10-K 1 d10k.htm FORM 10-K Form 10-K
Table of Contents
Index to Financial Statements

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, 2010

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 000-51845

FEDERAL HOME LOAN BANK OF ATLANTA

(Exact name of registrant as specified in its charter)

 

Federally chartered corporation   56-6000442
(State or other jurisdiction of
incorporation or organization)
  (I.R.S. Employer
Identification No.)
1475 Peachtree Street, NE, Atlanta, Ga.   30309
(Address of principal executive offices)   (Zip Code)

Registrant’s telephone number, including area code: (404) 888-8000

 

 

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

Securities registered pursuant to Section 12(g) of the Act:

Class B Stock, par value $100

(Title of class)

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 during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    ¨ Yes     ¨  No

Indicate by check mark if the disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the 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 small reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer  ¨    Accelerated filer  ¨
Non-accelerated filer  x  (Do not check if a smaller reporting company)    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

Registrant’s stock is not publicly traded and is only issued to members of the registrant. Such stock is issued and redeemed at par value, $100 per share, subject to certain regulatory and statutory limits. At June 30, 2010, the aggregate par value of the stock held by current and former members of the registrant was $8,363,690,000, and 83,636,900 total shares were outstanding as of that date. At February 28, 2011, 77,728,119 total shares were outstanding.


Table of Contents
Index to Financial Statements

Table of Contents

 

     PART I       

Item 1.

  

Business.

     4   

Item 1A.

  

Risk Factors.

     20   

Item 1B.

  

Unresolved Staff Comments.

     25   

Item 2.

  

Properties.

     25   

Item 3.

  

Legal Proceedings.

     25   

Item 4.

  

(Removed and Reserved).

     26   
   PART II   

Item 5.

  

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

     27   

Item 6.

  

Selected Financial Data.

     29   

Item 7.

  

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

     31   

Item 7A.

  

Quantitative and Qualitative Disclosures About Market Risk.

     80   

Item 8.

  

Financial Statements and Supplementary Data.

     81   

Item 9.

  

Changes in and Disagreements With Accountants on Accounting and Financial Disclosure.

     143   

Item 9A.

  

Controls and Procedures.

     143   

Item 9B.

  

Other Information.

     143   
   PART III   

Item 10.

  

Directors, Executive Officers and Corporate Governance.

     144   

Item 11.

  

Executive Compensation.

     151   

Item 12.

  

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

     170   

Item 13.

  

Certain Relationships, Related Transactions and Director Independence.

     171   

Item 14.

  

Principal Accountant Fees and Services.

     172   
   PART IV   

Item 15.

  

Exhibits and Financial Statement Schedules.

     173   

SIGNATURES

  


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Important Notice About Information in this Annual Report

In this annual report on Form 10-K (Report), unless the context suggests otherwise, references to the “Bank” mean the Federal Home Loan Bank of Atlanta. “FHLBanks” means the 12 district Federal Home Loan Banks, including the Bank, and “FHLBank System” means the FHLBanks and the Federal Home Loan Banks’ Office of Finance (Office of Finance), as regulated by the Federal Housing Finance Agency, or the “Finance Agency,” successor to the Federal Housing Finance Board (Finance Board) effective on July 30, 2008. “FHLBank Act” means the Federal Home Loan Bank Act of 1932, as amended.

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

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

Special Cautionary Notice Regarding Forward-looking Statements

Some of the statements made in this Report may be “forward-looking statements,” within the meaning of section 27A of the Securities Act of 1933, as amended, and section 21E of the Securities Exchange Act of 1934, as amended, and are intended to be covered by the safe harbor provided by the same. Forward-looking statements include statements with respect to the Bank’s beliefs, plans, objectives, goals, expectations, anticipations, assumptions, estimates, intentions, and future performance, and involve known and unknown risks, uncertainties, and other factors, many of which may be beyond the Bank’s control and which may cause the Bank’s actual results, performance, or achievements to be materially different from future results, performance, or achievements expressed or implied by the forward-looking statements. The reader can identify these forward-looking statements through the Bank’s use of words such as “may,” “will,” “anticipate,” “hope,” “project,” “assume,” “should,” “indicate,” “would,” “believe,” “contemplate,” “expect,” “estimate,” “continue,” “plan,” “point to,” “could,” “intend,” “seek,” “target,” and other similar words and expressions of the future. Such forward-looking statements include statements regarding any one or more of the following topics:

 

 

The Bank’s business strategy and changes in operations, including, without limitation, product growth and change in product mix

 

 

Future performance, including profitability, dividends, developments, or market forecasts

 

 

Forward-looking accounting and financial statement effects

 

 

Those other factors identified and discussed in the Bank’s public filings with the Securities and Exchange Commission (SEC).

It is important to note that the description of the Bank’s business is a statement about the Bank’s operations as of a specific date. It is not meant to be construed as a policy, and the Bank’s operations, including the portfolio of assets held by the Bank, are subject to reevaluation and change without notice.

The forward-looking statements may not be realized due to a variety of factors, including, without limitation, any one or more of the following factors:

 

 

Future economic and market conditions, including, for example, inflation and deflation, the timing and volume of market activity, general consumer confidence and spending habits, the strength of local economies in which the Bank conducts its business, and interest-rate changes that affect the housing markets

 

 

Demand for Bank advances resulting from changes in members’ deposit flows and credit demands, as well as from changes in other sources of funding and liquidity available to members

 

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Volatility of market prices, rates, and indices that could affect the value of collateral held by the Bank as security for the obligations of Bank members and counterparties to derivatives and similar agreements

 

 

The risks of changes in interest rates on the Bank’s interest-rate sensitive assets and liabilities

 

 

Changes in various governmental monetary or fiscal policies, as well as legislative and regulatory changes, including changes in accounting principles generally accepted in the United States of America (GAAP) and related industry practices and standards, or the application thereof

 

 

Political, national, and world events, including acts of war, terrorism, natural disasters or other catastrophic events, and legislative, regulatory, judicial, or other developments that affect the economy, the Bank’s market area, the Bank, its members, counterparties, its federal regulator, and/or investors in the consolidated obligations of the 12 FHLBanks

 

 

Competitive forces, including other sources of funding available to Bank members, other entities borrowing funds in the capital markets, and the ability to attract and retain skilled individuals

 

 

The Bank’s ability to develop, implement, promote the efficient performance of, and support technology and information systems, including the internet, sufficient to measure and manage effectively the risks of the Bank’s business

 

 

Changes in investor demand for consolidated obligations of the FHLBanks and/or the terms of derivatives and similar agreements, including changes in investor preference and demand for certain terms of these instruments, which may be less attractive to the Bank, or which the Bank may be unable to offer

 

 

The Bank’s ability to introduce, support, and manage the growth of new products and services and to manage successfully the risks associated with those products and services

 

 

The Bank’s ability to manage successfully the risks associated with any new types of collateral securing advances

 

 

The availability from acceptable counterparties, upon acceptable terms, of options, interest-rate and currency swaps, and other derivative financial instruments of the types and in the quantities needed for investment funding and risk-management purposes

 

 

The uncertainty and costs of litigation, including litigation filed against one or more of the 12 FHLBanks

 

 

Changes in the FHLBank Act or Finance Agency regulations that affect FHLBank operations and regulatory oversight

 

 

Adverse developments or events, including financial restatements, affecting or involving one or more other FHLBanks or the FHLBank System in general

 

 

Other factors and other information discussed herein under the caption “Risk Factors” and elsewhere in this Report, as well as information included in the Bank’s future filings with the SEC.

The forward-looking statements may not be realized due to a variety of factors, including, without limitation, those risk factors provided under Item 1A of this Report and in future reports and other filings made by the Bank with the SEC. The Bank operates in a changing economic environment, and new risk factors emerge from time to time. Management cannot predict accurately any new factors, nor can it assess the effect, if any, of any new factors on the business of the Bank or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those implied by any forward-looking statements.

All written or oral statements that are made by or are attributable to the Bank are expressly qualified in their entirety by this cautionary notice. The reader should not place undue reliance on forward-looking statements, since the statements speak only as of the date that they are made. The Bank has no obligation and does not undertake publicly to update, revise, or correct any of the forward-looking statements after the date of this Report, or after the respective dates on which these statements otherwise are made, whether as a result of new information, future events, or otherwise, except as may be required by law.

 

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Index to Financial Statements

PART I.

 

Item 1. Business.

Overview

The Bank is a federally chartered corporation organized in 1932 and one of 12 district FHLBanks. The FHLBanks, along with the Finance Agency and the Office of Finance, comprise the FHLBank System. The FHLBanks are U.S. government-sponsored enterprises (GSEs) organized under the authority of the FHLBank Act. Each FHLBank operates as a separate entity within a defined geographic district and has its own management, employees, and board of directors. The Bank’s defined geographic district includes Alabama, Florida, Georgia, Maryland, North Carolina, South Carolina, Virginia, and the District of Columbia.

The Bank is a cooperative owned by member institutions that are required to purchase capital stock in the Bank as a condition of membership. All federally insured depository institutions, insurance companies and certified community development financial institutions (CDFIs) chartered in the Bank’s defined geographic district and engaged in residential housing finance are eligible to apply for membership. The Bank’s stock is owned entirely by current or former members and is not publicly traded. As of December 31, 2010, the Bank’s membership totaled 1,110 financial institutions, comprising 801 commercial banks, 101 savings banks, 44 thrifts, 150 credit unions, 13 insurance companies and one certified CDFI.

The primary function of the Bank is to provide readily available, competitively priced funding to these member institutions. The Bank serves the public by providing its member institutions with a source of liquidity, thereby enhancing the availability of credit for residential mortgages and targeted community development.

A primary source of funds for the Bank is proceeds from the sale to the public of FHLBank debt instruments, known as “consolidated obligations,” or “COs,” which are the joint and several obligations of all of the FHLBanks. Deposits, other borrowings, and the issuance of capital stock provide additional funds to the Bank. The Bank accepts deposits from both member and eligible nonmember financial institutions and federal instrumentalities. The Bank also provides members and nonmembers with correspondent banking services such as safekeeping, wire transfer, and cash management.

The Bank is exempt from ordinary federal, state, and local taxation, except real property taxes, and it does not have any subsidiaries nor does it sponsor any off-balance sheet special purpose entities.

As of December 31, 2010, the Bank had total assets of $131.8 billion, total advances of $89.3 billion, total deposits of $3.1 billion, total COs of $119.1 billion, and a retained earnings balance of $1.1 billion. The Bank’s net income for the year ended December 31, 2010 was $278 million.

The Finance Board, an independent agency in the executive branch of the U.S. government, supervised and regulated the FHLBanks and the Office of Finance through July 29, 2008. The Housing and Economic Recovery Act of 2008 (Housing Act) established the Finance Agency as the new independent federal regulator of the FHLBanks, effective July 30, 2008. The Finance Board was merged into the Finance Agency as of October 27, 2008. The Office of Finance, a joint office of the FHLBanks, facilitates the issuance and servicing of the FHLBanks’ debt instruments and prepares the combined quarterly and annual financial reports of all 12 FHLBanks.

Products and Services

The Bank’s products and services include the following:

 

 

Credit Products

 

 

Mortgage Loan Purchase Programs

 

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Index to Financial Statements
 

Community Investment Services

 

 

Cash Management and Other Services

Credit Products

The credit products that the Bank offers to its members include both advances and standby letters of credit.

Advances

Advances are the Bank’s primary product. Advances are fully secured loans made to members and eligible housing finance agencies, called “housing associates” (nonmembers that are approved mortgagees under Title II of the National Housing Act). The book value of the Bank’s outstanding advances was $89.3 billion and $114.6 billion as of December 31, 2010 and 2009, respectively, and advances represented 67.7 percent and 75.7 percent of total assets as of December 31, 2010 and 2009, respectively. Advances generated 23.6 percent, 39.1 percent, and 71.3 percent of total interest income for the years ended December 31, 2010, 2009, and 2008, respectively. For further discussion of the decrease in total interest income from advances since 2008, see Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Results of Operations—Net Interest Income.”

Advances serve as a funding source to the Bank’s members for a variety of conforming and nonconforming mortgages. Thus, advances support important housing markets, including those focused on low- and moderate-income households. For those members that choose to sell or securitize their mortgages, advances can supply interim funding.

The Bank does not restrict the purpose for which members may use advances, other than indirectly through limitations on eligible collateral and as described below. Generally, member institutions use the Bank’s advances for one or more of the following purposes:

 

 

Providing funding for single-family mortgages and multifamily mortgages held in the member’s portfolio, including both conforming and nonconforming mortgages

 

 

Providing temporary funding during the origination, packaging, and sale of mortgages into the secondary market

 

 

Providing funding for commercial real estate loans

 

 

Assisting with asset-liability management by matching the maturity and prepayment characteristics of mortgage loans or adjusting the sensitivity of the member’s balance sheet to interest-rate changes

 

 

Providing a cost-effective alternative to meet contingent liquidity needs.

Pursuant to statutory and regulatory requirements, the Bank may make long-term advances only for the purpose of enabling a member to purchase or fund new or existing residential housing finance assets, which include, for community financial institutions, defined small business loans, small farm loans, small agri-business loans, and community development loans.

The Bank obtains a security interest in eligible collateral to secure a member’s advance prior to the time it originates or renews an advance. Eligible collateral is defined by the FHLBank Act, Finance Agency regulations, and the Bank’s credit and collateral policy. The Bank requires its borrowers to execute an advances and security agreement that establishes the Bank’s security interest in all collateral pledged by the borrower. The Bank perfects its security interest in collateral prior to making an advance to the borrower. As additional security for a member’s indebtedness, the Bank has a statutory and contractual lien on the member’s capital stock in the Bank. The Bank also may require additional or substitute collateral from a borrower, as provided in the FHLBank Act and the financing documents between the Bank and its borrowers.

 

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Index to Financial Statements

The Bank assesses member creditworthiness and financial condition typically on a quarterly basis to determine the term and maximum dollar amount of the advances the Bank will lend to a particular member. In addition, the Bank discounts eligible collateral and periodically revalues the collateral pledged by each member to secure its outstanding advances. The Bank has never experienced a credit loss on an advance.

The FHLBank Act affords any security interest granted to the Bank by any member of the Bank, 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), other than claims and rights that (1) would be entitled to priority under otherwise applicable law; and (2) are held by actual bona fide purchasers for value or by actual secured parties that are secured by actual perfected security interests.

Pursuant to its regulations, the Federal Deposit Insurance Corporation (FDIC) has recognized the priority of an FHLBank’s security interest under the FHLBank Act, and the right of an FHLBank to require delivery of collateral held by the FDIC as receiver for a failed depository institution.

The Bank offers the following standard advance products:

Adjustable Rate Credit Advance (ARC Advance). The ARC Advance is a long-term advance available for a term generally of up to 10 years with rate resets at periodic intervals.

Fixed Rate Credit Advance (FRC Advance). The FRC Advance offers fixed-rate funds with principal due at maturity generally from one month to 10 years.

Daily Rate Credit Advance (DRC Advance). The DRC Advance provides short-term funding with rate resets on a daily basis; similar to federal funds lines. The DRC Advance is available generally from one day to 24 months.

Advances also are typically customized to fit member needs. The Bank’s customized advances include, among other products, the following:

Callable Advance. The callable advance is a fixed- or variable-rate advance with a fixed maturity and the option for the member to prepay the advance on an option exercise date(s) before maturity without a fee. The options can be Bermudan (periodically during the life of the advance) or European (one-time). The Bank offers this product with a maturity generally of up to 10 years with options from three months to 10 years.

Hybrid Advance. The hybrid advance is a fixed- or variable-rate advance that allows the inclusion of interest-rate caps and/or floors.

Convertible Advance. The Bank purchases an option from the member that allows the Bank to modify the interest rate on the advance from fixed to variable on certain specified dates. The Bank’s option can be Bermudan or European. The Bank offers this product with a maturity generally of up to 15 years with options from three months to 15 years.

Capped and Floored Advances. The capped advance includes an interest-rate cap, while the floored advance includes an interest-rate floor. The interest rate on the advance adjusts according to the difference between the interest-rate cap/floor and the established index. The Bank offers this product with a maturity generally of one year to 10 years.

Expander Advance. The expander advance is a fixed-rate advance with a fixed maturity and an option by the borrower to increase the amount of the advance in the future at a predetermined interest rate. The option may be Bermudan or European. The Bank has established internal limits on the amount of such options that may be sold to mature in any given quarter. The Bank offers this product with a maturity generally of two years to 20 years with an option exercise date that can be set from one month to 10 years.

 

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The following table sets forth the par value of outstanding advances by product characteristics (dollars in millions). See “Note 9—Advances” to the audited financial statements for further information on the distinction between par value and book value of outstanding advances.

 

     As of December 31,  
     2010      2009  
     Amount      Percent of
Total
     Amount      Percent of
Total
 

Adjustable or variable rate indexed

   $ 8,852         10.41       $ 9,450         8.61   

Fixed rate

     23,073         27.13         24,607         22.41   

Convertible

     12,592         14.80         19,908         18.13   

Hybrid

     39,415         46.34         54,511         49.63   

Amortizing*

     1,119         1.32         1,337         1.22   
                                   

Total par value

   $     85,051         100.00       $     109,813         100.00   
                                   

 

* The Bank offers a fixed-rate advance that may be structured with principal amortization in either equal increments or similar to a mortgage.

The Bank establishes interest rates on advances using the Bank’s cost of funds and the interest-rate swap market. For short-term advances, interest rates are driven primarily by the Bank’s discount note pricing, and for longer term advances, interest rates are driven primarily by bond and interest-rate swap pricing. The Bank establishes an interest rate applicable to each type of advance each day and then adjusts those rates during the day to reflect changes in the cost of funds and interest rates.

The Bank includes prepayment fee provisions in most advance transactions. With respect to callable advances, prepayment fees apply to prepayments on a date other than an option exercise date(s). As required by Finance Agency regulations, the prepayment fee is intended to make the Bank economically indifferent to a borrower’s decision to prepay an advance before maturity or, with respect to a callable advance, on a date other than an option exercise date.

The following table presents information on the Bank’s 10 largest borrowers of advances (dollars in millions):

 

Institution

   City, State      As of December 31, 2010  
      Advances
Par Value
     Percent  of
Total
Advances
     Weighted-
average
Interest  Rate

(%)*
 

Bank of America, National Association

     Charlotte, NC       $ 25,040         29.44         4.65   

Branch Banking and Trust Company

     Winston Salem, NC         10,362         12.18         3.20   

Navy Federal Credit Union

     Vienna, VA         8,239         9.69         3.06   

Regions Bank

     Birmingham, AL         4,210         4.95         0.93   

E*TRADE Bank

     Arlington, VA         2,304         2.71         3.13   

BankUnited

     Miami Lakes, FL         2,215         2.60         3.05   

Compass Bank

     Birmingham, AL         1,880         2.21         2.15   

Pentagon Federal Credit Union

     Alexandria, VA         1,596         1.88         3.87   

Capital One, National Association

     McLean, VA         1,120         1.32         1.08   

Northern Trust, N.A.

