31/2014
12/31/2013
2014
2013
Ending Rate
Ending Rate
Overnight Federal funds effective/target rate1
0.09
%
0.11
%
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
0.03

0.05

0.04
0.07
3-month LIBOR1
0.23

0.27

0.26
0.25
2-year U.S. Treasury note1
0.45

0.30

0.67
0.38
5-year U.S. Treasury note1
1.63

1.16

1.65
1.73
10-year U.S. Treasury note1
2.53

2.34

2.17
3.00
30-year residential mortgage note rate2
4.35

4.20

4.04
4.72
                   
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.

Minutes from the January Federal Open Market Committee (FOMC) meeting indicated concern about the global outlook and expectations of substantial declines in inflation, which market participants interpreted as further delay in an increase in the Federal funds rate, although the strong labor report released in February 2015 has increased the likelihood of an increase in the target federal funds rate in mid-2015. The FOMC has indicated that they are considering a broad range of economic indicators, including international developments, in their consideration of continued accommodative monetary policy but do not expect to raise the target Federal funds rate prior to mid-2015. The FOMC concluded the asset purchase program in October 2014 but is maintaining its existing policy of reinvesting principal payments from its holdings of Agency debt and Agency MBS and of rolling over maturing U.S. Treasury securities at auction. The rates on U.S. Treasuries and Agency MBS are expected to increase once the Federal Reserve is no longer reinvesting those principal payments. 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.

During the majority of 2014, U.S. Treasury rates were fairly range-bound and volatility remained low, resulting in a steady funding environment. The market volatility that started in the last half of 2013 began to subside in late 2013 and early 2014 and has positively impacted demand for our longer-term debt, despite investors still being somewhat cautious about bond purchases due to the possibility of increases in market rates. The spread over U.S. Treasuries at which we can issue longer-term bullet and callable bonds has narrowed from what we experienced in 2013. We fund a majority of our fixed rate mortgage assets and some fixed rate advances with 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 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 2014. The current debt limit suspension expires on March 16, 2015, at which time the U.S. Treasury has the ability to invoke extraordinary measures that are expected to meet federal obligations until at least the summer of 2015, so concerns over the federal debt ceiling and related funding difficulties have been allayed until that time.


35


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 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 condition and results of operations 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 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. Although we still have a small number of derivative transactions designated as shortcut hedges outstanding, 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.
 

36


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, 2014 and 2013, 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 $1.0 billion as of December 31, 2014, which matches the notional amount of interest rate swaps hedging the GSE debentures in trading securities on that date. For asset/liability management purposes, the majority of our fixed rate GSE debentures currently classified as trading are matched to interest rate swaps that effectively convert the securities from fixed rate investments to variable rate instruments. See Tables 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, 2014 and 2013, certain assets and liabilities, including investments classified as trading and all derivatives, were presented in the Statements of Condition at fair value. Under GAAP, fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Fair values play an important role in the valuation of certain assets, liabilities and derivative transactions. The fair values we generate directly impact the Statements of Condition, Statements of Income, Statements of Comprehensive Income, Statements of Capital, and Statements of Cash Flows as well as risk-based capital, duration of equity (DOE), and market value of equity (MVE) disclosures. Management also estimates the fair value of collateral that borrowers pledge against advance borrowings and other credit obligations to confirm that we have sufficient collateral to meet regulatory requirements and to protect ourselves from a credit loss.
 
Fair values are based on market prices when they are available. If market quotes are not available, fair values are based on discounted cash flows using market estimates of interest rates and volatility, or on prices of similar instruments. Pricing models and their underlying assumptions are based on our best estimates for discount rates, prepayment speeds, market volatility and other factors. We validate our financial models at least annually and the models are calibrated to values from outside sources on a monthly basis. We validate modeled values to outside valuation services routinely to determine if the values generated from discounted cash flows are reasonable. Additionally, due diligence procedures are completed for third-party pricing vendors. The assumptions used by third-party pricing vendors or within our models may have a significant effect on the reported fair values of assets and liabilities, including derivatives, and the related income and expense. See Note 16 of the Notes to Financial Statements under Item 8 – “Financial Statements and Supplementary Data” for a detailed discussion of the assumptions used to calculate fair values and the due diligence procedures completed. The use of different assumptions as well as changes in market conditions could result in materially different net income and retained earnings.