     Miami, FL         1,077         1.27         4.24   
                       

Subtotal (10 largest borrowers)

        58,043         68.25         3.60   

Subtotal (all other borrowers)

        27,008         31.75         3.07   
                       

Total par value

      $ 85,051         100.00         3.42   
                       

 

* The average interest rate of the member’s advance portfolio weighted by each advance’s outstanding balance.

 

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A description of the Bank’s credit risk management and collateral valuation methodology as it relates to its advance activity is contained in Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Risk Management—Credit Risk.”

Standby Letters of Credit

The Bank provides members with irrevocable standby letters of credit to support certain obligations of the members to third parties. Members may use standby letters of credit for residential housing finance and community lending or for liquidity and asset-liability management. The Bank requires its borrowers to collateralize fully the face amount of any letter of credit issued by the Bank during the term of the letter of credit. If the Bank is required to make payment for a beneficiary’s draw, these amounts must be reimbursed by the member immediately or, subject to the Bank’s discretion, may be converted into an advance to the member. The Bank’s underwriting and collateral requirements for standby letters of credit are the same as the underwriting and collateral requirements for advances. Letters of credit are not subject to activity-based capital stock purchase requirements. The Bank has never experienced a credit loss related to a standby letter of credit reimbursement obligation. Unlike advances, standby letters of credit are accounted for as contingent liabilities because a standby letter of credit may expire in accordance with its terms without ever being drawn upon by the beneficiary. The Bank had $22.3 billion and $18.9 billion of outstanding standby letters of credit as of December 31, 2010 and 2009, respectively.

Advances and Standby Letters of Credit Combined

The following table presents information on the Bank’s 10 largest borrowers of advances and standby letters of credit combined (dollars in millions):

 

            As of December 31, 2010  

Institution

   City, State      Advances Par Value
and Standby Letters
of Credit Balance
     Percent of Total
Advances Par Value
and Standby Letters
of Credit
 

Bank of America, National Association

     Charlotte, NC       $ 31,944         29.75   

Branch Banking and Trust Company

     Winton Salem, NC         11,962         11.14   

Navy Federal Credit Union

     Vienna, VA         8,239         7.67   

SunTrust Bank

     Atlanta, GA         6,133         5.71   

Compass Bank

     Birmingham, AL         5,251         4.89   

Regions Bank

     Birmingham, AL         4,414         4.11   

E*TRADE Bank

     Arlington, VA         2,304         2.15   

BankUnited

     Miami Lakes, FL         2,215         2.06   

RBC Bank (USA)

     Raleigh, NC         2,111         1.97   

Pentagon Federal Credit Union

     Alexandria, VA         1,596         1.49   
                    

Subtotal (10 largest borrowers)

        76,169         70.94   

Subtotal (all other borrowers)

        31,215         29.06   
                    

Total advances par value and standby letters of credit

      $ 107,384         100.00   
                    

Mortgage Loan Purchase Programs

Historically, the Bank offered mortgage loan purchase programs to members to provide them an alternative to holding mortgage loans in portfolio or selling them into the secondary market. These programs, the Mortgage Partnership Finance® Program1 (MPF® Program or MPF) and the Mortgage Purchase Program (MPP), are authorized under applicable regulations. Under both the MPF Program and MPP, the Bank purchased loans

 

1

“Mortgage Partnership Finance” and “MPF” are registered trademarks of FHLBank Chicago.

 

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directly from participating financial institutions (PFIs) and not through an intermediary such as a trust. The loans consisted of one-to-four family residential properties with original maturities ranging from five years to 30 years. Depending upon the program, the acquired loans may have included qualifying conventional conforming, government Federal Housing Administration (FHA) insured, and Veterans Administration (VA) guaranteed fixed-rate mortgage loans. The Bank also purchased participation interests in loans on affordable multifamily rental properties through its Affordable Multifamily Participation Program (AMPP).

The Bank ceased purchasing new mortgage assets under MPF and MPP in 2008, and stopped purchasing participation interests under AMPP in 2006. The Bank plans to continue to support its existing MPP, MPF and AMPP portfolios, which eventually will be reduced to zero in the ordinary course of the maturities of the assets.

Regulatory interpretive guidance provides that an FHLBank may sell loans acquired through its mortgage loan purchase programs, so long as it also sells the related credit enhancement obligation. The Bank currently is not selling loans it has acquired through its mortgage loan purchase programs.

Descriptions of the MPF Program and MPP underwriting and eligibility standards and credit enhancement structures are contained in Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Risk Management—Credit Risk.”

MPF Program

The unpaid principal balance of MPF loans held by the Bank was $1.8 billion and $2.2 billion at December 31, 2010 and 2009, respectively. FHLBank Chicago developed the MPF Program and, as the MPF Provider, is responsible for providing transaction processing services, as well as developing and maintaining the underwriting criteria and program servicing guide. The Bank pays FHLBank Chicago a fee for providing these services. Conventional loans purchased from PFIs under the MPF Program are subject to varying levels of loss allocation and credit enhancement structures. FHA-insured and VA-guaranteed loans are not subject to the credit enhancement obligations applicable to conventional loans under the MPF Program. The Bank held $160 million and $209 million in FHA/VA loans under the MPF Program as of December 31, 2010 and 2009, respectively.

As of December 31, 2010, two of the Bank’s MPF PFIs, Branch Banking and Trust Company and Capital One, National Association, which like all PFIs currently are inactive, were among the Bank’s top 10 borrowers.

MPP

The unpaid principal balance of MPP loans held by the Bank was $241 million and $299 million as of December 31, 2010 and 2009, respectively. As the Bank operates its MPP independently of other FHLBanks, it has greater control over the prices offered to its customers, the quality of customer service, the relationship with any third-party service provider, and program changes. Certain benefits of greater Bank control include the Bank’s ability to control operating costs and to manage its regulatory relationship directly with the Finance Agency. As of December 31, 2010, there were no MPP PFIs that were among the Bank’s top 10 borrowers.

AMPP

The Bank held participation interests in AMPP loans with an unpaid principal balance of $21 million and $22 million as of December 31, 2010 and 2009, respectively.

Community Investment Services

Each FHLBank contributes 10 percent of its annual regulatory income to its Affordable Housing Program (AHP), or such additional prorated sums as may be required to assure that the aggregate annual contribution of the FHLBanks is not less than $100 million.

 

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AHP provides direct subsidy funds or subsidized advances to members to support the financing of rental and for-sale housing for very low-, low-, and moderate-income individuals and families. The Bank’s AHP is a competitive program that supports projects that provide affordable housing to those individuals and families. In addition to the competitive AHP, the Bank offers the following programs to facilitate affordable housing and promote community economic development:

 

 

The First-time Homebuyer Program (FHP), which provides funds through member financial institutions to be used for down payment and closing costs to families at or below 80 percent of the area median income

 

 

The Community Investment Program (CIP) and the Economic Development Program (EDP), each of which provides the Bank’s members with access to low-cost funding to create affordable rental and homeownership opportunities and to engage in commercial and economic development activities that benefit low- and moderate-income individuals and neighborhoods.

For the years ended December 31, 2010 and 2009, AHP assessments were $31 million and $32 million, respectively. The Bank is permitted by regulation to allocate up to 35 percent of its annual AHP contribution to fund the FHP.

Cash Management and Other Services

The Bank historically has provided a variety of services to help members meet day-to-day cash management needs. These services include cash management services that support member advance activity, such as daily investment accounts, automated clearing house transactions and custodial mortgage accounts. In addition to cash management services, the Bank provides other noncredit services, including wire transfer services and safekeeping services. These cash management, wire transfer, and safekeeping services do not generate material amounts of income and are performed primarily as ancillary services for the Bank’s members.

The Bank also acts as an intermediary for its members that have limited or no access to the capital markets but need to enter into derivatives. This service assists members with asset-liability management by giving them indirect access to the capital markets. These intermediary transactions involve the Bank’s entering into a derivative with a member and then entering into a mirror-image derivative with one of the Bank’s approved counterparties. The derivatives entered into by the Bank as a result of its intermediary activities do not qualify for hedge accounting treatment and are separately marked to fair value through earnings. The Bank attempts to earn income from this service sufficient to cover its operating expenses through the minor difference in rates on these mirror-image derivatives. The net result of the accounting for these derivatives is not material to the operating results of the Bank. The Bank may require both the member and the counterparty to post collateral for any market value exposure that may exist during the life of the transaction.

Investments

The Bank maintains a portfolio of short- and long-term investments for liquidity purposes, to provide for the availability of funds to meet member credit needs and to provide additional earnings for the Bank. Investment income also enhances the Bank’s capacity to meet its commitments to affordable housing and community investment, cover operating expenses and satisfy the Bank’s annual Resolution Funding Corporation (REFCORP) assessment, discussed below. The long-term investment portfolio generally provides the Bank with higher returns than those available in short-term investments.

The Bank’s short-term investments were $16.9 billion and $10.3 billion as of December 31, 2010 and 2009, respectively. The Bank’s long-term investments were $23.0 billion and $22.6 billion as of December 31, 2010 and 2009, respectively. Short- and long-term investments represented 30.3 percent and 21.8 percent of the Bank’s total assets as of December 31, 2010 and 2009, respectively. These investments generated 67.9 percent, 54.2 percent and 25.9 percent of total interest income for the years ended December 31, 2010, 2009 and 2008, respectively.

 

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The Bank’s short-term investments consist of overnight and term federal funds, certificates of deposit and interest-bearing deposits. The Bank’s long-term investments consist of mortgage-backed securities (MBS) issued by government-sponsored mortgage agencies or private securities that, at the time of purchase, carry the highest rating from Moody’s Investors Service (Moody’s) or Standard & Poor’s (S&P), securities issued by the U.S. government or U.S. government agencies, state and local housing agency obligations and COs issued by other FHLBanks.

The Bank’s MBS investment practice is to purchase MBS from a select group of Bank-approved dealers, which may include “primary dealers.” Primary dealers are banks and securities brokerages that trade in U.S. government securities with the Federal Reserve System. The Bank does not purchase MBS from its members, except in the case in which a member or its affiliate is on the Bank’s list of approved dealers. The Bank bases its investment decisions in all cases on the relative rates of return of competing investments and does not consider whether an MBS is being purchased from or issued by a member or an affiliate of a member. The MBS balance at December 31, 2010 and 2009 included MBS with a book value of $3.9 billion and $4.6 billion, respectively, issued by one of the Bank’s members and its affiliates with dealer relationships. See Notes 5 and 6 to the audited financial statements for a tabular presentation of the available-for-sale and held-to-maturity securities issued by members or affiliates of members.

Finance Agency regulations prohibit the Bank from investing in certain types of securities. These restrictions are set out in more detail in Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Risk Management—Credit Risk.”

Finance Agency regulations further limit the Bank’s investment in MBS and asset-backed securities by requiring that the total book value of MBS owned by the Bank not exceed 300 percent, or in certain cases 600 percent, of the Bank’s previous month-end total capital, as defined by regulation, plus mandatorily redeemable capital stock on the day it purchases the securities. For discussion regarding the Bank’s compliance with this regulatory requirement, refer to Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Financial Condition—Investments.”

The Bank periodically invests in the outstanding COs issued by other FHLBanks as a part of its investment strategy. A description of the FHLBanks’ COs appears below under the heading “Funding Sources–Consolidated Obligations.” The terms of these consolidated obligations generally are similar to the terms of COs issued by the Bank. The purchase of these investments is funded by a pool of liabilities and capital of the Bank and is not funded by specific or “matched” COs issued by the Bank.

The Bank purchases COs issued by other FHLBanks through third-party dealers as long-term investments. These investments provide a relatively predictable source of liquidity while at the same time maximizing earnings and the Bank’s leveraged capital ratio (as these longer-term investments typically earn a higher yield than short-term investments such as term federal funds sold). The Bank purchases long-term debt issued by other GSEs for the same reason, and generally the rates of return on such other long-term debt are similar to those on COs of the same maturity.

In determining whether to invest in COs issued by other FHLBanks, the Bank, as in the case of any of its investment decisions, compares the features of such investments, including rates of return, terms of maturity, and overall structure, to alternative permissible uses of available funds for investment, including the repayment of outstanding indebtedness of the Bank. At the time of such investment decision, however, indebtedness of the Bank may not be available for repurchase.

While the Bank seeks to manage its entire portfolio of investments to achieve an overall rate of return in excess of the Bank’s funding costs, certain individual investments, including COs issued by other FHLBanks, may have a stated interest rate that is less than the Bank’s cost of funds at the time of purchase as a result of various factors, such as the changing nature of market interest rates and the hedging strategies adopted by the Bank. Although the stated interest rate on any series of COs is based in part on the joint and several liability of the FHLBanks, particular series of COs may have different structures and remaining maturities; consequently, they may have

 

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different rates of return to investors, including the Bank. The FHLBanks’ joint and several liability is the same for all COs issued by the FHLBanks, regardless of whether an FHLBank owns a particular series of them. Normally, at the time of purchase of these investments, the Bank also enters into derivatives with mirror-image terms to the investments to offset price movements in the investment. This hedging helps maintain an appropriate repricing balance between assets and liabilities.

Investment by the Bank in COs issued by other FHLBanks is not currently, nor is it anticipated to be, precluded by Finance Agency regulations. Current regulations do not impose any express limitation on the ability of the Bank to receive payments on COs issued by other FHLBanks in the event that the issuing FHLBank is unable to make such payments itself, and the other FHLBanks, including the Bank, are required to make such payments. However, 12 CFR Section 966.8(c) prohibits COs from being placed directly with any FHLBank. Regulatory interpretative guidance on this provision has clarified that the regulation also prohibits purchases from underwriters in an initial offering of COs. The Bank does not purchase COs issued by other FHLBanks during their period of initial issuance, so this guidance has not affected its investment strategy in this regard.

The following table sets forth the Bank’s investments in U.S. agency securities (dollars in millions):

 

      As of December 31,  
      2010      2009  
      Amount      Percent of
Total
Investments
     Weighted
-average
Yield
(%)
     Amount      Percent of
Total
Investments
     Weighted
-average
Yield
(%)
 

Government-sponsored enterprises debt obligations

   $ 4,179         10.48         3.61       $ 3,470         10.54         4.20   

Other FHLBank’s bond (1)

     74         0.19         17.63         72         0.22         15.17   

Mortgage-backed securities:

                 

U.S. agency obligations-guaranteed

     960         2.41         1.07         777         2.36         1.21   

Government-sponsored enterprises

     8,716         21.86         2.57         6,598         20.03         4.32   

 

(1) Includes one inverse variable-rate consolidated obligation bond.

The Bank is subject to credit and market risk on its investments. For discussion as to how the Bank manages these risks, see Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Risk Management.”

Funding Sources

Consolidated Obligations

Consolidated obligations or “COs,” consisting of bonds and discount notes, are the joint and several obligations of the FHLBanks, backed only by the financial resources of the 12 FHLBanks. COs are not obligations of the U.S. government, and the United States does not guarantee the COs. The Bank, working through the Office of Finance, is able to customize COs to meet investor demands. Customized features can include different indices and embedded derivatives. These customized features are offset predominately by derivatives to reduce the market risk associated with the COs.

Although the Bank is primarily liable for its portion of COs (i.e., those issued on its behalf), the Bank also is jointly and severally liable with the other 11 FHLBanks for the payment of principal and interest on COs of all the FHLBanks. If the principal or interest on any CO issued on behalf of the Bank is not paid in full when due, the Bank may not pay any extraordinary expenses or pay dividends to, or redeem or repurchase shares of stock from, any member of the Bank. The Finance Agency, under 12 CFR Section 966.9(d), may at any time require any FHLBank to make principal or interest payments due on any COs, whether or not the primary obligor FHLBank has defaulted on the payment of that obligation.

 

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To the extent that an FHLBank makes any payment on a CO on behalf of another FHLBank, the paying FHLBank is entitled to reimbursement from the noncomplying FHLBank. However, if the Finance Agency determines that the noncomplying FHLBank is unable to satisfy its obligations, the Finance Agency may allocate the outstanding liability among the remaining FHLBanks on a pro rata basis in proportion to each FHLBank’s participation in all COs outstanding or on any other basis the Finance Agency may determine.

Finance Agency regulations also state that the Bank must maintain the following types of assets free from any lien or pledge in an aggregate amount at least equal to the amount of the Bank’s portion of the COs outstanding, provided that any assets that are subject to a lien or pledge for the benefit of the holders of any issue of COs shall be treated as if they were assets free from any lien or pledge for purposes of this negative pledge requirement:

 

 

Cash

 

 

Obligations of, or fully guaranteed by, the United States

 

 

Secured advances

 

 

Mortgages that have any guaranty, insurance, or commitment from the United States or any agency of the United States

 

 

Investments described in Section 16(a) of the FHLBank 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

 

 

Other securities that have been assigned a rating or assessment by a nationally recognized statistical rating organization (NRSRO) that is equivalent to or higher than the rating or assessment assigned by that NRSRO to the COs.

The following table presents the Bank’s compliance with this requirement (in millions):

 

      Outstanding Debt      Aggregate Unencumbered Assets  

As of December 31, 2010

   $ 119,113       $ 131,532   

As of December 31, 2009

     138,577         150,885   

The Office of Finance has responsibility for facilitating and executing the issuance of the COs. It also services all outstanding debt.

Consolidated Obligation Bonds. Consolidated obligation bonds satisfy longer-term funding requirements. Typically, the maturity of these securities ranges from one year to 10 years, but the maturity is 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. The FHLBanks also use the TAP issue program for fixed-rate, noncallable bonds. Under this program, the FHLBanks offer debt obligations at specific maturities that may be reopened daily, generally during a three-month period through competitive auctions. The goal of the TAP program is to aggregate frequent smaller issues into a larger bond issue that may have greater market liquidity.

Consolidated Obligation Discount Notes. Through the Office of Finance, the FHLBanks also issue consolidated obligation discount notes to provide short-term funds for advances to members, for the Bank’s short-term investments, and for the Bank’s variable-rate and convertible advance programs. These securities have maturities up to 366 days and are offered daily through a consolidated obligation discount-note selling group. Discount notes are issued at a discount and mature at par.

 

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The following table shows the net amount of the Bank’s outstanding consolidated obligation bonds and discount notes (in millions). The net amount is described in more detail in the table summarizing the Bank’s participation in COs outstanding included within Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Financial Condition—Consolidated Obligations.”

 

     As of December 31,  
     2010      2009  

Consolidated obligations, net:

     

Bonds

   $ 95,198       $ 121,450   

Discount notes

     23,915         17,127   
                 

Total

   $     119,113       $     138,577   
                 

Certification and Reporting Obligations. Under Finance Agency regulations, before the end of each calendar quarter and before paying any dividends for that quarter, the president of the Bank must certify to the Finance Agency that, based upon known current facts and financial information, the Bank will remain in compliance with applicable liquidity requirements and will remain capable of making full and timely payment of all current obligations (which includes the Bank’s obligation to pay principal and interest on COs issued on its behalf through the Office of Finance) coming due during the next quarter. The Bank is required to provide notice to the Finance Agency upon the occurrence of any of the following:

 

 

The Bank is unable to provide the required certification

 

 

The Bank projects at any time that it will fail to comply with its liquidity requirements or will be unable to meet all of its current obligations due during the quarter

 

 

The Bank actually fails to comply with its liquidity requirements or to meet all of its current obligations due during the quarter

 

 

The Bank negotiates to enter or enters into an agreement with one or more other FHLBanks to obtain financial assistance to meet its current obligations due during the quarter.

An FHLBank must file a CO payment plan for Finance Agency approval upon the occurrence of any of the following:

 

 

The FHLBank becomes a noncomplying FHLBank as a result of failing to provide a required certification related to liquidity requirements and ability to meet all current obligations

 

 

The FHLBank becomes a noncomplying FHLBank as a result of being required to provide notice to the Finance Agency of certain matters related to liquidity requirements or inability to meet current obligations

 

 

The Finance Agency determines that the FHLBank will cease to be in compliance with its liquidity requirements or will lack the capacity to meet all of its current obligations due during the quarter.

Regulations permit a noncompliant FHLBank to continue to incur and pay normal operating expenses in the regular course of business. However, a noncompliant FHLBank may not incur or pay any extraordinary expenses, declare or pay dividends, or redeem any capital stock until such time as the Finance Agency has approved the FHLBank’s CO payment plan or inter-FHLBank assistance agreement or has ordered another remedy, and the noncompliant FHLBank has paid all its direct obligations.

Deposits

The FHLBank Act allows the Bank to accept deposits from its members, any institution for which it is providing correspondent services, other FHLBanks, or other governmental instrumentalities. Deposit programs provide some of the Bank’s funding resources while also giving members a low-risk earning asset that satisfies their

 

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regulatory liquidity requirements. The Bank offers several types of deposit programs, including demand and overnight deposits. As of December 31, 2010 and 2009, the Bank had demand and overnight deposits of $3.1 billion and $3.0 billion, respectively.

To support its member deposits, the FHLBank Act requires the Bank to have as a reserve an amount equal to or greater than its current deposits from members. These reserves are required to be invested in obligations of the United States, deposits in eligible banks or trust companies, or certain advances with maturities not exceeding five years. As of December 31, 2010 and 2009, the Bank had excess deposit reserves of $76.4 billion and $93.2 billion, respectively.

Capital, Capital Rules, Retained Earnings, and Dividends

Capital and Capital Rules

The Bank is required to comply with regulatory requirements for total capital, leverage capital, and risk-based capital. Under these requirements, the Bank must maintain total capital in an amount equal to at least four percent of total assets and weighted leverage capital in an amount equal to at least five percent of total assets. “Weighted leverage capital” is defined as the sum of permanent capital weighted 1.5 times and nonpermanent capital weighted 1.0 times. In addition, the Bank must maintain permanent capital, defined by the FHLBank Act and applicable regulations as the sum of paid-in capital for Class B stock and retained earnings, in an amount equal to or greater than the risk-based capital requirements set forth in the Gramm-Leach-Bliley Act of 1999. The regulatory definition of permanent capital results in a calculation of permanent capital different from that determined in accordance with GAAP because the regulatory definition treats mandatorily redeemable capital stock as capital. Risk-based capital is the sum of credit, market, and operating risk capital requirements.

Credit risk capital is the sum of the capital charges for the Bank’s assets, off-balance sheet items, and derivatives contracts. The Bank calculates these charges using the methodology and risk weights assigned to each classification by the Finance Agency. Market risk capital is the sum of the market value of the Bank’s portfolio at risk from movement in interest rates, foreign exchange rates, commodity prices, and equity prices that could occur during times of market stress and the amount, if any, by which the market value of total capital is less than 85 percent of the book value of total capital. Operational risk capital is equal to 30 percent of the sum of the credit risk capital component and the market risk capital component. Regulations define “total capital” as the sum of:

 

 

Permanent capital

 

 

The amount of paid-in Class A stock, if any (the Bank does not issue Class A stock)

 

 

The amount of the Bank’s general allowance for losses (if any)

 

 

The amount of any other instruments identified in the Bank’s capital plan that the Finance Agency has determined to be available to absorb losses.

To satisfy these capital requirements, the Bank maintains a capital plan, as last amended effective March 6, 2009. Each member’s minimum stock requirement is an amount equal to the sum of a “membership” stock component and an “activity-based” stock component under the plan. The FHLBank Act and applicable regulations require that the minimum stock requirement for members must be sufficient to enable the Bank to meet its minimum leverage and risk-based capital requirements. If necessary, the Bank may adjust the minimum stock requirement from time to time within the ranges established in the capital plan. Each member is required to comply promptly with any adjustment to the minimum stock requirement.

The capital plan permits the Bank’s board of directors to set the membership and activity-based stock requirements within a range as set forth in the capital plan. As of December 31, 2010, the membership stock requirement was 0.15 percent (15 basis points) of the member’s total assets, subject to a cap of $26 million.

 

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As of December 31, 2010, the activity-based stock requirement was the sum of the following:

 

 

4.50 percent of the member’s outstanding par value of advances; and

 

 

8.00 percent of any outstanding targeted debt/equity investment (investments similar to AMPP assets) sold by the member to the Bank on or after December 17, 2004.

In addition, the activity-based stock requirement may include a percentage of any outstanding balance of acquired member assets (such as MPF and MPP assets), although this percentage was set at zero percent as of December 31, 2010. As of December 31, 2010, all of the Bank’s AMPP assets had been acquired from a nonmember, and, therefore, the 8.00 percent activity-based stock requirement did not apply with respect to those AMPP assets.

Although applicable regulations allow the Bank to issue Class A stock or Class B stock, or both, to its members, the Bank’s capital plan allows it to issue only Class B stock. For additional information regarding the Bank’s stock, refer to Item 5, “Market For Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.”

Retained Earnings and Dividends

The Bank has established a capital management policy to help preserve the value of the members’ investment in the Bank and reasonably mitigate the effect on capital of unanticipated operating and accounting events. At least quarterly, the Bank assesses the adequacy of its retained earnings. This assessment considers forecasted income, mark-to-market adjustments on derivatives and trading securities, market risk, operational risk and credit risk. Quarterly, the board sets the targeted amount of retained earnings the Bank is required to hold after the payment of dividends based on this assessment. Based upon this quantitative analysis, the board of directors established the target amount of retained earnings at $533 million as of December 31, 2010. The Bank’s retained earnings at December 31, 2010 were higher than this target by $591 million, as discussed in more detail in Item 7, “Management’s Discussion and analysis of Financial Condition and Results of Operation.”

The Bank may pay dividends on its capital stock only out of its retained earnings or current net earnings. The Bank’s board of directors has discretion to declare or not declare dividends and to determine the rate of any dividends declared. The board of directors may neither declare nor require the Bank to pay dividends when it is not in compliance with all of its capital requirements or if, after giving effect to the dividend, the Bank would fail to meet any of its capital requirements. The Bank also may not declare a dividend if the dividend would create a financial safety and soundness issue for the Bank.

The Finance Agency prohibits any FHLBank from issuing dividends in the form of stock or otherwise issuing new “excess stock” if that FHLBank has excess stock greater than one percent of that FHLBank’s total assets or if issuing such dividends or new excess stock would cause that FHLBank to exceed the one percent excess stock limitation. Excess stock is FHLBank capital stock not required to be held by the member to meet its minimum stock requirement under an FHLBank’s capital plan. At December 31, 2010, the Bank’s excess capital stock outstanding was 2.07 percent of the Bank’s total assets. Historically, the Bank has not issued dividends in the form of stock, and a member’s existing excess activity-based stock is applied to any activity-based stock requirements related to new advances.

Derivatives

Finance Agency regulations and the Bank’s Risk Management Policy (RMP) establish guidelines for derivatives. These policies and regulations prohibit trading in or the speculative use of these instruments and limit permissible credit risk arising from these instruments. The Bank enters into derivatives only to manage the interest-rate risk exposures inherent in otherwise unhedged assets and funding positions, and to achieve the Bank’s risk management objectives. These derivatives consist of interest-rate swaps (including callable swaps

 

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and putable swaps), swaptions, interest-rate cap and floor agreements, and futures and forward contracts. Generally, the Bank uses derivatives in its overall interest-rate risk management to accomplish one or more of the following objectives:

 

 

Reduce the interest-rate net sensitivity of consolidated obligations, advances, investments, and mortgage loans by, in effect, converting them to a short-term interest rate, usually based on the London Interbank Offered Rate (LIBOR)

 

 

Manage embedded options in assets and liabilities

 

 

Hedge the market value of existing assets or liabilities

 

 

Hedge the duration risk of pre-payable instruments.

The total notional amount of the Bank’s outstanding derivatives was $142.2 billion and $192.0 billion as of December 31, 2010 and 2009, respectively. The contractual or notional amount of a derivative is not a measure of the amount of credit risk from that transaction. Rather, the notional amount serves as a basis for calculating periodic interest payments or cash flows.

The Bank may enter into derivatives concurrently with the issuance of consolidated obligations with embedded options. Issuing bonds while simultaneously entering into derivatives converts, in effect, fixed-rate liabilities into variable-rate liabilities. The continued attractiveness of such debt depends on price relationships in both the bond market and derivatives markets. If conditions in these markets change, the Bank may alter the types or terms of the bonds issued. Similarly, the Bank may enter into derivatives in conjunction with the origination of advances with embedded options. Issuing fixed-rate advances while simultaneously entering into derivatives converts, in effect, fixed-rate advances into variable-rate earning assets.

The Bank is subject to credit risk in all derivatives due to potential nonperformance by the derivative counterparty. The Bank reduces this risk by executing derivatives only with highly-rated financial institutions. In addition, the legal agreements governing the Bank’s derivatives require the credit exposure of all derivatives with each counterparty to be netted. As of December 31, 2010, the Bank had credit risk exposure to one counterparty, before considering collateral, in an aggregate amount of $66 million. As of December 31, 2009, the Bank had credit risk exposure to five counterparties, before considering collateral, in an aggregate amount of $113 million.

The market risk of derivatives can be measured meaningfully only on a portfolio basis, taking into account the entire balance sheet and all derivatives. The market risk of the derivatives and the hedged items is included in the measurement of the Bank’s effective duration gap (the difference between the expected weighted average maturities of the Bank’s assets and liabilities). As of December 31, 2010, the Bank’s duration calculations suggested an effective duration gap of negative 0.11 years. While duration calculations are inherently approximate rather than absolute, a positive duration gap generally indicates an overall exposure to rising interest rates; conversely, a negative duration gap normally indicates an overall exposure to falling interest rates. The larger the duration gap, whether positive or negative, indicates a larger exposure risk.

For further discussion as to how the Bank manages its credit risk and market risk on its derivatives, see Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operation—Risk Management.”

Competition

Advances. A number of factors affect demand for the Bank’s advances, including, but not limited to, the availability and cost of other sources of liquidity for the Bank’s members, such as demand deposits, brokered deposits and the repurchase market. The Bank individually competes with other suppliers of secured and unsecured wholesale funding. Such other suppliers may include investment banks, commercial banks, and in certain circumstances, other FHLBanks. Smaller members may have access to alternative funding sources through sales of securities under agreements to repurchase, while larger members may have access to all the alternatives listed. Large members also may have independent access to the national and global credit markets.

 

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The availability of alternative funding sources to members can influence significantly the demand for the Bank’s advances and can vary as a result of a number of factors including, among others, market conditions, members’ creditworthiness, and availability of collateral. Although most government programs created in light of the credit crisis, which provided competitive funding alternatives to the Bank’s members, expired during the first half of 2010, members have experienced significant levels of liquidity throughout 2010, in part due to higher FDIC deposit insurance limits, which has increased members’ deposits and decreased member demand for advances. Effective October 3, 2008, the standard maximum deposit insurance amount was increased temporarily from $100,000 to $250,000 per depositor through December 31, 2010. On May 20, 2009, this temporary increase was extended through December 31, 2013. The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act), which was signed into law on July 21, 2010, permanently increased the standard maximum deposit insurance amount to $250,000 per depositor. On June 28, 2010, the FDIC extended its Transaction Account Guaranty Program (TAG), which provided depositors with unlimited coverage for qualifying noninterest-bearing accounts, through December 31, 2010. The Dodd-Frank Act expanded TAG coverage to certain accounts that were previously excluded under the FDIC rule and statutorily extended TAG through December 31, 2012; on November 15, 2010, the FDIC issued a final rule to implement this provision of the Dodd-Frank Act.

Debt Issuance. The Bank competes with 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 debt markets. Increases in the supply of competing debt products may, in the absence of increases in demand, result in higher debt costs or lesser amounts of debt issued at the same cost than otherwise would be the case. In addition, the availability and cost of funds raised through the issuance of certain types of unsecured debt may be affected adversely by regulatory initiatives that tend to reduce investments by certain depository institutions in unsecured debt with greater price volatility or interest-rate sensitivity than fixed-rate, fixed-maturity instruments of the same maturity. Further, a perceived or actual higher level of government support for other GSEs may increase demand for their debt securities relative to similar FHLBank securities.

Interest-rate Exchange Agreements. The sale of callable debt and the simultaneous execution of callable interest-rate swaps that mirror the debt have been important sources of competitive funding for the Bank. As such, the availability of markets for callable debt and interest-rate swaps may be an important determinant of the Bank’s relative cost of funds. There is considerable competition among high credit quality issuers in the markets for these instruments.

Regulatory Oversight, Audits, and Examinations

The Finance Agency supervises and regulates the FHLBanks. The Finance Agency is responsible for ensuring that (1) the FHLBanks operate in a safe and sound manner, including maintenance of adequate capital and internal controls; (2) the operations and activities of the FHLBanks foster liquid, efficient, competitive and resilient national housing finance markets; (3) the FHLBanks comply with applicable laws and regulations; and (4) the FHLBanks carry out their housing finance mission through authorized activities that are consistent with the public interest. In this capacity, the Finance Agency issues regulations and policies that govern, among other things, the permissible activities, powers, investments, risk-management practices, and capital requirements of the FHLBanks, and the authorities and duties of FHLBank directors. The Finance Agency conducts annual, on-site examinations of the Bank as well as periodic off-site reviews. In addition, the Bank must submit to the Finance Agency monthly financial information on the condition and results of operations of the Bank.

Effective May 16, 2006, in accordance with the Finance Board’s regulation, the Bank registered its Class B stock with the SEC under Section 12(g)(1) of the Securities Exchange Act of 1934, as amended (Exchange Act). The Housing Act codified the regulatory requirement that each FHLBank register a class of its common stock under Section 12(g) of the Exchange Act. As a result of this registration, the Bank is required to comply with the disclosure and reporting requirements of the Exchange Act and to file with the SEC annual, quarterly and current reports, as well as meet other SEC requirements, subject to certain exemptive relief obtained from the SEC and under the Housing Act.

 

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The Government Corporation Control Act provides that, before a government corporation (which includes the FHLBanks) issues and offers obligations to the public, the Secretary of the Treasury shall prescribe (1) the form, denomination, maturity, interest rate, and conditions of the obligations; (2) the time and manner in which issued; and (3) the selling price. Under the Housing Act, the Secretary of the Treasury has the authority, at his or her discretion, to purchase COs, subject to the federal debt ceiling limits. Previously, the FHLBank Act had authorized the Secretary of the Treasury, at his or her discretion, to purchase COs up to an aggregate principal amount of $4.0 billion. No borrowings under this authority have been outstanding since 1977. The U.S. Department of the Treasury (Treasury) receives the Finance Agency’s annual report to Congress, weekly reports reflecting securities transactions of the FHLBanks, and other reports reflecting the operations of the FHLBanks.

The Comptroller General has authority under the FHLBank Act to audit or examine the Finance Agency and the Bank and to decide the extent to which they fairly and effectively fulfill the purposes of the FHLBank 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, he or she must report the results and provide his or her recommendations to Congress, the Office of Management and Budget, and the FHLBank in question. The Comptroller General also may conduct his or her own audit of any financial statements of the Bank.

The Bank has an internal audit department, the Bank’s board of directors has an audit committee, and an independent registered public accounting firm audits the annual financial statements of the Bank. The independent registered public accounting firm conducts these audits following the standards of the Public Company Accounting Oversight Board (United States) and Government Auditing Standards issued by the Comptroller General. The FHLBanks, the Finance Agency, and Congress receive the Bank’s Report and audited financial statements. The Bank 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 registered public accounting firm on the financial statements.

Personnel

As of December 31, 2010, the Bank employed 404 full-time and 13 part-time employees.

Taxation/Assessments

Although the Bank is exempt from all federal, state, and local taxation, except for real property taxes, the Bank is obligated to make payments to REFCORP. Each FHLBank is required to pay to REFCORP 20 percent of its annual income calculated in accordance with GAAP after the assessment for AHP, but before the assessment for REFCORP.

The FHLBanks will continue to expense and pay these amounts until the aggregate amounts actually paid by all 12 FHLBanks are equivalent to a $300 million annual annuity (or a scheduled payment of $75 million per quarter) whose final maturity date is April 15, 2030, at which point the required payment of each FHLBank to REFCORP will be fully satisfied. The cumulative amount to be paid to REFCORP by the Bank is not determinable at this time because it depends on the future earnings of all FHLBanks and interest rates. If the Bank experienced a net loss during a quarter but still had net income for the year, the Bank’s obligation to the REFCORP would be calculated based on the Bank’s year-to-date GAAP net income. If the Bank had net income in subsequent quarters, it would be required to contribute additional amounts to meet its calculated annual obligation. The Bank would be entitled to either a refund or a credit for amounts paid for the full year that were in excess of its calculated annual obligation. If the Bank experienced a net loss for a full year, the Bank would have no obligation to the REFCORP for the year.

 

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The Finance Agency is required to extend the term of the FHLBanks’ obligation to the REFCORP for each calendar quarter in which the FHLBanks’ quarterly payment falls short of $75 million.