As of December 31, 2014, 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.
 

37


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.

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 an automated valuation model or housing pricing index. If the collateral value less cost to sell is less than the recorded investment in the loan, the loan is considered impaired. Beginning in January 2015, the excess of the recorded investment in the loan over the loan’s collateral value less cost to sell is charged off if the loan is over 180 days delinquent or in bankruptcy. 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.


38


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, 2014 and 2013, and all such investments acquired during the years ended December 31, 2014 and 2013 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 under Item 8 – “Financial Statements and Supplementary Data.”

Results of Operations
Earnings Analysis: Table 10 presents changes in the major components of our net income (dollar amounts in thousands):

Table 10
 
Increase (Decrease) in Earnings Components
 
2014 vs. 2013
2013 vs. 2012
 
Dollar Change
Percentage Change
Dollar Change
Percentage Change
Total interest income
$
(14,764
)
(3.3
)%
$
(51,718
)
(10.5
)%
Total interest expense
(22,156
)
(9.8
)
(49,811
)
(18.1
)
Net interest income
7,392

3.4

(1,907
)
(0.9
)
Provision (reversal) for credit losses on mortgage loans
(3,541
)
(183.9
)
(570
)
(22.8
)
Net interest income after mortgage loan loss provision
10,933

5.1

(1,337
)
(0.6
)
Net gain (loss) on trading securities
22,286

43.7

(22,937
)
(81.8
)
Net gain (loss) on derivatives and hedging activities
(48,337
)
(478.3
)
31,585

147.1

Other non-interest income
1,019

10.1

3,450

52.2

Total other income (loss)
(25,032
)
(81.2
)
12,098

28.2

Operating expenses
775

1.8

1,080

2.6

Other non-interest expenses
(394
)
(4.1
)
(14
)
(0.1
)
Total other expenses
381

0.7

1,066

2.1

AHP assessments
(1,446
)
(10.9
)
968

7.9

NET INCOME
$
(13,034
)
(10.9
)%
$
8,727

7.9
 %


39


Table 11 presents the amounts contributed by our principal sources of interest income (dollar amounts in thousands):

Table 11
 
Year Ended December 31,
 
2014
2013
2012
 
Interest Income
Percent of Total
Interest Income
Percent of Total
Interest Income
Percent of Total
Investments1
$
98,492

23.0
%
$
117,327

26.5
%
$
144,028

29.1
%
Advances
123,748

28.9

128,441

29.0

154,560

31.2

Mortgage loans held for portfolio
204,547

47.7

195,644

44.1

194,363

39.3

Other
1,514

0.4

1,653

0.4

1,832

0.4

TOTAL INTEREST INCOME
$
428,301

100.0
%
$
443,065

100.0
%
$
494,783

100.0
%
                   
1 
Includes trading securities, held-to-maturity securities, interest-bearing deposits, securities purchased under agreements to resell and Federal funds sold.

Net income for the year ended December 31, 2014 was $106.0 million compared to $119.0 million for the year ended December 31, 2013. The $13.0 million decrease was due to an increase in losses on derivative and hedging activities, partially offset by a decrease in negative fair value changes on trading securities, an increase in net interest income, and a decrease in the provision/reversal for credit losses on mortgage loans. The increase in net interest income was due primarily to a decrease in the overall cost of borrowing compared to 2012 and an increase in the average yield on mortgage loans. The decrease in the provision/reversal for credit losses on mortgage loans was a result of continued improvement in the housing market, along with refinements to our allowance for credit loss technique. Return on equity (ROE) was 6.29 percent and 6.37 percent for the years ended December 31, 2014 and 2013, respectively. The decrease in ROE was a result of the decline in net income, but the impact of the decline on ROE was reduced by the changes in capital management practices that went into effect during the second quarter of 2014, which caused a decrease in average capital for the period due to the repurchase of excess stock. The change in capital management practices also resulted in an increase in dividend rates. Dividends paid to members totaled $46.2 million for the year ended December 31, 2014 compared to $33.0 million for the same period in the prior year.