The FHLBanks’ aggregate payments through 2010 have exceeded the scheduled payments, effectively accelerating payment of the REFCORP obligation and shortening its remaining term to October 15, 2011, effective December 31, 2010. The FHLBanks’ aggregate payments through 2010 have satisfied $65 million of the $75 million scheduled payment due in the fourth quarter of 2011 and all scheduled payments thereafter. This date assumes that the FHLBanks will pay exactly $300 million annually after December 31, 2010 until the annuity is satisfied.

The benchmark payments or portions of them could be reinstated if the actual REFCORP payments of the FHLBanks fall short of $75 million in a quarter. The maturity date of the REFCORP obligation may be extended beyond April 15, 2030 if such extension is necessary to ensure that the value of the aggregate amounts paid by the FHLBanks exactly equals a $300 million annual annuity. Any payment beyond April 15, 2030 will be paid to the Treasury.

Each year the Bank must set aside for its AHP 10 percent of its annual regulatory income, or such prorated sums as may be required to assure that the aggregate contribution of the FHLBanks is not less than $100 million. Regulatory income is defined as GAAP income before interest expense related to mandatorily redeemable capital stock and the assessment for AHP, but after the assessment for REFCORP. If an FHLBank experienced a regulatory loss for a full year, the FHLBank would have no obligation to the AHP for that year, since each FHLBank’s required annual AHP contribution is limited to its annual regulatory income.

REFCORP has been designated as the calculation agent for AHP and REFCORP assessments. The combined REFCORP and AHP assessments for the Bank were $100 million for the year ended December 31, 2010. These assessments were the equivalent of a 26.6 percent effective annual income tax rate for the Bank.

On February 28, 2011, the Bank, together with the other 11 FHLBanks, executed a Joint Capital Enhancement Agreement (Joint Capital Agreement) which provides that upon satisfying the RECORP obligation, each FHLBank will allocate a portion of its net income to a restricted retained earnings account to be established at each FHLBank (Restricted Retained Earnings Account). Refer to Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Results of Operations—Capital” for further discussion of the Joint Capital Agreement.

 

Item 1A. Risk Factors.

The following discussion summarizes some of the more important risks that the Bank faces. This discussion is not exhaustive, and there may be other risks that the Bank faces, which are not described below. These risks should be read in conjunction with the other information included in this Report, including, without limitation, in “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” the financial statements and notes and “Special Cautionary Notice Regarding Forward-looking Statements.” The risks described below, if realized, could affect negatively the Bank’s business operations, financial condition, and future results of operations and, among other things, could result in the Bank’s inability to pay dividends on its capital stock.

The Bank is jointly and severally liable for payment of principal and interest on the consolidated obligations issued by the other 11 FHLBanks.

Each of the FHLBanks relies upon the issuance of COs as a primary source of funds. COs are the joint and several obligations of all of the FHLBanks, backed only by the financial resources of the FHLBanks. Accordingly, the Bank is jointly and severally liable with the other FHLBanks for the COs issued by the FHLBanks through the Office of Finance, regardless of whether the Bank receives all or any portion of the proceeds from any particular issuance of COs.

 

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The Finance Agency may by regulation require any FHLBank to make principal or interest payments due on any CO at any time, whether or not the FHLBank that was the primary obligor has defaulted on the payment of that obligation. The Finance Agency may allocate the liability among one or more FHLBanks on a pro rata basis or on any other basis the Finance Agency may determine. Accordingly, the Bank could incur significant liability beyond its primary obligation under COs due to the failure of other FHLBanks to meet their obligations, which could affect negatively the Bank’s financial condition and results of operations.

During 2010, at least one of the other FHLBanks was classified by the Finance Agency as undercapitalized. In addition, during the recent financial crisis several FHLBanks announced matters related to net losses, suspension of dividends, suspension of stock repurchases and risk-based capital deficiencies, primarily in light of recent declines in the value of private-label MBS.

The Bank’s funding depends upon its ability to access the capital markets.

The Bank seeks to be in a position to meet its members’ credit and liquidity needs and pay its obligations without maintaining excessive holdings of low-yielding liquid investments or being forced to incur unnecessarily high borrowing costs. The Bank’s primary source of funds is the sale of consolidated obligations in the capital markets, including the short-term discount note market. The Bank’s ability to obtain funds through the sale of consolidated obligations depends in part on prevailing conditions in the capital markets (including investor demand), such as the effects of the reduction of liquidity in financial markets, which are beyond the Bank’s control.

Changes in the Bank’s credit ratings may affect adversely the Bank’s ability to issue consolidated obligations on acceptable terms.

The Bank currently has the highest credit rating from Moody’s and S&P. In addition, the consolidated obligations of the FHLBanks have been rated Aaa/P-1 by Moody’s and AAA/A-1+ by S&P. These ratings are subject to revision or withdrawal at any time by the rating agencies; therefore, the Bank may not be able to maintain these credit ratings. Negative ratings actions or negative guidance may affect adversely the Bank’s cost of funds and ability to issue consolidated obligations on acceptable terms, which could have a negative effect on the Bank’s financial condition and results of operations.

The Bank faces competition for loan demand, which could have an adverse effect on earnings.

Advances represent the Bank’s primary product offering. For the year ended December 31, 2010, advances represented 67.7 percent of the Bank’s total assets. The Bank competes with other suppliers of wholesale funding, both secured and unsecured, including investment banks, commercial banks, and in certain circumstances, other FHLBanks. The Bank’s members have access to alternative funding sources, which may offer more favorable terms on their loans than the Bank does on its advances, including more flexible credit or collateral standards. During 2010, the Bank’s members experienced high deposit levels partly as a result of the FDIC’s increased deposit insurance coverage, decreasing member demand for advances. In addition, many of the Bank’s competitors are not subject to the same body of regulation applicable to the Bank, which enables those competitors to offer products and terms that the Bank is not able to offer.

The availability of alternative funding sources to the Bank’s members that are more attractive than those funding products offered by the Bank may decrease significantly the demand for the Bank’s advances. Any change made by the Bank in the pricing of its advances in an effort to compete effectively with these competitive funding sources may decrease the Bank’s profitability on advances, which could result in lower dividend yields to members. A decrease in the demand for the Bank’s advances or a decrease in the Bank’s profitability on advances could have a material adverse effect on the Bank’s financial condition and results of operations.

 

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The Bank is exposed to risks because of customer concentration.

The Bank is subject to customer concentration risk as a result of the Bank’s reliance on a relatively small number of member institutions for a large portion of the Bank’s total advances and resulting interest income. As of December 31, 2010 and 2009, the Bank’s largest borrower, Bank of America, National Association, accounted for $25.0 billion and $37.4 billion, respectively, of the Bank’s total advances then outstanding, which represented 29.4 percent and 34.0 percent, respectively, of the Bank’s total advances then outstanding. In addition, as of December 31, 2010 and 2009, 10 of the Bank’s member institutions (including Bank of America, National Association) collectively accounted for $58.0 billion and $75.4 billion, respectively, of the Bank’s total advances then outstanding, which represented 68.3 percent and 68.7 percent, respectively, of the Bank’s total advances then outstanding. If, for any reason, the Bank were to lose, or experience a decrease in the amount of, its business relationships with its largest borrower or a combination of several of its large borrowers—whether as the result of any such member becoming a party to a merger or other transaction, or as a result of market conditions, competition or otherwise – the Bank’s financial condition and results of operations could be affected negatively.

The financial services industry has seen a significant number of failed financial institutions during 2010, and this trend is expected to continue through 2011. All or a portion of the assets and liabilities of a failed financial institution may be acquired by another financial institution. This consolidation of the industry may reduce the number of potential members in the Bank’s district and result in a loss of overall business for the Bank.

Changes in interest rates could affect significantly the Bank’s earnings.

Like many financial institutions, the Bank realizes income primarily from the spread between interest earned on the Bank’s outstanding loans and investments and interest paid on the Bank’s borrowings and other liabilities. Although the Bank uses a number of measures to monitor and manage changes in interest rates, the Bank may experience “gaps” in the interest-rate sensitivities of its assets and liabilities resulting from both duration and convexity mismatches. The existence of gaps in interest-rate sensitivities means that either the Bank’s interest-bearing liabilities will be more sensitive to changes in interest rates than its interest-earning assets, or vice versa. In either case, if interest rates move contrary to the Bank’s position, any such gap could affect adversely the net present value of the Bank’s interest-sensitive assets and liabilities, which could affect negatively the Bank’s financial condition and results of operations.

Prepayment of mortgage assets could affect earnings.

The Bank invests in both MBS and whole mortgage loans. Changes in interest rates can affect significantly the prepayment patterns of these assets, and such prepayment patterns could affect the Bank’s earnings. In management’s experience, it is difficult to hedge prepayment risk in mortgage loans. Therefore, prepayments of mortgage assets could have an adverse effect on the income of the Bank.

The Bank’s exposure to credit risk could have an adverse effect on the Bank’s financial condition and results of operations.

The Bank assumes secured and unsecured credit risk exposure associated with the risk of default by, or insolvency of, a borrower or counterparty. Any substantial devaluation of collateral, failure to properly perfect the Bank’s security interest in collateral, an inability to liquidate collateral, or any disruptions in the servicing of collateral in the event of a default could create credit losses for the Bank.

The Bank invests in U.S. agency (Fannie Mae, Freddie Mac, and Ginnie Mae) and private-label MBS rated AAA by S&P or Fitch Ratings or Aaa by Moody’s at the time of purchase. As of December 31, 2010, a substantial portion of the Bank’s MBS portfolio consisted of private-label MBS. Market prices for many of these private-label MBS have deteriorated since 2007. Given continued uncertainty in market conditions and the significant judgments involved in determining market value, there is a risk that further declines in fair value in the Bank’s MBS portfolio may occur and that the Bank may record additional other-than-temporary impairment losses in future periods, which could materially adversely affect the Bank’s earnings and retained earnings and the value of Bank membership.

 

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The insolvency or other inability of a significant counterparty to perform its obligations could affect the Bank adversely.

The Bank assumes credit risk when entering into securities transactions, money market transactions, supplemental mortgage insurance agreements, and derivative contracts with counterparties. The Bank routinely executes transactions with counterparties in the financial services industry, including commercial banks, brokers and dealers, investment banks, and other institutional clients. The insolvency or other inability of a significant counterparty to perform its obligations under a derivative contract or other agreement could have an adverse effect on the Bank’s financial condition and results of operations. In addition, the Bank’s credit risk may be exacerbated based on market movements or when the collateral pledged to the Bank cannot be realized upon or is liquidated at prices not sufficient to recover the full amount of the credit or derivative exposure due to the Bank.

The Bank uses master derivative contracts that contain provisions that require the Bank to net the exposure under all transactions with the counterparty to one amount to calculate collateral requirements. At times, the Bank enters into derivative contracts with foreign counterparties in jurisdictions in which it is uncertain whether the netting provisions would be enforceable in the event of insolvency of the foreign counterparty. Although the Bank attempts to monitor the creditworthiness of all counterparties, it is possible that the Bank may not be able to terminate the agreement with a foreign counterparty before the counterparty would become subject to an insolvency proceeding.

The Bank relies upon derivative instruments to reduce its interest-rate risk, and the Bank may not be able to enter into effective derivative instruments on acceptable terms.

The Bank uses derivative instruments to attempt to reduce its interest-rate risk and mortgage prepayment risk. The Bank’s management determines the nature and quantity of hedging transactions based on various factors, including market conditions and the expected volume and terms of advances. As a result, the Bank’s effective use of these instruments depends on the ability of Bank management to determine the appropriate hedging positions in light of the Bank’s assets, liabilities, and prevailing and anticipated market conditions. In addition, the effectiveness of the Bank’s hedging strategy depends upon the Bank’s ability to enter into these instruments with acceptable parties, upon terms satisfactory to the Bank, and in the quantities necessary to hedge the Bank’s corresponding obligations. If the Bank is unable to manage its hedging positions properly or is unable to enter into hedging instruments upon acceptable terms, the Bank may be unable to manage its interest-rate and other risks, or may be required to decrease its MBS holdings, which could affect the Bank’s financial condition and results of operations.

Please refer to the information set forth in Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Results of Operation—Accounting for Derivatives and Hedging Activities” for a discussion of the effect of the Bank’s use of derivative instruments on the Bank’s net income and “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Legislative and Regulatory Developments” for a discussion of the new statutory and regulatory requirements for derivative transactions under the Dodd-Frank Act.

The financial models and the underlying assumptions used to value financial instruments may differ materially from actual results.

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. 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 models used by the Bank to value instruments and measure risk exposures are subject to periodic validation by

 

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independent parties, rapid changes in market conditions could impact the value of our instruments, as well as the Bank’s financial condition and results of operations. 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 from actual results.

An increase in the percentage of AHP contributions that the Bank is required to make could decrease the Bank’s dividends payable to its members.

If the aggregate AHP contributions of the 12 FHLBanks were to fall below $100 million, the Finance Agency would prorate the remaining sums among the FHLBanks, subject to certain conditions, as may be required to meet the minimum $100 million annual contribution. Increasing the Bank’s AHP contribution in such a scenario would reduce the Bank’s earnings and potentially reduce the dividend paid to members.

The Bank may not be able to pay dividends at rates consistent with historical practices.

The Bank’s board of directors may declare dividends on the Bank’s capital stock, payable to members, from the Bank’s retained earnings and current net earnings. The Bank’s ability to pay dividends also is subject to statutory and regulatory liquidity requirements. For example, the Bank has adopted a capital management policy to address regulatory guidance issued to all FHLBanks regarding retained earnings. The Bank’s capital management policy requires the Bank to establish a target amount of retained earnings by considering factors such as forecasted income, mark-to-market adjustments on derivatives and trading securities, market risk, operational risk, and credit risk, all of which may be influenced by events beyond the Bank’s control. Events such as changes in interest rates, collateral value, credit quality of members and any future other-than-temporary impairment losses may affect the adequacy of the Bank’s retained earnings and may require the Bank to reduce its dividends from historical ratios to achieve and maintain the targeted amount of retained earnings.

An economic downturn or natural disaster in the Bank’s region could affect the Bank’s profitability and financial condition adversely.

Economic recession over a prolonged period or other unfavorable economic conditions in the Bank’s region could have an adverse effect on the Bank’s business, including the demand for Bank products and services, and the value of the Bank’s collateral securing advances, investments and mortgage loans held in portfolio. Portions of the Bank’s region also are subject to risks from hurricanes, tornadoes, floods or other natural disasters. These natural disasters, including those resulting from significant climate changes, could damage or dislocate the facilities of the Bank’s members, may damage or destroy collateral that members have pledged to secure advances, may affect adversely the viability of the Bank’s mortgage purchase programs or the livelihood of borrowers of the Bank’s members, or otherwise could cause significant economic dislocation in the affected areas of the Bank’s region.

The Bank relies heavily upon information systems and other technology.

The Bank relies heavily upon information systems and other technology to conduct and manage its business. The Bank owns some of these systems and technology, and third parties own and provide to the Bank some of the systems and technology. To the extent that the Bank experiences a failure or interruption in any of these systems or other technology, the Bank may be unable to conduct and manage its business effectively, including, without limitation, its hedging and advances activities. The Bank can make no assurance that it will be able to prevent, timely and adequately address, or mitigate the negative effects of, any such failure or interruption. Any failure or interruption could harm significantly the Bank’s customer relations, risk management, and profitability, which could have a negative effect on the Bank’s financial condition and results of operations.

 

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The Bank is subject to a complex body of laws and regulations, which could change in a manner detrimental to the Bank’s operations.

The FHLBanks are GSEs, organized under the authority of the FHLBank Act, and as such, are governed by federal laws and regulations as adopted and applied by the Finance Agency. From time to time, Congress has amended the FHLBank Act in ways that have affected the rights and obligations of the FHLBanks and the manner in which the FHLBanks carry out their housing finance mission and business operations. New or modified legislation enacted by Congress or regulations adopted by the Finance Agency could have a negative effect on the Bank’s ability to conduct business or on the cost of doing business.

Changes in regulatory requirements could result in, among other things, an increase in the FHLBanks’ cost of funding and regulatory compliance, a change in permissible business activities, or a decrease in the size, scope, or nature of the FHLBanks’ lending activities, which could affect the Bank’s financial condition and results of operations.

The statutory and regulatory framework under which most financial institutions, including the Bank, operate will change substantially over the next several years as a result of the enactment of the Dodd-Frank Act and subsequent implementing regulations. Please refer to Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Legislative and Regulatory Developments” for a discussion of recent legislative and regulatory activity that could affect the Bank.

 

Item 1B. Unresolved Staff Comments.

None.

 

Item 2. Properties.

The Bank owns approximately 235,000 square feet of office space at 1475 Peachtree Street, NE, Atlanta, Georgia 30309. The Bank occupies approximately 200,000 square feet of this space. The Bank leases 18,032 square feet of office space in an off-site backup facility located in Norcross, Georgia. The Bank also leases 3,193 square feet of office space located in Washington, D.C. for its government relations personnel. The Bank believes these facilities are well maintained and are adequate for the purposes for which they currently are used.

 

Item 3. Legal Proceedings.

On January 18, 2011, the Bank filed a complaint in the State Court of Fulton County, Georgia against Countrywide Financial Corporation (n/k/a/ Bank of America Home Loans), Countywide Securities Corporation, Countrywide Home Loans, Inc., Bank of America Corporation (as successor to the Countrywide defendants), J.P. Morgan Securities, LLC (f/k/a J.P. Morgan Securities, Inc. and Bear Stearns & Co., Inc.) and UBS Securities, LLC, et al. The Bank’s claims arise from material misrepresentations in the offering documents of thirty private-label MBS sold to the Bank. The Bank’s complaint alleges that the Countrywide Defendants (Countrywide Financial Corporation, Countrywide Securities Corporation, and Countrywide Home Loans, Inc.) and J.P. Morgan Securities, LLC violated the Georgia RICO (Racketeer Influenced and Corrupt Organizations) Act. The complaint further alleges that those defendants, as well as UBS Securities, LLC committed fraud and negligent misrepresentation in violation of Georgia law, and that Bank of America Corporation is liable to the Bank as a successor to the Countrywide Defendants. The Bank is seeking monetary damages and other relief as compensation for losses it has incurred in connection with the purchase of these private-label MBS. On February 17, 2011, certain of the defendants filed a Notice of Removal to remove the case from the State Court of Fulton County, Georgia to the United States District Court for the Northern District of Georgia, Atlanta Division (Case No. 1:11-cv-00489). On March 11, 2011, the Bank filed a motion to remand the case to the State Court of Fulton County, and that motion is currently pending before the district court.