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 gains on derivative and hedging activities compared to losses in the prior year, partially offset by an increase in negative fair value changes on trading securities. There was also a slight decrease in the provision for credit losses on mortgage loans, 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. ROE was 6.37 percent and 6.23 percent for the years 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 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 increase in net interest income for the year ended December 31, 2014 compared to 2013 was due to an increase in our net interest spread and margin despite a decrease in the average balance and average yield on interest-earning assets (see Table 11). 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. The increases in net interest spread and margin in 2014 were driven primarily by an overall decrease in the cost of borrowing and also by an increase in the average yield on mortgage loans, which are discussed in greater detail below.

The average yield on investments, which consist of interest-bearing deposits, Federal funds sold, reverse repurchase agreements, and investment securities, remained relatively flat, at 1.05 percent for the years ended December 31, 2013 and 2014, despite the compositional changes in the portfolio, including a lower concentration of higher yielding MBS, and increases in the average balance of Federal funds sold, which had a lower average yield during 2014. At times during 2014, we did not reinvest MBS portfolio prepayments in new MBS because of the focus on our core mission assets ratio as well as our inability to purchase MBS at prices that would generate what we consider to be acceptable spreads. While we plan to maintain our focus on our core mission assets ratio during 2015, we anticipate that we will purchase MBS as long as we can do so at prices that will generate what we consider to be acceptable spreads. The decrease in the average yield on investments between 2012 and 2013 was a result of declining interest rates, including LIBOR, and prepayments of higher rate MBS/CMO that were reinvested into lower rate or variable rate MBS/CMOs.


40


The average yield on advances decreased six basis points, from 0.70 percent for the year ended December 31, 2013 to 0.64 percent for the year ended December 31, 2014. The decrease in the average yield on advances was due to a continued shift in composition that began in 2012 and has resulted in an increase in our lowest yielding advance product. Prepayment fees also decreased during 2014 as a result of borrowers restructuring a higher level of non-callable advances into new advances and incurring a fee in the prior year. Further, the low interest rate environment in 2013 generally resulted in a higher fee calculation for prepaid advances.

The average yield on mortgage loans increased seven basis points, from 3.29 percent for the year ended December 31, 2013 to 3.36 percent for the year ended December 31, 2014. The increase in yield is due to a decline in premium amortization as mortgage rates increased in 2014 and prepayments on higher coupon loans decreased (yields on interest earning assets decline as premiums are amortized; amortization accelerates as prepayments increase). We expect to see an increase in prepayments and a related acceleration in premium amortization in 2015, as mortgage rates have declined, which will reduce our average yield on mortgage loans. The decrease in yield of 23 basis points between 2012 and 2013 was due primarily to prepayments of higher yielding mortgages and the associated premium amortization, and new loan volume at average rates below the existing portfolio rate.

The average cost of consolidated obligation bonds decreased four basis points, from 1.01 percent for the year ended December 31, 2013 to 0.97 percent for the current period. This decrease was largely a result of: (1) replacing some called and matured higher-cost consolidated obligation bonds with debt at a much lower cost in late 2013; (2) the decrease in the average one- and three-month LIBOR rates during 2014 compared to 2013 (a considerable portion of our consolidated obligation bonds are swapped to LIBOR); and (3) a general decline in rates in 2014 which allowed us to issue and to call and replace higher rate debt at lower rates. The average balance of lower rate discount notes has increased between periods while average bond balances have declined, which has reduced the total cost of our interest-bearing liabilities. We expect short-term interest rates to remain low for much of 2015, so we expect our total interest bearing liability cost to remain relatively stable over the next few quarters. However, we do not expect to be able to call and replace debt at lower rates to the same extent during 2015 as we did in 2014 or 2013. When we call and replace callable debt, it 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 using the level-yield method. 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. Further, net interest payments or receipts on interest rate swaps designated as fair value hedges and the amortization/accretion of hedging activities are recognized as adjustments to the interest income or expense of the hedged asset or liability. 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.