 

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On January 21, 2011, the Bank (together with certain other private-label MBS holders collectively comprising greater than 25 percent of the voting rights with respect to certain private-label MBS) instructed Bank of New York, in its capacity as indenture trustee, to pursue enforcement of seller representations and warranties concerning the eligibility of mortgages for securitization in certain Countrywide-issued private-label MBS.

The Bank is subject to other various legal proceedings and actions from time to time in the ordinary course of its business. After consultation with legal counsel, management does not anticipate that the ultimate liability, if any, arising out of those matters presently known to the Bank will have a material adverse effect on the Bank’s financial condition or results of operations.

 

Item 4. (Removed and Reserved).

 

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PART II

 

Item 5. Market For Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.

The Bank’s members or former members own all the stock of the Bank. The Bank’s stock is not publicly traded or quoted, and there is no established marketplace for it, nor does the Bank expect a market to develop. The Bank’s capital plan prohibits the trading of its capital stock, except in connection with merger or acquisition activity.

A member may request that the Bank redeem at par its excess stock five years after the Bank receives a written request by the member, subject to certain regulatory requirements and to the satisfaction of any ongoing stock investment requirements applicable to the member. In addition, any member may withdraw from membership upon five years’ written notice to the Bank. Subject to the member’s satisfaction of any outstanding indebtedness and other statutory requirements, the Bank shall redeem at par the member’s stock upon withdrawal from membership. The Bank, in its discretion, may repurchase shares held by a member in excess of its required stock holdings. Historically, it was the Bank’s general practice to promptly repurchase a member’s excess activity-based stock, subject to certain limitations and thresholds in the Bank’s capital plan. During the first quarter of 2009, the Bank notified members of an increase in the excess stock threshold amount from $100 thousand to $2.5 billion and a change from the automatic daily repurchase of excess stock to a quarterly evaluation process. The Bank repurchased $4 million, $503 million and $247 million of excess activity-based stock during the first, third and fourth quarters of 2010, respectively. Repurchases of excess activity-based stock during the first quarter of 2010 were limited to an amount equal to each member’s increased membership stock requirement for 2010, if any, pursuant to the annual recalculation of each member’s minimum stock requirement. The par value of all capital stock is $100 per share. As of February 28, 2011, the Bank had 1,156 member and non-member shareholders and 77.7 million shares of its common stock outstanding (including mandatorily redeemable shares); 3.74 million of those outstanding shares represented excess membership stock and 25.8 million of those outstanding shares represented excess activity-based stock. For further discussion of excess activity-based stock, see Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations— Executive Summary—Business Outlook.”

The Bank declares and pays any dividends only after net income is calculated for the preceding quarter. The Bank declared quarterly cash dividends in 2010 and 2009 as outlined in the table below (dollars in millions).

Quarterly Dividends Declared

 

     2010      2009  
     Amount      Annualized Rate (%)      Amount      Annualized Rate (%)  

First

   $ 5         0.27       $ —           —     

Second

     6         0.26         —           —     

Third

     8         0.44         16         0.84   

Fourth

     8         0.39         8         0.41   

In each case, the dividend rate (if any) was equal to the average three-month LIBOR for the preceding quarter.

The Bank may pay dividends on its capital stock only out of its retained earnings not allocated to the Restricted Retained Earnings Account or out of its current net earnings. The Bank’s board of directors has discretion to declare or not declare dividends and to determine the rate of any dividends declared. The Bank’s board of directors may neither declare nor require the Bank to pay dividends if, after giving effect to the dividend, the Bank would fail to meet any of its capital requirements. The Bank also may not declare any dividend when it is not in compliance with all of its capital requirements or if it is determined that the dividend would create a financial safety and soundness issue for the Bank.

 

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The Bank’s board of directors has adopted a capital management policy that includes a targeted amount of retained earnings separate and apart from the Restricted Retained Earnings Account. For further discussion of the Bank’s dividends and the Joint Capital Agreement, see Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

Because only member institutions, not individuals, may own the Bank’s capital stock, the Bank has no equity compensation plans.

The Bank also issues standby letters of credit in the ordinary course of its business. From time to time, the Bank provides standby letters of credit to support members’ obligations, members’ letters of credit or obligations issued to support unaffiliated, third-party offerings of notes, bonds, or other securities. The Bank issued $10.9 billion, $13.2 billion, and $5.7 billion in letters of credit in 2010, 2009, and 2008, respectively. To the extent that these letters of credit are securities for purposes of the Securities Act of 1933, the issuance of the letter of credit by the Bank is exempt from registration pursuant to section 3(a)(2) thereof.

 

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Item 6. Selected Financial Data.

The following selected historical financial data of the Bank should be read in conjunction with the audited financial statements and related notes thereto, and with Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” which are included elsewhere in this Report. The following data, insofar as it relates to each of the years 2006 to 2010, have been derived from annual financial statements, including the statements of condition at December 31, 2010 and 2009 and the related statements of income and of cash flows for the three years ended December 31, 2010 and notes thereto appearing elsewhere in this Report. The financial information presented in the following table, and in the financial statements included in this Report, is not necessarily indicative of the financial condition, results of operations, or cash flows of any other interim or yearly periods (dollars in millions).

 

    As of and for the Years Ended December 31,  
    2010     2009     2008     2007     2006  

Statements of Condition (at year end)

         

Total assets

  $     131,798      $     151,311      $     208,564      $     188,938      $     140,534   

Investments (1)

    39,879        32,940        38,376        41,527        35,090   

Mortgage loans held for portfolio

    2,040        2,523        3,252        3,527        3,004   

Allowance for credit losses on mortgage loans

    (1)        (1)        (1)        (1)        (1)   

Advances, net

    89,258        114,580        165,856        142,867        101,476   

REFCORP prepayment

    —          —          14        —          —     

Deposits

    3,093        2,989        3,573        7,135        4,478   

Consolidated obligations, net:

         

Discount notes

    23,915        17,127        55,195        28,348        4,934   

Bonds

    95,198        121,450        138,181        142,237        122,068   

Total consolidated obligations, net (2)

    119,113        138,577        193,376        170,585        127,002   

Mandatorily redeemable capital stock

    529        188        44        55        216   

Affordable Housing Program payable

    126        125        139        156        130   

Payable to REFCORP

    20        21        —          31        23   

Capital stock—putable

    7,224        8,124        8,463        7,556        5,772   

Retained earnings

    1,124        873        435        469        407   

Accumulated other comprehensive loss

    (402)        (744)        (5)        (3)        (5)   

Total capital

    7,946        8,253        8,893        8,022        6,174   

Statements of Income (for the year ended)

         

Net interest income

    558        404        845        704        671   

Net impairment losses recognized in earnings

    (143)        (316)        (186)        —          —     

Net gains (losses) on trading securities

    31        (135)        200        107        (99)   

Net gains (losses) on derivatives and hedging activities

    8        543        (229)        (97)        91   

Other income (3)

    3        3        1        3        4   

Other expenses (4)

    79        113        286        110        102   

Income before assessments

    378        386        345        607        565   

Assessments

    100        103        91        162        151   

Net income

    278        283        254        445        414   

Performance Ratios

         

Return on equity (5)

    3.42%        3.58%        2.95%        6.47%        6.59%   

Return on assets (6)

    0.19%        0.16%        0.13%        0.28%        0.29%   

Net interest margin (7)

    0.39%        0.22%        0.42%        0.44%        0.48%   

Regulatory capital ratio
(at year end) (8)

    6.74%        6.07%        4.29%        4.28%        4.55%   

Equity to assets ratio (9)

    5.63%        4.34%        4.25%        4.27%        4.41%   

Dividend payout ratio (10)

    9.63%        8.51%        113.36%        85.97%        81.17%   

Ratio of earnings to fixed charges

    1.44        1.21        1.06        1.08        1.09   

 

(1) Investments consist of deposits with other FHLBank, federal funds sold, and securities classified as trading, available-for-sale and held-to-maturity.

 

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(2) The amounts presented are the Bank’s primary obligations on consolidated obligations outstanding. The par value of the FHLBanks’ outstanding consolidated obligations for which the Bank is jointly and severally liable were as follows (in millions):

 

December 31, 2010

   $      678,528   

December 31, 2009

     793,314   

December 31, 2008

     1,060,410   

December 31, 2007

     1,019,272   

December 31, 2006

     823,936   
(3) Other income includes service fees and other.
(4) For the year ended December 31, 2010, amount includes $51 million which represents the reversal of a portion of the provision for credit losses established on a receivable due from a past derivatives counterparty with the Bank. For the year ended December 31, 2008, amount includes $170 million which represents a provision for credit losses established on a receivable due from a past derivatives counterparty with the Bank.
(5) Calculated as net income divided by average total equity.
(6) Calculated as net income divided by average total assets.
(7) Net interest margin is net interest income as a percentage of average earning assets.
(8) Regulatory capital ratio is regulatory capital stock plus retained earnings as a percentage of total assets at year end.
(9) Calculated as average equity divided by average total assets.
(10) Calculated as dividends declared during the year divided by net income during the year.

 

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

The following discussion and analysis relates to the Bank’s financial condition as of December 31, 2010 and 2009, and results of operations for the years ended December 31, 2010, 2009, and 2008. This section explains the changes in certain key items in the Bank’s financial statements from year to year, the primary factors driving those changes, the Bank’s risk management processes and results, known trends or uncertainties that the Bank believes may have a material effect on the Bank’s future performance, as well as how certain accounting principles affect the Bank’s financial statements.

This discussion should be read in conjunction with the Bank’s audited financial statements and related notes for the year ended December 31, 2010 included in Item 8 of this Report. Readers also should review carefully “Special Cautionary Notice Regarding Forward-looking Statements” and Item 1A, “Risk Factors” for a description of the forward-looking statements in this Report and a discussion of the factors that might cause the Bank’s actual results to differ, perhaps materially, from these forward-looking statements.

Executive Summary

Financial Condition

As of December 31, 2010, total assets were $131.8 billion, a decrease of $19.5 billion, or 12.9 percent, from December 31, 2009. This decrease was due primarily to a $25.3 billion, or 22.1 percent, decrease in advances, partially offset by a $6.9 billion increase in total investments. Advances, the largest asset on the Bank’s balance sheet, decreased during the year due to maturing advances, prepayments as a result of member failures, and decreased demand for new advances resulting from members’ significant deposit balances and slow loan growth. The increase in total investments was due primarily to a $5.7 billion increase in federal funds sold and an $890 million increase in certificates of deposit during the year due to the availability of these short-term investments at attractive interest rates, relative to the Bank’s cost of funds.

As of December 31, 2010, total liabilities were $123.9 billion, a decrease of $19.2 billion, or 13.4 percent, from December 31, 2009. This decrease was due primarily to a $19.5 billion decrease in COs. The decrease in COs corresponds to the decrease in demand for advances by the Bank’s members during the year.

As of December 31, 2010, total capital was $7.9 billion, a decrease of $307 million, or 3.72 percent, from December 31, 2009. This decrease was due to the repurchase of $754 million in excess activity-based capital stock, the reclassification of $398 million in capital stock to mandatorily redeemable capital stock (a liability) as a result of 28 member institutions obtaining nonmember status (primarily due to failure) and the payment of $27 million in dividends during the year. This decrease was partially offset by a $342 million decrease in accumulated other comprehensive loss, the issuance of $252 million in capital stock, and $278 million in net income recorded in retained earnings during the year.

Results of Operations

The Bank recorded net income of $278 million for 2010, a decrease of $5 million from net income of $283 million for 2009. The decrease in net income was due primarily to a $369 million decrease in net gains on trading securities and derivatives and hedging activities, partially offset by a $154 million increase in net interest income, a $173 million decrease in other-than-temporary impairment losses recognized in earnings and a $34 million decrease in other expenses.

One way in which the Bank analyzes its performance is by comparing its annualized return on equity (ROE) to three-month average LIBOR. The Bank’s ROE was 3.42 percent for 2010, compared to 3.58 percent for 2009. ROE decreased in 2010 compared to 2009 primarily as a result of decreased net income, as discussed above, and an increase in average capital. ROE spread to three-month average LIBOR increased in 2010 compared to 2009, equaling 3.08 percent for 2010 as compared to 2.89 percent for 2009. The increase in this spread was due primarily to a decrease in three-month LIBOR during the year.

 

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The Bank’s interest rate spread increased by 19 basis points in 2010 compared to 2009. Approximately 13 basis points of this increase was the result of derivative and hedging adjustments in 2009 (that did not reoccur in 2010) that decreased interest income on advances, offset by increases in other income. The remaining increase resulted from interest rates on liabilities decreasing faster than yields on assets over categories with comparable balances.

Business Outlook

During 2010, the Bank maintained consistent net income, grew its retained earnings, repurchased excess capital stock and paid dividends despite the slow overall economic recovery. In 2011, the Bank faces continued softness in advances activity, uncertainty with respect to the Bank’s private-label MBS portfolio, and limited investment opportunities. The Bank seeks to maintain a conservative capital and financial management approach that will protect members’ investment in the Bank and position the Bank for future growth.

Overall advance demand decreased during 2010 as a result of scheduled repayments, prepayments as a result of member closures, and members’ significant deposit holdings and slow loan growth. The Bank saw some increases in advances activity at certain points during the year, however, and the decline in advances slowed during the second half of the year as members began to focus on extending their existing low interest-rate advances. The Bank believes advances likely will continue to decline somewhat but may show greater stabilization during 2011.

Although the credit related portion of other-than-temporary impairment losses recognized in earnings was lower during 2010 compared to 2009, credit losses on the Bank’s private-label MBS are expected to continue to reflect uneven recovery in the housing market. Delays in foreclosures with respect to defaulted loans underlying the private-label MBS may increase credit related losses, as delays have the effect of diverting cash streams to subordinate tranches of the private-label MBS and shortening the amount of time until the Bank’s more senior tranches may be required to absorb any losses. The Bank has seen some recovery in fair market values for some of its private-label MBS; this recovery reduces pressure on the Bank’s retained earnings.

Despite the Bank’s repurchases of excess capital stock during 2010, the Bank had more excess capital stock subject to repurchase by the Bank at the end of 2010 than at the end of 2009, due primarily to increased member failures during 2010. Excess activity-based stock may have a negative impact on the Bank’s ROE if the Bank is unable to profitably leverage the excess capital and may affect adversely member demand for advances. The Bank’s board of directors remains focused on supporting repurchases of excess capital stock and payments of dividends.

Financial Condition

The Bank’s principal assets consist of advances, short- and long-term investments, and mortgage loans held for portfolio. The Bank obtains funding to support its business primarily through the issuance of debt securities in the form of consolidated obligations by the Office of Finance on the Bank’s behalf.

 

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The following table presents the distribution of the Bank’s total assets, liabilities, and capital by major class as of the dates indicated (dollars in millions). These items are discussed in more detail below.

 

    As of December 31,     Increase/(Decrease)  
    2010     2009    
    Amount     Percent of Total     Amount     Percent of Total     Amount     Percent  

Advances, net

  $ 89,258        67.72      $ 114,580        75.72      $ (25,322)        (22.10)   

Long-term investments

    22,986        17.44        22,594        14.93        392        1.74   

Short-term investments

    16,893        12.82        10,346        6.84        6,547        63.28   

Mortgage loans, net

    2,039        1.55        2,522        1.67        (483)        (19.15)   

Other assets

    622        0.47        1,269        0.84        (647)        (50.97)   
                                         

Total assets

  $     131,798        100.00      $     151,311        100.00      $     (19,513)        (12.90)   
                                         

Consolidated obligations, net:

           

Discount notes

  $ 23,915        19.31      $ 17,127        11.97      $ 6,788        39.63   

Bonds

    95,198        76.86        121,450        84.90        (26,252)        (21.61)   

Deposits

    3,093        2.50        2,989        2.09        104        3.45   

Other liabilities

    1,646        1.33        1,492        1.04        154        10.38   
                                         

Total liabilities

  $ 123,852        100.00      $ 143,058        100.00      $ (19,206)        (13.43)   
                                         

Capital stock

  $ 7,224        90.92      $ 8,124        98.44      $ (900)        (11.07)   

Retained earnings

    1,124        14.14        873        10.58        251        28.76   

Accumulated other comprehensive loss

    (402)        (5.06)        (744)        (9.02)        342        45.91   
                                         

Total capital

  $ 7,946        100.00      $ 8,253        100.00      $ (307)        (3.72)   
                                         

Advances

The following table sets forth the Bank’s advances outstanding by year of maturity and the related weighted- average interest rate (dollars in millions):

 

     As of December 31,  
     2010      2009  
     Amount     Weighted-
average
Interest
Rate

(%)
     Amount     Weighted-
average
Interest
Rate

(%)
 

Year of contractual maturity:

         

Overdrawn demand deposit accounts

   $ 1        5.47       $ —          —     

Due in one year or less

     26,628        3.23         32,808        3.68   

Due after one year through two years

     16,186        3.28         21,565        4.30   

Due after two years through three years

     10,938        3.59         14,665        4.06   

Due after three years through four years

     6,369        3.32         10,757        3.87   

Due after four years through five years

     3,678        3.75         5,910        3.33   

Due after five years

     21,251        3.89         24,108        3.87   
                     

Total par value

     85,051        3.48         109,813        3.89   

Discount on AHP advances

     (13        (13  

Discount on EDGE advances

     (11        (12  

Hedging adjustments

     4,238           4,798     

Deferred commitment fees

     (7        (6  
                     

Total

   $     89,258         $     114,580     
                     

 

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The decrease in advances from December 31, 2009 to December 31, 2010 was due to maturing advances, prepayments as a result of member failures, and decreased demand for new advances resulting from members’ increased deposit balances and slower loan growth. At December 31, 2010, 88.1 percent of the Bank’s advances were fixed-rate. However, the Bank often simultaneously enters into derivatives with the issuance of advances to convert the rates on them, in effect, into a short-term variable interest rate, usually based on LIBOR. As of December 31, 2010 and 2009, 87.4 percent and 90.9 percent, respectively, of the Bank’s fixed-rate advances were swapped and 9.42 percent and 12.4 percent, respectively, of the Bank’s variable-rate advances were swapped. The majority of the Bank’s variable-rate advances were indexed to LIBOR. The Bank also offers variable-rate advances tied to the federal funds rate, prime rate and constant maturity swap rates.

The concentration of the Bank’s advances to its 10 largest borrowing member institutions was as follows (dollars in millions):

 

     Advances to 10 largest
borrowing member
institutions
     Percent of total
advances outstanding

December 31, 2010

     $58,043       68.25

December 31, 2009

       75,418       68.68

A breakdown of these advance holdings as of December 31, 2010 is contained in Item 1, “Business—Credit Products—Advances.” Management believes that the Bank holds sufficient collateral, on a member-specific basis, to secure the advances to all borrowers, including these 10 institutions, and the Bank does not expect to incur any credit losses on these advances.