41


Table 12 presents average balances and yields of major earning asset categories and the sources funding those earning assets (dollar amounts in thousands):

Table 12
 
2014
2013
2012
 
Average
Balance
Interest
Income/
Expense
Yield
Average
Balance
Interest
Income/
Expense
Yield
Average
Balance
Interest
Income/Expense
Yield
Interest-earning assets:
 

 

 

 

 

 

 
 
 
Interest-bearing deposits
$
204,708

$
169

0.08
%
$
272,385

$
311

0.11
%
$
353,494

$
513

0.15
%
Securities purchased under agreements to resell
446,233

575

0.13

847,010

1,027

0.12

1,371,914

2,742

0.20

Federal funds sold
1,619,589

1,368

0.08

1,259,512

1,346

0.11

854,682

1,285

0.15

Investment securities1
7,073,094

96,380

1.36

8,839,549

114,643

1.30

8,880,851

139,488

1.57

Advances2,3
19,467,171

123,748

0.64

18,278,197

128,441

0.70

17,348,927

154,560

0.89

Mortgage loans2,4,5
6,087,417

204,547

3.36

5,947,390

195,644

3.29

5,526,009

194,363

3.52

Other interest-earning assets
23,182

1,514

6.53

26,170

1,653

6.32

29,305

1,832

6.25

Total earning assets
34,921,394

428,301

1.23

35,470,213

443,065

1.25

34,365,182

494,783

1.44

Other non-interest-earning assets
83,523

 

 

153,265

 

 

166,083

 
 
Total assets
$
35,004,917

 

 

$
35,623,478

 

 

$
34,531,265

 
 
 
 
 
 
 
 
 
 
 
 
Interest-bearing liabilities:
 

 

 

 

 

 

 
 
 
Deposits
$
878,016

$
770

0.09
%
$
1,070,135

$
983

0.09
%
$
1,601,019

$
1,511

0.09
%
Consolidated obligations2:
 

 

 

 

 

 

 

 

 

Discount Notes
12,155,756

9,242

0.08

10,751,832

8,884

0.08

9,674,078

9,237

0.10

Bonds
19,896,561

192,910

0.97

21,233,465

215,239

1.01

20,698,141

264,134

1.28

Other borrowings
10,377

214

2.06

21,600

186

0.87

13,818

221

1.60

Total interest-bearing liabilities
32,940,710

203,136

0.62

33,077,032

225,292

0.68

31,987,056

275,103

0.86

Capital and other non-interest-bearing funds
2,064,207

 

 

2,546,446

 

 

2,544,209

 
 
Total funding
$
35,004,917

 

 

$
35,623,478

 

 

$
34,531,265

 
 
 
 
 
 
 
 
 
 
 
 
Net interest income and net interest spread6
 

$
225,165

0.61
%
 

$
217,773

0.57
%
 
$
219,680

0.58
%
 
 
 
 
 
 
 
 
 
 
Net interest margin7
 

 

0.64
%
 

 

0.61
%
 
 
0.64
%
                   
1 
The non-credit portion of the OTTI discount on held-to-maturity securities is excluded from the average balance for calculations of yield since the change is an adjustment to equity.
2 
Interest income/expense and average rates include the effect of associated derivatives.
3 
Advance income includes prepayment fees on terminated advances.
4 
CE fee payments are netted against interest earnings on the mortgage loans. The expense related to CE fee payments to PFIs was $4.9 million, $4.7 million, and $4.2 million for the December 31, 2014, 2013, and 2012, respectively.
5 
Mortgage loans average balance includes outstanding principal for non-performing conventional loans. However, these loans no longer accrue interest.
6 
Net interest spread is the difference between the yield on interest-earning assets and the cost of interest-bearing liabilities.
7 
Net interest margin is net interest income as a percentage of average interest-earning assets.


42


Changes in the volume of interest-earning assets and the level of interest rates influence changes in net interest income, net interest spread and net interest margin. Table 13 summarizes changes in interest income and interest expense (in thousands):

Table 13
 
2014 vs. 2013
2013 vs. 2012
 
Increase (Decrease) Due to
Increase (Decrease) Due to
 
Volume1,2
Rate1,2
Total
Volume1,2
Rate1,2
Total
Interest Income:
 

 

 

 
 
 
Interest-bearing deposits
$
(67
)
$
(75
)
$
(142
)
$
(105
)
$
(97
)
$
(202
)
Securities purchased under agreements to resell
(513
)
61

(452
)
(845
)
(870
)
(1,715
)
Federal funds sold
338

(316
)
22

499

(438
)
61

Investment securities
(23,835
)
5,572

(18,263
)
(646
)
(24,199
)
(24,845
)
Advances
8,032

(12,725
)
(4,693
)
7,925

(34,044
)
(26,119
)
Mortgage loans
4,658

4,245

8,903

14,302

(13,021
)
1,281

Other assets
(194
)
55

(139
)
(198
)
19

(179
)
Total earning assets
(11,581
)
(3,183
)
(14,764
)
20,932

(72,650
)
(51,718
)
Interest Expense:
 

 

 

 
 
 
Deposits
(171
)
(42
)
(213
)
(488
)
(40
)
(528
)
Consolidated obligations:
 

 

 

 

 

 

Discount notes
1,103

(745
)
358

966

(1,319
)
(353
)
Bonds
(13,204
)
(9,125
)
(22,329
)
6,674

(55,569
)
(48,895
)
Other borrowings
(133
)
161

28

93

(128
)
(35
)
Total interest-bearing liabilities
(12,405
)
(9,751
)
(22,156
)
7,245

(57,056
)
(49,811
)
Change in net interest income
$
824

$
6,568

$
7,392

$
13,687

$
(15,594
)
$
(1,907
)
                   
1 
Changes in interest income and interest expense not identifiable as either volume-related or rate-related have been allocated to volume and rate based upon the proportion of the absolute value of the volume and rate changes.
2 
Amounts used to calculate volume and rate changes are based on numbers in dollars. Accordingly, recalculations using the amounts in thousands as disclosed in this report may not produce the same results.

Net Gain (Loss) on Derivatives and Hedging Activities: The volatility in other income (loss) is driven predominantly by fair value fluctuations on derivative and hedging transactions, which include interest rate swaps, caps, and floors. Net gain (loss) from derivatives and hedging activities is sensitive to several factors, including: (1) the general level of interest rates; (2) the shape of the term structure of interest rates; and (3) implied volatilities of interest rates. The fair value of options, particularly interest rate caps and floors, are also impacted by the time value decay that occurs as the options approach maturity, but this factor represents the normal amortization of the cost of these options and flows through income irrespective of any changes in the other factors impacting the fair value of the options (level of rates, shape of curve, and implied volatility).

As demonstrated in Tables 13 through 15, the majority of the derivative gains and losses are related to economic hedges, such as interest rate swaps matched to GSE debentures classified as trading securities and interest rate caps and floors, which do not qualify for hedge accounting treatment under GAAP. Net interest payments or receipts on these economic hedges flow through net gain (loss) on derivatives and hedging activities instead of net interest income, which distorts yields, especially for trading investments that are swapped to variable rates. Net interest received/paid on economic hedges is identified in Tables 13 through 15. Ineffectiveness on fair value hedges contributes to gains and losses on derivatives, but to a much lesser degree. We generally record net fair value gains on derivatives when the overall level of interest rates rises over the period and record net fair value losses when the overall level of interest rates falls over the period, due to the mix of the economic hedges.


43


In 2013, net gains and losses on derivatives and hedging activities resulted in an increase to net income of $10.1 million, compared to a decrease in net income of $38.2 million in 2014. As noted previously, the changes are primarily attributable to volatility in the fair value of our economic derivatives. The losses on economic derivatives for 2014 were primarily a result of losses on our interest rate cap portfolio as fair values declined due to a lower forward curve, decreased long-term cap volatility and time value decay compared to gains recognized during 2013 as fair values increased due to an increase and steepening of the general level of the interest rate swap curve with the gains somewhat limited by a decrease in long-term cap volatility at the end of 2013 as well. In both years, we experienced increases in the fair value of our interest rate swaps matched to GSE debentures as a result of increasing interest rates for their respective maturities (pay fixed rate swap), but these increases were offset by decreases in the fair values of the swapped GSE debentures, which are recorded in net gain (loss) on trading securities.