Supplementary financial data on the Bank’s advances is set forth under Item 8, “Financial Statements and Supplementary Information.”

Investments

The Bank maintains a portfolio of investments for liquidity purposes, to provide for the availability of funds to meet member credit needs and to provide additional earnings. Investment income also enhances the Bank’s capacity to meet its commitment to affordable housing and community investment, to cover operating expenses, and to satisfy the Bank’s annual REFCORP assessment.

 

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The Bank’s short-term investments consist of overnight and term federal funds, certificates of deposit and interest-bearing deposits. The Bank’s long-term investments consist of MBS issued by government-sponsored mortgage agencies or private securities that, at purchase, carried the highest rating from Moody’s or S&P, securities issued by the U.S. government or U.S. government agencies, state and local housing agency obligations, and consolidated obligations issued by other FHLBanks. The long-term investment portfolio generally provides the Bank with higher returns than those available in the short-term money markets. The following table sets forth more detailed information regarding short- and long-term investments held by the Bank (dollars in millions):

 

     As of December 31,      Increase/(Decrease)  
     2010      2009      Amount      Percent  

Short-term investments:

           

Deposits with other FHLBank

   $ 2       $ 3       $ (1)         (17.52)   

Certificates of deposit

     1,190         300         890         296.67   

Federal funds sold

     15,701         10,043         5,658         56.33   
                             

Total short-term investments

     16,893         10,346         6,547         63.28   
                             

Long-term investments:

           

State or local housing agency debt obligations

     111         126         (15)         (11.40)   

U.S. government agency debt obligations

     4,253         3,542         711         20.04   

Mortgage-backed securities:

           

U.S. government agency securities

     9,676         7,375         2,301         31.20   

Private label

     8,946         11,551         (2,605)         (22.55)   
                             

Total mortgage-backed securities

     18,622         18,926         (304)         (1.60)   
                             

Total long-term investments

     22,986         22,594         392         1.74   
                             

Total investments

   $     39,879       $     32,940       $     6,939         21.07   
                             

The increase in short-term investments from December 31, 2009 to December 31, 2010 was due primarily to an increase in federal funds sold and certificates of deposits during the year due to the continued availability of these short-term investments at attractive interest rates relative to the Bank’s cost of funds.

The increase in long-term investments from December 31, 2009 to December 31, 2010 was due primarily to an increase in MBS and debt obligations issued by U.S. government agencies, partially offset by a decrease in private-label MBS during the year due primarily to principal repayments and maturities and a lack of additional purchases by the Bank of private-label MBS.

As of December 31, 2010 and 2009, the total MBS balance included MBS with a book value of $3.9 billion and $4.6 billion, respectively, issued by one of the Bank’s members and their affiliates with dealer relationships.

The Finance Agency limits an FHLBank’s investment in MBS and asset-backed securities by requiring that the total book value of MBS owned by the FHLBank generally may not exceed 300 percent of the FHLBank’s previous month-end total capital, as defined by regulation, plus its mandatorily redeemable capital stock on the day it purchases the securities. Under a regulatory advisory bulletin issued April 3, 2008, the FHLBanks had temporary authority through March 31, 2010 to purchase securities up to 600 percent of previous month-end total capital plus mandatorily redeemable capital stock. The Bank did not exercise this authority prior to its expiration. These investments amounted to 210 percent and 206 percent of total capital plus mandatorily redeemable capital stock at December 31, 2010 and 2009, respectively. The Bank has been below its target range of 250 percent to 275 percent due to a lack of quality MBS at attractive prices during recent market conditions.

As of December 31, 2010, the Bank had a total of 44 securities classified as available-for-sale in an unrealized loss position, with total gross unrealized losses of $397 million and a total of 130 securities classified as

 

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held-to-maturity in an unrealized loss position, with total gross unrealized losses of $234 million. As of December 31, 2009, the Bank had a total of 32 securities classified as available-for-sale in an unrealized loss position, with total gross unrealized losses of $739 million, and a total of 187 securities classified as held-to-maturity in an unrealized loss position, with total gross unrealized losses of $883 million.

The Bank evaluates its individual investment securities for other-than-temporary impairment on at least a quarterly basis, as described in detail in “Note 7—Other-than-temporary Impairment” to the Bank’s 2010 financial statements. Based on that impairment analysis, for 2010 and 2009, the Bank recognized total other-than-temporary impairment losses of $200 million and $1.3 billion, respectively, related to private-label MBS in its investment securities portfolio. The total amount of other-than-temporary impairment is calculated as the difference between the security’s amortized cost basis and its fair value. The credit related portion of $143 million and $316 million, respectively, of these other-than-temporary impairment losses is reported in the Statements of Income as “Net impairment losses recognized in earnings.” The noncredit portion of $57 million and $990 million, respectively, of the other-than-temporary impairment losses is recorded as a component of other comprehensive loss.

Certain other private-label MBS in the Bank’s investment securities portfolio that have not been designated as other-than-temporarily impaired have experienced unrealized losses and decreases in fair value due to interest-rate volatility, illiquidity in the marketplace, and credit deterioration in the U.S. mortgage markets. These declines in fair value are considered temporary as the Bank presently expects to collect all contractual cash flows and the Bank does not intend to sell the securities and it is not more likely than not that the Bank will be required to sell the securities before the anticipated recovery of its remaining amortized cost basis, which may be at maturity. This assessment is based on the determination that the Bank has sufficient capital and liquidity to operate its business and has no need to sell these securities, nor has the Bank entered into any contractual constraints that would require the Bank to sell these securities.

Based on the Bank’s impairment analysis for the year ended December 31, 2008, the Bank recognized an other-than-temporary impairment loss of $186 million related to private-label MBS in its held-to-maturity securities portfolio. The Bank concluded that these securities were other-than-temporarily impaired based on an analysis of both quantitative and qualitative factors, including rating agency actions, default rates, loss severity, home price depreciation and the potential for continued adverse developments.

Supplementary financial data on the Bank’s investment securities is set forth under Item 8, “Financial Statements and Supplementary Data.”

Mortgage Loans Held for Portfolio

The decrease in mortgage loans held for portfolio from December 31, 2009 to December 31, 2010 was due to the maturity of these assets during the year. In 2006, the Bank ceased purchasing multifamily residential mortgage loans, and in 2008 the Bank ceased purchasing single-family residential mortgage loans. If the Bank does not resume purchasing mortgage loans under these programs, each of the existing mortgage loans held for portfolio will mature according to the terms of its note. The Bank purchased loans with maturity dates extending out to 2038.

 

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The following table presents information on mortgage loans held for portfolio (in millions).

 

     As of December 31,  
     2010      2009  

Mortgage loans held for portfolio:

     

Fixed-rate medium-term* single-family residential mortgage loans

   $ 458       $ 619   

Fixed-rate long-term single-family residential mortgage loans

     1,564         1,886   

Multifamily residential mortgage loans

     21         22   
                 

Total unpaid principal balance

     2,043         2,527   

Premiums

     9         12   

Discounts

     (12)         (16)   
                 

Total

   $     2,040       $     2,523   
                 

 

* Medium-term is defined as a term of 15 years or less.

As of December 31, 2010 and 2009, the Bank’s conventional mortgage loan portfolio was concentrated in the southeastern United States because those members selling loans to the Bank were located primarily in that region. The following table provides the percentage of unpaid principal balance of conventional single-family residential mortgage loans held for portfolio for the five largest state concentrations.

 

     As of December 31,  
     2010      2009  
     Percent of Total      Percent of Total  

South Carolina

     24.50         24.49   

Florida

     21.07         19.16   

Georgia

     14.42         14.47   

North Carolina

     14.12         15.13   

Virginia

     9.19         9.26   

All other

     16.70         17.49   
                 

Total

     100.00         100.00   
                 

Supplementary financial data on the Bank’s mortgage loans is set forth under Item 8, “Financial Statements and Supplementary Data.”

Consolidated Obligations

The Bank funds its assets primarily through the issuance of consolidated obligation bonds and, to a lesser extent, consolidated obligation discount notes. CO issuances financed 90.4 percent of the $131.8 billion in total assets at December 31, 2010, remaining relatively stable from the financing ratio of 91.6 percent as of December 31, 2009.

The net decrease in COs from December 31, 2009 to December 31, 2010 corresponds to the decrease in demand for advances by the Bank’s members during the year and the increase in liquidity from advance prepayments as a result of member failures. CO bonds decreased and CO discount notes increased during the year due to increased demand in the marketplace for short-term debt and a corresponding decrease in demand for long-term debt in light of market conditions. CO bonds outstanding at December 31, 2010 and 2009 were primarily fixed-rate. However, the Bank often simultaneously enters into derivatives with the issuance of CO bonds to convert the interest rates on them, in effect, into short-term variable interest rates, usually based on LIBOR. As of December 31, 2010 and 2009, 77.3 percent and 79.4 percent, respectively, of the Bank’s fixed-rate CO bonds were swapped and 0.24 percent and 0.52 percent, respectively, of the Bank’s variable-rate CO bonds were swapped.

 

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As of December 31, 2010, callable CO bonds constituted 26.3 percent of the total par value of CO bonds outstanding, compared to 27.7 percent at December 31, 2009. This decrease was due to market conditions that made the issuance of callable fixed maturity debt less attractive to the Bank. The derivatives that the Bank may employ to hedge against the interest-rate risk associated with the Bank’s callable CO bonds generally are callable by the counterparty. The Bank generally will call a hedged CO bond if the call feature of the derivative is exercised. These call features could require the Bank to refinance a substantial portion of outstanding liabilities during times of decreasing interest rates. Call options on unhedged callable CO bonds generally are exercised when the bond can be replaced at a lower economic cost.

The following is a summary of the Bank’s participation in CO bonds outstanding (dollars in millions):

 

     As of December 31,  
     2010      2009  
     Amount      Weighted-
average
Interest
Rate (%)
     Amount      Weighted-
average
Interest
Rate (%)
 

Year of contractual maturity:

           

Due in one year or less

   $     46,987         0.76       $     63,383         1.27   

Due after one year through two years

     13,751         1.50         17,743         1.76   

Due after two years through three years

     14,097         2.63         11,806         2.39   

Due after three years through four years

     4,378         3.70         9,726         3.60   

Due after four years through five years

     4,660         1.89         6,016         3.67   

Due after five years

     10,054         4.19         11,498         4.43   
                       

Total par value

     93,927         1.70         120,172         2.05   

Premiums

     127            116      

Discounts

     (48)            (60)      

Hedging adjustments

     1,192            1,222      
                       

Total

   $ 95,198          $ 121,450      
                       

The Bank’s CO bonds outstanding by type (in millions):

 

     As of December 31,  
     2010      2009  

Noncallable

   $ 69,248       $ 86,905   

Callable

     24,679         33,267   
                 

Total par value

   $     93,927       $     120,172   
                 

Supplementary financial data on the Bank’s short-term borrowings is set forth under Item 8, “Financial Statements and Supplementary Data.”

Deposits

The Bank offers demand and overnight deposit programs to members primarily as a liquidity management service. In addition, a member that services mortgage loans may deposit in the Bank funds collected in connection with the mortgage loans, pending disbursement of those funds to the owners of the mortgage loan. For demand deposits, the Bank pays interest at the overnight rate. Most of these deposits represent member liquidity investments, which members may withdraw on demand. Therefore, the total account balance of the Bank’s deposits may be volatile. As a matter of prudence, the Bank typically invests deposit funds in liquid short-term assets. Member loan demand, deposit flows, and liquidity management strategies influence the amount and volatility of deposit balances carried with the Bank. Total deposits were relatively stable at December 31, 2010 compared to December 31, 2009.

 

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To support its member deposits, the FHLBank Act requires the Bank to have as a reserve an amount equal to or greater than the current deposits received from members. These reserves are required to be invested in obligations of the United States, deposits in eligible banks or trust companies, or advances with maturities not exceeding five years. The Bank was in compliance with this depository liquidity requirement as of December 31, 2010.

Capital

The decrease in total capital from December 31, 2009 to December 31, 2010 was due to the repurchase of $754 million in excess activity-based capital stock, the reclassification of $398 million in capital stock to mandatorily redeemable capital stock (a liability) as a result of 28 member institutions obtaining nonmember status (primarily due to failure) and the payment of $27 million in dividends during the year. This decrease was partially offset by a $342 million decrease in accumulated other comprehensive loss, the issuance of $252 million in capital stock, and $278 million in net income recorded in retained earnings during the year.

The FHLBank Act and Finance Agency regulations specify that each FHLBank must meet certain minimum regulatory capital standards. The Bank must maintain (1) total capital in an amount equal to at least four percent of its total assets; (2) leverage capital in an amount equal to at least five percent of its total assets, and (3) permanent capital in an amount equal to at least its regulatory risk-based capital requirement. Permanent capital is defined by the FHLBank Act and applicable regulations as the sum of paid-in capital for Class B stock and retained earnings. Mandatorily redeemable capital stock is considered capital for regulatory purposes.

The Bank was in compliance with these regulatory capital rules and requirements as of December 31, 2010 and 2009, as shown in the following table (dollars in millions):

 

     As of December 31,  
     2010      2009  
     Required      Actual      Required      Actual  

Regulatory capital requirements:

           

Risk based capital

   $ 2,377       $ 8,877       $ 3,010       $ 9,185   

Total capital-to-assets ratio

     4.00%         6.74%         4.00%         6.07%   

Total regulatory capital*

   $     5,272       $ 8,877       $ 6,052       $ 9,185   

Leverage ratio

     5.00%         10.10%         5.00%         9.11%   

Leverage capital

   $ 6,590       $     13,316       $     7,566       $     13,777   

 

* Mandatorily redeemable capital stock is considered capital for regulatory purposes, and “total regulatory capital” includes the Bank’s $529 million and $188 million in mandatorily redeemable capital stock at December 31, 2010 and 2009, respectively.

Finance Agency regulations establish criteria based on the amount and type of capital held by an FHLBank for four capital classifications as follows:

 

 

Adequately Capitalized—FHLBank meets both risk-based and minimum capital requirements

 

 

Undercapitalized—FHLBank does not meet one or both of its risk-based or minimum capital requirements

 

 

Significantly Undercapitalized—FHLBank has less than 75 percent of one or both of its risk-based or minimum capital requirements

 

 

Critically Undercapitalized—FHLBank total capital is two percent or less of total assets.

Under the regulations, the Director of the Finance Agency (Director) will make a capital classification for each FHLBank at least quarterly and notify the FHLBank in writing of any proposed action and provide an opportunity for the FHLBank to submit information relevant to such action. The Director is permitted to make discretionary classifications. An FHLBank must provide written notice to the Finance Agency within 10 days of

 

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any event or development that has caused or is likely to cause its permanent or total capital to fall below the level required to maintain its most recent capital classification or reclassification. The regulation delineates the types of prompt corrective actions the Director may order in the event an FHLBank is not adequately capitalized, including submission of a capital restoration plan by the FHLBank and restrictions on its dividends, stock redemptions, executive compensation, new business activities, or any other actions the Director determines will ensure safe and sound operations and capital compliance by the FHLBank. On December 22, 2010, the Bank received notification from the Director that, based on September 30, 2010 data, the Bank meets the definition of “adequately capitalized.”

As of December 31, 2010, the Bank had capital stock subject to mandatory redemption from 63 members and former members, consisting of B1 membership stock and B2 activity-based stock, compared to 45 members and former members as of December 31, 2009, consisting of B1 membership stock and B2 activity-based stock. The Bank is not required to redeem or repurchase such stock until the expiration of the five-year redemption period or, with respect to activity-based stock, until the later of the expiration of the five-year redemption period or the activity no longer remains outstanding. During 2010, the Bank made determinations regarding repurchases of excess capital stock on a quarterly basis.

As of December 31, 2010 and 2009, the Bank’s outstanding stock included $2.7 billion and $1.9 billion, respectively, of excess shares subject to repurchase by the Bank at its discretion.

The Joint Capital Agreement among the FHLBanks requires each FHLBank to allocate a portion of its net income to a Restricted Retained Earnings Account. The Joint Capital Agreement generally prohibits each FHLBank from paying dividends out of its Restricted Retained Earnings Account.

The Joint Capital Agreement provides that each FHLBank’s quarterly allocations to its Restricted Retained Earnings Account will begin as of the end of the calendar quarter in which the final REFCORP payments are made and continue on a quarterly basis until the balance of an FHLBank’s Restricted Retained Earnings Account is at least equal to one percent of its Total Consolidated Obligations (as defined in the Agreement).

Under the Joint Capital Agreement, the required allocations to the Restricted Retained Earnings Account generally shall equal 20 percent of an FHLBank’s annual net income, but may increase if an FHLBank incurs net losses for a calendar year that result in a decline in the balance of the Restricted Retained Earnings Account. Generally, any losses must be applied first to an FHLBank’s unrestricted retained earnings. An FHLBank may, in its discretion, allocate more than 20 percent of its net income to its Restricted Retained Earnings Account, and if an FHLBank’s Restricted Retained Earnings Account exceeds 1.5 percent of its Total Consolidated Obligations, the FHLBank may transfer amounts from its Restricted Retained Earnings Account to another retained earnings account, but only to the extent that the balance of its Restricted Retained Earnings Account remains at least equal to 1.5 percent of the FHLBank’s Total Consolidated Obligations immediately following such transfer.

The Joint Capital Agreement requires each FHLBank to submit an application to the Finance Agency to amend its capital plan consistent with the terms of the Joint Capital Agreement. The Bank expects to submit this application to the Finance Agency during the second quarter of 2011 in concert with similar applications by each of the other FHLBanks. Under the Joint Capital Agreement, if the FHLBanks’ REFCORP obligations end before the Finance Agency has approved all proposed capital plan amendments, each FHLBank shall nevertheless commence the required allocation to its Restricted Retained Earnings Account beginning as of the end of the calendar quarter in which the final REFCORP payments are made. The FHLBanks’ aggregate payments through 2010 have exceeded the scheduled payments, effectively accelerating payment of the REFCORP obligation and shortening its remaining term to October 15, 2011.

The Joint Capital Agreement expressly provides that it will not affect the rights of the Bank’s Class B stock holders in the retained earnings, including those held in the Restricted Retained Earnings Account of the Bank, as granted under Section 6(h) (12 U.S.C. Sec. 1426(h)) of the FHLBank Act.

 

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Results of Operations

The following is a discussion and analysis of the Bank’s results of operations for the years ended December 31, 2010, 2009, and 2008.

Net Income

The following table sets forth the Bank’s significant income and expense items for the years ended December 31, 2010, 2009, and 2008, and provides information regarding the changes during each of these periods (dollars in millions):

 

     For the Years Ended December 31,      Increase/(Decrease)
2010 vs. 2009
     Increase/(Decrease)
2009 vs. 2008
 
     2010      2009      2008      Amount      Percent      Amount      Percent  

Net interest income

   $     558       $     404       $     845       $     154         38.02       $     (441)         (52.21)   

Other (loss) income

     (101)         95         (214)         (196)         (207.38)         309         144.20   

Other expense

     79         113         286         (34)         (30.36)         (173)         (60.68)   

Total assessments

     100         103         91         (3)         (2.01)         12         11.68   

Net income

     278         283         254         (5)         (2.03)         29         11.70   

Net income decreased in 2010 compared to 2009 by $5 million. Net interest income increased by $154 million in 2010 compared to 2009 due primarily to certain derivative and hedging adjustments that occurred in 2009, but did not reoccur in 2010. Other-than-temporary impairment losses recorded in earnings decreased by $173 million in 2010, compared to 2009, reflecting the Bank’s current forecast of the U.S. housing market and other economic assumptions. Additionally, other expenses declined by $34 million in 2010 compared to 2009, due primarily to a reduction in the allowance for credit loss on a receivable due from Lehman Brothers Special Financing, Inc. (LBSF) and the subsequent sale of the receivable. Offsetting the above increases to net income was a $369 million decrease in net gains on investments classified as trading securities and derivatives and hedging activities in 2010 compared to 2009. This decrease is primarily related to hedge accounting adjustments associated with certain events that occurred in 2009 and the accounting for financial instruments that did not receive hedge accounting treatment.

Net income increased in 2009 compared to 2008 due primarily to an increase in net gains on derivatives and hedging activities, recorded in “Other (loss) income,” as a result of a decrease in LIBOR during 2009 and mark-to-market gains on swaps in discontinued hedging relationships and a decrease in other expense as a result of the establishment of a $170 million allowance for a credit loss on a receivable due from LBSF, with a corresponding loss recognized in other expense during 2008. These changes were offset by a decrease in net interest income due primarily to the write-off of hedging-related basis adjustments on advances that were prepaid during 2009 and amortization related to discontinued hedging activities, as well as a decrease in interest rates and the size of the Bank’s balance sheet. For more information about the LBSF receivable, see “Note 17—Derivatives and Hedging Activities—Managing Credit Risk on Derivatives” to the audited financial statements.

Net Interest Income

A primary source of the Bank’s earnings is net interest income. Net interest income equals interest earned on assets (including member advances, mortgage loans, MBS held in portfolio, and other investments), less the interest expense incurred on consolidated obligations, deposits, and other borrowings. Also included in net interest income are miscellaneous related items such as prepayment fees earned and the amortization of debt issuance discounts, concession fees and derivative instruments and hedging activities related adjustments.

Net interest income increased by $154 million in 2010 compared to 2009. The primary factor associated with this increase was an increase of $244 million due to hedging adjustments on prepaid advances that lowered net interest income during 2009 but were not repeated in 2010. This was offset by decreases due to a smaller reduction of interest expense on debt than the decrease in interest income on advances, as a result of lower

 

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volume declines on debt than advances, net of the derivatives and hedging adjustments previously discussed. A final offsetting factor relates to a decrease in net interest income due to the re-investment of prepaid MBS in lower yielding short-term investments.

Net interest income decreased by $441 million in 2009 compared to 2008. Approximately $300 million of the reduction was due to the write-off of hedging-related basis adjustments on advances that were prepaid during 2009, amortization related to discontinued hedging activities and the transfer of interest from net interest income to other income on derivatives in non qualifying hedging relationships. This $300 million also is reflected as an increase to other income. The remaining decrease in net interest income was due to a decrease in interest rates and a reduction in the size of the Bank’s balance sheet.

The following table summarizes key components of net interest income for the years presented (in millions):

 

     Years Ended December 31,  
     2010      2009      2008  

Interest income:

        

Advances

   $     334       $     888       $     4,729   

Investments

     960         1,232         1,721   

Mortgage loans held for portfolio

     121         152         183   
                          

Total interest income

     1,415         2,272         6,633   
                          

Interest expense:

        

Consolidated obligations

     852         1,862         5,674   

Deposits

     3         4         110   

Other

     2         2         4   
                          

Total interest expense

     857         1,868         5,788   
                          

Net interest income

   $ 558       $ 404       $ 845   
                          

Net interest income also includes components of hedging activity. When a hedging relationship is discontinued, the cumulative fair value adjustment on the hedged item will be amortized into interest income or expense over the remaining life of the asset or liability. Also, when hedging relationships qualify for hedge accounting, the interest components of the hedging derivatives will be reflected in interest income or expense. As shown in the table summarizing the net effect of derivatives and hedging activity on the Bank’s results of operations, the impact of the hedging on interest income was a decrease of $2.1 billion, $2.5 billion and $755 million during the years ended December 31, 2010, 2009 and 2008, respectively.

The following table presents spreads between the average yield on total interest-earning assets and the average cost of interest-bearing liabilities for the years ended December 31, 2010, 2009 and 2008 (dollars in millions). The interest-rate spread is affected by the inclusion or exclusion of net interest income/expense associated with the Bank’s derivatives. For example, if the derivatives qualify for fair-value hedge accounting under GAAP, the net interest income/expense associated with the derivative is included in net interest income and in the calculation of interest rate spread. If the derivatives do not qualify for fair-value hedge accounting under GAAP, the net interest income/expense associated with the derivatives is excluded from net interest income and the calculation of the interest rate spread. Amortization associated with hedging-related basis adjustments also are reflected in net interest income, which affect interest rate spread.

 

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Spread and Yield Analysis

 

    For the Years Ended December 31,  
    2010     2009     2008  
    Average
Balance
    Interest     Yield/
Rate
(%)
    Average
Balance
    Interest     Yield/
Rate
(%)
    Average
Balance
    Interest     Yield/
Rate
(%)
 

Assets

                 

Federal funds sold

  $ 13,302      $ 31        0.23      $ 11,637      $ 22        0.19      $ 11,994      $ 239        1.99   

Interest-bearing deposits (1)

    3,655        7        0.18        4,427        7        0.17        1,839        29        1.57   

Certificates of deposit

    1,146        4        0.33        17        —          0.19        553        17        3.14   

Long-term investments (2)

    21,814        918        4.21        25,096        1,203        4.79        28,427        1,436        5.05   

Advances

    100,948        334        0.33        136,868        888        0.65        153,841        4,729        3.07   

Mortgage loans held for portfolio (3)

    2,300        121        5.25        2,861        152        5.30        3,420        183        5.34   

Loans to other FHLBanks

    1        —          0.19        1        —          0.18        4        —          2.14   
                                                     

Total interest-earning assets

    143,166        1,415        0.99        180,907        2,272        1.26        200,078        6,633        3.32   
                                   

Allowance for credit losses on mortgage loans

    (1         (1)            (1)       

Other assets

    1,013            1,403            2,632       
                                   

Total assets

  $ 144,178          $ 182,309          $ 202,709       
                                   

Liabilities and Capital

                 

Deposits (4)

  $ 3,142        3        0.09      $ 4,067        4        0.09      $ 5,765        110        1.90   

Short-term borrowings

    19,486        29        0.15        38,200        260        0.68        38,505        988        2.57   

Long-term debt

    107,614        823        0.76        124,514        1,602        1.29        143,614        4,686        3.26   

Other borrowings

    443        2        0.38        380        2        0.40        104        4        2.99   
                                                     

Total interest-bearing liabilities

    130,685        857        0.66        167,161        1,868        1.12        187,988        5,788        3.08   
                                   

Noninterest bearing deposits

    —              —              6       

Other liabilities

    5,372            7,236            6,102       

Total capital

    8,121            7,912            8,613       
                                   

Total liabilities and capital

  $   144,178          $   182,309          $   202,709       
                                   

Net interest income and net yield on interest-earning assets

    $ 558        0.39       $ 404        0.22        $ 845        0.42   
                                                     

Interest rate spread

        0.33           0.14            0.24   
                                   

Average interest-earning assets to interest-bearing liabilities

        109.55           108.22            106.43   
                                   

 

Notes

 

(1) Includes amounts recognized for the right to reclaim cash collateral paid under master netting agreements with derivative counterparties.
(2) Includes trading securities at fair value and available-for-sale securities at amortized cost.
(3) Nonperforming loans are included in average balances used to determine average rate.
(4) Includes amounts recognized for the right to return cash collateral received under master netting agreements with derivative counterparties.

The interest-rate spread increased by 19 basis points in 2010 compared to 2009. Approximately 13 basis points of this increase was the result of derivative and hedging adjustments in 2009 that decreased interest income on advances that were offset by increases in other income that did not reoccur in 2010. The remaining increase resulted from rates on liabilities decreasing faster than yields on assets over categories with comparable balances.

The interest-rate spread decreased by 10 basis points in 2009 compared to 2008. This decrease was due primarily to lower yields on advances due to the write-off of hedging-related basis adjustments on advances that were prepaid during 2009.

 

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Net interest income for the years presented was affected by changes in average balances (volume change) and changes in average rates (rate change) of interest-earning assets and interest-bearing liabilities. The following table presents the extent to which changes in interest rates and changes in the volume of interest-earning assets and interest-bearing liabilities affected the Bank’s interest income and interest expense (in millions). As noted in the table below, the overall increase in net interest income in 2010 compared to 2009, and decrease in net interest income in 2009 compared to 2008, was primarily rate related.

Volume and Rate Table *

 

     2010 vs. 2009      2009 vs. 2008  
     Volume      Rate      Increase/
(Decrease)
     Volume      Rate      Increase/
(Decrease)
 

Increase (decrease) in interest income:

                 

Federal funds sold

   $ 3       $ 6       $ 9       $ (7)       $ (210)       $ (217)   

Interest-bearing deposits

     (1)         1         —           18         (40)         (22)   

Certificates of deposit

     4         —           4         (9)         (8)         (17)   

Long-term investments

     (149)         (136)         (285)         (162)         (71)         (233)   

Advances

     (193)         (361)         (554)         (471)         (3,370)         (3,841)   

Mortgage loans held for portfolio

     (29)         (2)         (31)         (30)         (1)         (31)   
                                                     

Total

     (365)         (492)         (857)         (661)         (3,700)         (4,361)   
                                                     

Increase (decrease) in interest expense:

                 

Deposits

     (1)         —           (1)         (25)         (81)         (106)   

Short-term borrowings

     (89)         (142)         (231)         (8)         (720)         (728)   

Long-term debt

     (195)         (584)         (779)         (555)         (2,529)         (3,084)   

Other borrowings

     —           —           —           2         (4)         (2)   
                                                     

Total

     (285)         (726)         (1,011)         (586)         (3,334)         (3,920)   
                                                     

(Decrease) increase in net interest income

   $ (80)       $     234       $     154       $     (75)       $     (366)       $     (441)   
                                                     

 

* Volume change is calculated as the change in volume multiplied by the previous rate, while rate change is the change in rate multiplied by the previous volume. The rate/volume change, change in rate multiplied by change in volume, is allocated between volume change and rate change at the ratio each component bears to the absolute value of its total.

Other Income (Loss)

The following table presents the components of other income (loss) (in millions):

 

     For the Years Ended December 31,      Increase/ (Decrease)  
     2010      2009      2008      2010 vs. 2009      2009 vs. 2008  

Other Income (Loss):

              

Net impairment losses recognized in earnings

   $ (143)       $     (316)       $     (186)       $ 173       $ (130)   

Net gains (losses) on trading securities

     31         (135)         200         166         (335)   

Net gains (losses) on derivatives and hedging activities

     8         543         (229)         (535)         772   

Other

     3         3         1         —           2   
                                            

Total other (loss) income

   $     (101)       $ 95       $ (214)       $ (196)       $ 309   
                                            

 

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Other income (loss) decreased by $196 million in 2010 compared to 2009. The primary reasons for the decline was a $244 million decrease in derivatives and hedging adjustments associated with prepaid advances that were offset in net interest income that occurred in 2009 but did not reoccur in 2010. In addition, there was a $125 million decrease in net gains on derivative and hedging activities, net of trading securities. These decreases were partially offset by a $173 million decrease in other-than-temporary impairment losses recognized in earnings in 2010 compared to 2009.

The overall changes in other income (loss) during 2009 compared to 2008, were due primarily to adjustments required to report trading securities at fair value, as required by GAAP, and hedging-related adjustments, which are reported in the overall net gains (losses) on derivatives and hedging activities classification (including those related to trading securities). The Bank hedges trading securities with derivatives, and the income effect of the market-value change for these securities was offset by market-value changes in the related derivatives. In addition, during 2009 and 2008, the Bank recorded $316 million and $186 million, respectively, of net impairment losses recognized in earnings as part of other income (loss).

The following tables summarize the net effect of derivatives and hedging activity on the Bank’s results of operations (in millions):

 

    For the Year Ended December 31, 2010  
Net Effect of Derivatives and Hedging
Activities
  Advances     Investments     Consolidated
Obligation
Bonds
    Consolidated
Obligation
Discount
Notes
    Balance
Sheet
    Total  

Net interest income:

           

Amortization/accretion of hedging activities in net interest income(1)

  $ (254)      $ —        $ 55      $ —        $ —        $ (199)   

Net interest settlements included in net interest income(2)

    (3,068)        —          1,149        10        —          (1,909)   
                                               

Total net interest (expense) income

    (3,322)        —          1,204        10        —          (2,108)   
                                               

Net gains (losses) on derivatives and hedging activities:

           

Gains (losses) on fair value hedges

    234        —          (35)        (3)        —          196   

(Losses) gains on derivatives not receiving hedge accounting

    —          (192)        13        —          (9)        (188)   
                                               

Total net gains (losses) on derivatives and hedging activities

    234        (192)        (22)        (3)        (9)        8   
                                               

Total net interest income and net gains (losses) on derivatives and hedging activities

    (3,088)        (192)        1,182        7        (9)        (2,100)   
                                               

Net gains on trading securities(3)

    —          31        —          —          —          31   
                                               

Total net effect of derivatives and hedging activities

  $     (3,088)      $     (161)      $ 1,182      $ 7      $     (9)      $     (2,069)   
                                               

 

(1)

Represents the amortization/accretion of hedging fair value adjustments for both open and closed hedge positions.

(2)

Represents interest income/expense on derivatives included in net interest income.

(3)

Includes only those gains or losses on trading securities or financial instruments held at fair value that have an economic derivative “assigned,” therefore, this line item may not agree to the income statement.

 

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    For the Year Ended December 31, 2009  
Net Effect of Derivatives and Hedging
Activities
  Advances     Investments     Consolidated
Obligation
Bonds
    Consolidated
Obligation
Discount
Notes
    Balance
Sheet
    Total  

Net interest income:

           

Amortization/accretion of hedging activities in net interest income(1)

  $ (605)      $ —        $ 68      $ (1)      $ —        $ (538)   

Net interest settlements included in net interest income(2)

    (3,527)        —          1,491        103        —          (1,933)   
                                               

Total net interest (expense) income

    (4,132)        —          1,559        102        —          (2,471)   
                                               

Net gains (losses) on derivatives and hedging activities:

           

Gains (losses) on fair value hedges

    518        —          (39)        (9)        —          470   

Gains (losses) on derivatives not receiving hedge accounting

    7        49        8        4        5        73   
                                               

Total net gains (losses) on derivatives and hedging activities

    525        49        (31)        (5)        5        543   
                                               

Total net interest income and net gains (losses) on derivatives and hedging activities

    (3,607)        49        1,528        97        5        (1,928)   
                                               

Net losses on trading securities(3)

    —          (135)        —          —          —          (135)   
                                               

Total net effect of derivatives and hedging activities

  $     (3,607)      $ (86)      $ 1,528      $ 97      $ 5      $     (2,063)   
                                               

 

(1)

Represents the amortization/accretion of hedging fair value adjustments for both open and closed hedge positions.

(2)

Represents interest income/expense on derivatives included in net interest income.

(3)

Includes only those gains or losses on trading securities or financial instruments held at fair value that have an economic derivative “assigned,” therefore, this line item may not agree to the income statement.

 

    For the Year Ended December 31, 2008  
Net Effect of Derivatives and Hedging
Activities
  Advances     Investments     Consolidated
Obligation
Bonds
    Consolidated
Obligation
Discount
Notes
    Balance
Sheet
    Intermediary
Positions and
Other
    Total  

Net interest income:

             

Amortization/accretion of hedging activities in net interest income(1)

  $ (130)      $ —        $ (2)      $ —        $ —        $ —        $ (132)   

Net interest settlements included in net interest income(2)

    (1,395)        —          799        (27)        —          —          (623)   
                                                       

Total net interest (expense) income

    (1,525)        —          797        (27)        —          —          (755)   
                                                       

Net gains (losses) on derivatives and hedging activities:

             

(Losses) gains on fair value hedges

    (72)        —          15        10        —          —          (47)   

(Losses) gains on derivatives not receiving hedge accounting

    (3)        (458)        (70)        1        23        325        (182)   
                                                       

Total net gains (losses) on derivatives and hedging activities

    (75)        (458)        (55)        11        23        325        (229)   
                                                       

Total net interest income and net gains (losses) on derivatives and hedging activities

    (1,600)        (458)        742        (16)        23        325        (984)   
                                                       

Net gains on trading securities(3)

    —          200        —          —          —          —          200   
                                                       

Total net effect of derivatives and hedging activities

  $     (1,600)      $ (258)      $ 742      $ (16)      $ 23      $ 325      $     (784)   
                                                       

 

(1)

Represents the amortization/accretion of hedging fair value adjustments for both open and closed hedge positions.

(2)

Represents interest income/expense on derivatives included in net interest income.

(3)

Includes only those gains or losses on trading securities or financial instruments held at fair value that have an economic derivative “assigned,” therefore, this line item may not agree to the income statement.

 

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Non-interest Expense

The following table presents the components of non-interest expense (in millions).