While the net interest received (paid) on the associated economic interest rate swap is recorded in net gain (loss) on derivatives and hedging activities, the interest on the underlying hedged items, the GSE debentures, is recorded in interest income, with any changes in fair value recognized in net gain (loss) on trading securities. See Tables 62 and 63 under Item 7A – “Quantitative and Qualitative Disclosures About Market Risk” for additional detail regarding notional and fair value amounts of derivative instruments.

Tables 14 through 16 categorize the earnings impact by product for hedging activities (in thousands):

Table 14
 
2014
 
Advances
Investments
Mortgage Loans
Consolidated
Obligation Bonds
Total
Impact of derivatives and hedging activities in net interest income:
 
 
 
 
 
Net amortization/accretion of hedging activities
$
(11,529
)
$

$
(1,914
)
$
203

$
(13,240
)
Net interest settlements
(131,093
)


89,873

(41,220
)
Subtotal
(142,622
)

(1,914
)
90,076

(54,460
)
Net gain (loss) on derivatives and hedging activities:
 
 
 
 
 
Fair value hedges:
 
 
 
 
 
Interest rate swaps
540



(2,977
)
(2,437
)
Economic hedges – unrealized gain (loss) due to fair value changes:
 
 
 
 
 
Interest rate swaps

30,231


1,679

31,910

Interest rate caps/floors

(32,767
)


(32,767
)
Mortgage delivery commitments


4,272


4,272

Economic hedges – net interest received (paid)

(44,264
)

5,056

(39,208
)
Subtotal
540

(46,800
)
4,272

3,758

(38,230
)
Net impact of derivatives and hedging activities
(142,082
)
(46,800
)
2,358

93,834

(92,690
)
Net gain (loss) on trading securities hedged on an economic basis with derivatives

(28,517
)


(28,517
)
TOTAL
$
(142,082
)
$
(75,317
)
$
2,358

$
93,834

$
(121,207
)


44


Table 15
 
2013
 
Advances
Investments
Mortgage Loans
Consolidated
Obligation Bonds
Intermediary
Positions
Total
Impact of derivatives and hedging activities in net interest income:
 
 
 
 
 
 
Net amortization/accretion of hedging activities
$
(12,288
)
$

$
(2,149
)
$
(408
)
$

$
(14,845
)
Net interest settlements
(146,463
)


102,125


(44,338
)
Subtotal
(158,751
)

(2,149
)
101,717


(59,183
)
Net gain (loss) on derivatives and hedging activities:
 
 
 
 
 
 
Fair value hedges:
 
 
 
 
 
 
Interest rate swaps
3,348



(5,682
)

(2,334
)
Economic hedges – unrealized gain (loss) due to fair value changes:
 
 
 
 
 
 
Interest rate swaps

50,328


(6,981
)
(17
)
43,330

Interest rate caps/floors

11,682




11,682

Mortgage delivery commitments


(4,052
)


(4,052
)
Economic hedges – net interest received (paid)

(45,901
)

7,379

3

(38,519
)
Subtotal
3,348

16,109

(4,052
)
(5,284
)
(14
)
10,107

Net impact of derivatives and hedging activities
(155,403
)
16,109

(6,201
)
96,433

(14
)
(49,076
)
Net gain (loss) on trading securities hedged on an economic basis with derivatives

(50,203
)



(50,203
)
TOTAL
$
(155,403
)
$
(34,094
)
$
(6,201
)
$
96,433

$
(14
)
$
(99,279
)


45


Table 16
 
2012
 
Advances
Investments
Mortgage Loans
Consolidated
Obligation Discount Notes
Consolidated
Obligation Bonds
Intermediary
Positions
Total
Impact of derivatives and hedging activities in net interest income:
 
 
 
 
 
 
 
Net amortization/accretion of hedging activities
$
(11,278
)
$

$
(5,389
)
$

$
(906
)
$

$
(17,573
)
Net interest settlements
(175,082
)


12

143,261


(31,809
)
Subtotal
(186,360
)

(5,389
)
12

142,355


(49,382
)
Net gain (loss) on derivatives and hedging activities:
 
 
 
 
 
 
 
Fair value hedges:
 
 
 
 
 
 


Interest rate swaps
(1,825
)


(21
)
4,638


2,792

Economic hedges – unrealized gain (loss) due to fair value changes:
 
 
 
 
 
 
 
Interest rate swaps

18,848



8,580

(1
)
27,427

Interest rate caps/floors

(24,032
)




(24,032
)
Mortgage delivery commitments


7,509




7,509

Economic hedges – net interest received (paid)

(41,294
)


6,105

15

(35,174
)
Subtotal
(1,825
)
(46,478
)
7,509

(21
)
19,323

14

(21,478
)
Net impact of derivatives and hedging activities
(188,185
)
(46,478
)
2,120

(9
)
161,678

14

(70,860
)
Net gain (loss) on trading securities hedged on an economic basis with derivatives

(21,679
)




(21,679
)
TOTAL
$
(188,185
)
$
(68,157
)
$
2,120

$
(9
)
$
161,678

$
14

$
(92,539
)

Net Gain (Loss) on Trading Securities: All gains and losses related to trading securities are recorded in other income (loss) as net gain (loss) on trading securities; however, only gains and losses relating to trading securities that are related to economic hedges are included in Tables 13 through 15. Unrealized gains (losses) fluctuate as the fair value of our trading portfolio fluctuates. There are a number of factors that can impact the fair value of a trading security including the movement in absolute interest rates, changes in credit spreads, the passage of time and changes in price volatility. Table 17 presents the major components of the net gain (loss) on trading securities (in thousands):

Table 17
 
2014
2013
2012
GSE debentures
$
(28,987
)
$
(50,671
)
$
(24,493
)
U.S. Government guaranteed debentures


(5,558
)
U.S. Treasury note
4

43


Agency MBS/CMO
293

(351
)
1,285

Short-term money market securities
(9
)
(6
)
718

TOTAL
$
(28,699
)
$
(50,985
)
$
(28,048
)


46


The majority of the volatility in the net gain (loss) of our trading portfolio can be attributed to fair value changes on GSE debentures. The largest component of our trading portfolio is comprised of fixed and variable rate GSE debentures, and generally most of the fixed rate securities are related to economic hedges. The fair values of the fixed rate GSE debentures are more affected by changes in intermediate interest rates (e.g., two-year to four-year rates) and are swapped to three-month LIBOR. The variable rate securities reset daily based on the Federal funds effective rate or monthly based on the one-month LIBOR index. During 2012 and especially in 2013, interest rates and GSE credit spreads increased, which resulted in fair value losses on the GSE debentures. During 2014, interest rates in the one- to three- year range increased compared to 2013 which resulted in additional losses on the GSE debentures, but the decrease in GSE credit spreads reduced the magnitude of those losses. In addition to interest rates and credit spreads, the value of these securities is affected by time decay. These fixed rate GSE debentures possess coupons which are well above current market rates for similar securities and, therefore, are currently valued at substantial premiums. As these securities approach maturity, their prices will converge to par resulting in a decrease in their current premium price (i.e., time decay). Given that the variable rate GSE debentures re-price daily, they generally account for a very small portion of the net gain (loss) on trading securities unless current market spreads on these variable rate securities diverge from the spreads at the time of our acquisition of the securities.

Controllable Operating Expenses: Controllable operating expenses include compensation and benefits and other operating expenses as presented in the Statements of Income included under Item 8 – “Financial Statements and Supplementary Data.” As noted in Table 18, approximately two-thirds of our operating expenses consist of compensation and benefits expense. We anticipate an increase in compensation and benefits expense during 2015 due to an expected increase in the number of employees primarily to meet our increasing technology needs. Table 18 presents operating expenses for the last three years (dollar amounts in thousands):

Table 18
 
For the Year Ended December 31,
Percent Increase (Decrease)
 
2014
2013
2012
2014 vs. 2013
2013 vs. 2012
Compensation and benefits
$
30,282

$
29,541

$
29,231

2.5
 %
1.1
%
Occupancy cost
1,754

1,622

1,348

8.1

20.4

Other operating expense
11,916

12,014

11,518

(0.8
)
4.3

TOTAL CONTROLLABLE OPERATING EXPENSES
$
43,952

$
43,177

$
42,097

1.8
 %
2.6
%

Finance Agency and Office of Finance Expenses: We, together with the other FHLBanks, are charged fo