 

     For the Years Ended December 31,      Increase/(Decrease)  
     2010      2009      2008      2010 vs. 2009      2009 vs. 2008  

Other expense:

              

Compensation and benefits

   $ 66       $ 55       $ 65       $ 11       $ (10)   

Cost of quarters

     4         4         3         —           1   

Other operating expenses

     45         42         36         3         6   
                                            

Total operating expenses

     115         101         104         14         (3)   
                                            

Finance Agency and Office of Finance

     14         11         10         3         1   

(Reversal of) provision for credit losses on receivable

     (51)         —           170         (51)         (170)   

Other

     1         1         2         —           (1)   
                                            

Total other expense

     79         113         286         (34)         (173)   
                                            

Assessments:

              

Affordable Housing Program

     31         32         28         (1)         4   

REFCORP

     69         71         63         (2)         8   
                                            

Total assessments

     100         103         91         (3)         12   
                                            

Total non-interest expense

   $     179       $     216       $     377       $ (37)       $     (161)   
                                            

The primary reason for the decrease in non-interest expense in 2010 compared to 2009 was the reduction of the allowance for credit loss on a receivable due from LBSF and the sale of the receivable in the third quarter of 2010. This reduction in other expense was partially offset by a $14 million increase in total operating expenses. For more information about the LBSF receivable, see “Note 17—Derivatives and Hedging Activities—Managing Credit Risk on Derivatives” to the audited financial statements.

Liquidity and Capital Resources

Liquidity is necessary to satisfy members’ borrowing needs on a timely basis, repay maturing and called consolidated obligations, and meet other obligations and operating requirements. Many members rely on the Bank as a source of standby liquidity, and the Bank attempts to be in a position to meet member funding needs on a timely basis.

Finance Agency regulations require the Bank to maintain contingent liquidity in an amount sufficient to meet its liquidity needs for five business days if it is unable to access the capital markets. The Bank met this regulatory liquidity requirement during 2010. During the recent financial crisis, the Finance Agency provided liquidity guidance to the FHLBanks generally to provide ranges of days within which each FHLBank should maintain positive cash balances based upon different assumptions and scenarios. The Bank has operated within these ranges since the Finance Agency issued this guidance.

In addition, the Bank strives to maintain sufficient liquidity to service debt obligations for at least 45 days, assuming restricted debt market access. The Bank implemented this 45-day debt service goal effective January 28, 2010; prior to that, the Bank’s goal was to maintain sufficient liquidity for 90 days. The Bank determined that changing the Bank’s liquidity goal from 90 days to 45 days would more closely align the Bank’s internal measures with those recommended by the Finance Agency and would more accurately reflect the Bank’s practice of not committing to consolidated obligation settlements beyond 30 days. The Bank met its internal liquidity goal during 2010.

 

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The Bank’s principal source of liquidity is consolidated obligation debt instruments. To provide liquidity, the Bank also may use other short-term borrowings, such as federal funds purchased, securities sold under agreements to repurchase, and loans from other FHLBanks. These funding sources depend on the Bank’s ability to access the capital markets at competitive market rates. Although the Bank maintains secured and unsecured lines of credit with money market counterparties, the Bank’s income and liquidity would be affected adversely if it were not able to access the capital markets at competitive rates for an extended period. Historically, the FHLBanks have had excellent capital market access, although the FHLBanks experienced a decrease in investor demand for consolidated obligation bonds beginning in mid-July 2008 and continuing through the first half of 2009. During that time, the Bank increased its issuance of short-term discount notes as an alternative source of funding. The Bank’s funding costs and ability to issue longer-term and structured debt generally have returned to pre-2008 levels, but continue to reflect some market volatility.

Contingency plans are in place that prioritize the allocation of liquidity resources in the event of operational disruptions at the Bank or the Office of Finance, as well as systemic Federal Reserve wire transfer system disruptions. Under the Housing Act, the Secretary of Treasury has the authority, at his or her discretion, to purchase COs, subject to the general federal debt ceiling limits. Previously, this purchasing authority was limited under the FHLBank Act to an aggregate amount of $4.0 billion. No borrowings under this authority have been outstanding since 1977 and the Bank has no immediate plans to request the Treasury to exercise this authority under the Housing Act.

Off-Balance Sheet Commitments

The Bank’s primary off-balance sheet commitments are as follows:

 

 

The Bank’s joint and several liability for all FHLBank COs

 

 

The Bank’s outstanding commitments arising from standby letters of credit.

Should an FHLBank be unable to satisfy its payment obligation under a consolidated obligation for which it is the primary obligor, any of the other FHLBanks, including the Bank, could be called upon to repay all or any part of such payment obligation, as determined or approved by the Finance Agency. The Bank considers the joint and several liability to be a related-party guarantee. These related-party guarantees meet the scope exception under GAAP. Accordingly, the Bank has not recognized a liability for its joint and several obligations related to other FHLBanks’ COs at December 31, 2010 and 2009. As of December 31, 2010, the FHLBanks had $796.4 billion in aggregate par value of COs issued and outstanding, $117.8 billion of which was attributable to the Bank. No FHLBank ever has defaulted on its principal or interest payments under any consolidated obligation, and the Bank has never been required to make payments under any CO as a result of the failure of another FHLBank to meet its obligations.

As of December 31, 2010, the Bank had outstanding standby letters of credit of $22.3 billion with original terms of less than two months to 20 years, with the longest final expiration in 2030. As of December 31, 2009, the Bank had outstanding standby letters of credit of $18.9 billion with original terms of less than four months to 19 years, with the longest final expiration in 2025. The Bank generally requires standby letters of credit to contain language permitting the Bank, upon annual renewal dates and prior notice to the beneficiary, to choose not to renew the standby letter of credit, which effectively terminates the standby letter of credit prior to its scheduled final expiration date. The Bank may issue standby letters of credit for terms of longer than one year without annual renewals or for open-ended terms with annual renewals (commonly known as evergreen letters of credit) based on the creditworthiness of the member applicant. Outstanding standby letters of credit have increased in recent years due to increased acceptance of standby letters of credit by public unit depositors as collateral for public deposits, a decrease in the credit ratings of other standby letter of credit issuers, a decrease in the number of financial institutions providing standby letters of credit or alternative forms of credit enhancement, and provisions of the Housing Act which permitted the use of FHLBank standby letters of credit as credit

 

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enhancement for tax-exempt bonds issued or refunded from July 30, 2008 through December 31, 2010. Despite the expiration of the Housing Act authority, the Bank expects its overall standby letter of credit activity to remain stable for the near future.

Commitments to extend credit, including standby letters of credit, are agreements to lend. The Bank issues a standby letter of credit for the account of a member in exchange for a fee. A member may use these standby letters of credit to facilitate a financing arrangement. The Bank requires its borrowers, upon the effective date of the letter of credit through its expiration, to collateralize fully the face amount of any letter of credit issued by the Bank, as if such face amount were an advance to the borrower. Standby letters of credit are not subject to activity-based capital stock purchase requirements. If the Bank is required to make payment for a beneficiary’s draw, the Bank in its discretion may convert such paid amount to an advance to the member and will require a corresponding activity-based capital stock purchase. The Bank’s underwriting and collateral requirements for standby letters of credit are the same as those requirements for advances. Based on management’s credit analyses and collateral requirements, the Bank does not deem it necessary to have an allowance for credit losses for these unfunded standby letters of credit as of December 31, 2010. Management regularly reviews its standby letter of credit pricing in light of several factors, including the Bank’s potential liquidity needs related to draws on its standby letters of credit.

Contractual Obligations

The tables below present the payment due dates or expiration terms of the Bank’s contractual obligations and commitments as of December 31, 2010 (in millions):

 

     One year or less      After one year
through three years
     After three years
through  five years
     After five years      Total  

Contractual obligations:

              

Long-term debt

   $ 46,987       $ 27,848       $ 9,038       $ 10,054       $ 93,927   

Operating leases

     1         2         —           —           3   

Mandatorily redeemable capital stock

     —           20         503         6         529   
                                            

Total contractual obligations

   $ 46,988       $ 27,870       $ 9,541       $ 10,060       $ 94,459   
                                            

Other commitments:

              

Standby letters of credit

   $ 5,413       $ 4,935       $ 863       $ 11,122       $ 22,333   
                                            

Total other commitments

   $ 5,413       $ 4,935       $ 863       $ 11,122       $     22,333   
                                            

Critical Accounting Policies and Estimates

The preparation of the Bank’s financial statements in accordance with GAAP requires management to make a number of judgments and assumptions that affect the Bank’s reported results and disclosures. Several of the Bank’s accounting policies inherently are subject to valuation assumptions and other subjective assessments and are more critical than others to the Bank’s results. The Bank has identified the following policies that, given the assumptions and judgment used, are critical to an understanding of the Bank’s financial condition and results of operation:

 

 

Fair Value Measurements

 

 

Other-than-temporary Impairment Analysis

 

 

Allowance for Credit Losses

 

 

Derivatives and Hedging Activities.

 

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Fair Value Measurements

The Bank carries certain assets and liabilities, including investments classified as trading and available-for-sale, and all derivatives on the balance sheet at fair value. 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, representing an exit price.

Fair values play an important role in the valuation of certain of the assets, liabilities and hedging transactions of the Bank. Fair values are based on quoted market prices or market-based prices, if such prices are available, even in situations in which trading volume may be low when compared with prior periods as has been the case during the current market disruption. If quoted market prices or market-based prices are not available, the Bank determines fair values based on valuation models that use discounted cash flows, using market estimates of interest rates and volatility.

Valuation models and their underlying assumptions are based on the best estimates of management of the Bank with respect to:

 

 

market indices (primarily LIBOR)

 

 

discount rates

 

 

prepayments

 

 

market volatility

 

 

other factors, including default and loss rates.

These assumptions, particularly estimates of market indices and discount rates, may have a significant effect on the reported fair values of assets and liabilities, including derivatives, and the income and expense related thereto. The use of different assumptions, as well as changes in market conditions, could result in materially different net income and retained earnings. The assumptions used in the models are corroborated by and independently verified against market observable data where possible.

The Bank categorizes its financial instruments carried at fair value into a three-level classification in accordance with GAAP. The valuation hierarchy is based upon the transparency (observable or unobservable) of inputs to the valuation of an asset or liability as of the measurement date. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect the Bank’s market assumptions. The Bank utilizes valuation techniques that maximize the use of observable inputs and minimize the use of unobservable inputs.

As of December 31, 2010 and 2009, the fair value of the Bank’s available-for-sale private-label MBS investment portfolio was determined using unobservable inputs.

For further discussion regarding how the Bank measures financial assets and financial liabilities at fair value, see “Note 18—Estimated Fair Values” to the Bank’s 2010 financial statements.

Other-than-temporary Impairment Analysis

The Bank evaluates its individual available-for-sale and held-to-maturity investment securities for other-than-temporary impairment on at least a quarterly basis. The Bank recognizes an other-than-temporary impairment loss when the Bank determines it will not recover the entire amortized cost basis of a security. Securities in the Bank’s private-label MBS portfolio are evaluated by estimating the projected cash flows using a model that incorporates projections and assumptions based on the structure of the security and certain economic environment assumptions such as delinquency and default rates, loss severity, home price appreciation, interest rates, and securities prepayment speeds while factoring in the underlying collateral and credit enhancement.

 

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If the present value of the expected cash flows of a particular security is less than the security’s amortized cost basis, the security is considered to be other-than temporarily impaired. The amount of the other-than-temporary impairment is separated into two components: (1) the amount of the total impairment related to credit loss; and (2) the amount of the total impairment related to all other factors. The portion of the other-than-temporary impairment loss that is attributable to the credit loss (that is, the difference between the present value of the cash flows expected to be collected and the amortized cost basis) is recognized in other income (loss). If the Bank does not intend to sell the security and it is not more likely than not that the Bank will be required to sell the debt security before the anticipated recovery of its remaining amortized cost basis, the portion of the impairment loss that is not attributable to the credit loss is recognized through other comprehensive loss.

If the Bank determines that an other-than-temporary impairment exists, the Bank accounts for the investment security as if it had been purchased on the measurement date of the other-than-temporary impairment loss at an amortized cost basis equal to the previous amortized cost basis less the other-than-temporary impairment recognized in income. For debt securities classified as held-to-maturity the difference between the new amortized cost basis and the cash flows expected to be collected is accreted into interest income prospectively over the remaining life of the security.

Allowance for Credit Losses

The Bank is required to assess potential credit losses and establish an allowance for credit losses, if required, for each identified portfolio segment of financing receivables. A portfolio segment is the level at which the Bank develops and documents a systematic method for determining its allowance for credit losses. The Bank has established a reserve methodology for each of the following portfolio segments of financing receivables: advances and letters of credit, conventional single-family residential mortgage loans, government-guaranteed or insured single-family residential mortgage loans, and multifamily residential mortgage loans.

The Bank considers the application of these standards to its advance and mortgage loan portfolio a critical accounting policy, as determining the appropriate amount of the allowance for credit losses requires the Bank to make a number of assumptions. The Bank’s assumptions are based on information available as of the date of the financial statements. Actual results may differ from these estimates.

Advances

Finance Agency regulations require the Bank to obtain eligible collateral from borrowing members to protect against potential credit losses. Eligible collateral is defined by statute and regulation. The Bank monitors the financial condition of borrowers and regularly verifies the existence and characteristics of a risk-based sample of mortgage collateral pledged to secure advances. Each borrower’s collateral requirements and the scope and frequency of its collateral verification reviews are dependent upon certain risk factors. Since its establishment in 1932, the Bank has never experienced a credit loss on an advance. Based on the collateral held as security, its collateral policies, management’s credit analysis and the repayment history on advances, the Bank’s management did not anticipate any credit losses on advances as of December 31, 2010 or 2009. Accordingly, the Bank has not recorded any allowance for credit losses. Refer to Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Risk Management—Credit Risk” for further discussion regarding the Bank’s credit risk policies and practice.

Single-family Residential Mortgage Loans

Conventional single-family residential mortgage loans are evaluated collectively for impairment. The overall allowance for credit losses is determined by an analysis (at least quarterly) that includes consideration of various data, such as past performance, current performance, loan portfolio characteristics, collateral valuations, industry data, and prevailing economic conditions. Inherent in the Bank’s evaluation of past performance are the effects of various credit enhancements. As a result of this analysis, the Bank has determined that for each master

 

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commitment of conventional single-family residential mortgage loans the available credit enhancements currently exceed the expected losses estimated by the Bank. Accordingly, no allowance for credit losses on single-family residential mortgage loans is considered necessary as of December 31, 2010 and 2009.

The Bank also invests in government-guaranteed or insured fixed-rate mortgage loans secured by one-to-four family residential properties. Government-guaranteed or insured mortgage loans are mortgage loans guaranteed or insured by the VA or the FHA. Any losses from such loans are expected to be recovered from those entities. Any losses from such loans that are not recovered from those entities are absorbed by the servicers. Therefore, there is no allowance for credit losses on government-guaranteed or insured mortgage loans.

Multifamily Residential Mortgage Loans

Multifamily residential mortgage loans are individually evaluated for impairment. An independent third-party loan review is performed annually on all the Bank’s multifamily residential mortgage loans to identify credit risks and to assess the overall ability of the Bank to collect on those loans. This assessment may be conducted more frequently if management notes significant changes in the portfolio’s performance in the quarterly review report provided on each loan. The allowance for credit losses related to multifamily residential mortgage loans is comprised of specific reserves and a general reserve.

The Bank establishes a specific reserve for all multifamily residential mortgage loans with a credit rating at or below a predetermined classification. A loan is considered impaired when, based on current information and events, it is probable that the Bank will be unable to collect all amounts due, including principal and interest, according to the contractual terms of the loan. The loans are collateral dependent; that is, the ability to repay the loan is dependent on amounts generated by the collateral. Therefore, should a loan be classified as impaired, the loan will be adjusted to reflect the fair value of the underlying collateral less cost to sell.

To identify the loans that will be subject to review for impairment, the Bank reviews all multifamily residential mortgage loans with a credit rating at or below a predetermined classification. The Bank uses six grade categories when assigning credit ratings to individual loans. These credit ratings involve a high degree of judgment in estimating the amount and timing of future cash flows and collateral values. While the Bank’s allowance for credit losses is sensitive to the credit ratings assigned to a loan, a hypothetical one-level downgrade or upgrade in the Bank’s credit ratings for all multifamily residential mortgage loans would not result in a change in the allowance for credit losses that would be material as a proportion of the unpaid principal balance of the Bank’s mortgage loan portfolio.

A general reserve is maintained on multifamily residential mortgage loans not subject to specific reserve allocations to recognize the economic uncertainty and the imprecision inherent in estimating and measuring losses when evaluating reserves for individual loans. To establish the general reserve, the Bank assigns a risk classification to this population of loans. A specified percentage is allocated to the general reserve for designated risk classification levels. The loans and risk classification designations are reviewed by the Bank on an annual basis.

As of December 31, 2010 and 2009, the allowance for credit losses on multifamily residential mortgage loans was $1 million.

See “Note 1—Summary of Significant Accounting Policies—Mortgage Loans Held in Portfolio” to the Bank’s 2010 financial statements and Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Risk Management—Credit Risk” for a further discussion of management’s estimate of credit losses.

 

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Derivatives and Hedging Activities

General

The Bank records all derivatives on the balance sheet at fair value with changes in fair value recognized in current period earnings. The Bank designates derivatives as either fair-value hedging instruments or non-qualifying hedging instruments for which hedge accounting is not applied. The Bank has not entered into any cash-flow hedges as of December 31, 2010. The Bank uses derivatives in its risk management program for the following purposes:

 

 

Conversion of a fixed rate to a variable rate

 

 

Conversion of a variable rate with a fixed component to another variable rate

 

 

Macro hedging of balance sheet risks.

To qualify for hedge accounting, the Bank documents the following concurrently with the execution of each hedging relationship:

 

 

The hedging strategy

 

 

Identification of the hedging instrument and the hedged item

 

 

Determination of the appropriate accounting designation

 

 

The method used for the determination of effectiveness for transactions qualifying for hedge accounting

 

 

The method for recording ineffectiveness for hedging relationships.

The Bank also evaluates each debt issuance, advance made, and financial instrument purchased to determine whether the cash item contains embedded derivatives that meet the criteria for bifurcation. If, after evaluation, it is determined that an embedded derivative must be bifurcated, the Bank will measure the fair value of the embedded derivative.

Assessment of Hedge Effectiveness

An assessment must be made to determine the effectiveness of qualifying hedging relationships; the Bank uses two methods to make such an assessment. If the hedging instrument is a swap and meets specific criteria, the hedging relationship may qualify for the short-cut method of assessing effectiveness. The short-cut method allows for an assumption of no ineffectiveness, which means that the change in the fair value of the hedged item is assumed to be equal and offsetting of the change in fair value of the hedging instrument. For periods beginning after May 31, 2005, management determined that it would no longer apply the short-cut method to new hedging relationships.

The long-haul method of effectiveness is used to assess effectiveness for hedging relationships that qualify for hedge accounting but do not meet the criteria for the use of the short-cut method. The long-haul method requires separate valuations of both the hedged item and the hedging instrument. If the hedging relationship is determined to be highly effective, the change in fair value of the hedged item related to the designated risk is recognized in current period earnings in the same period as the change in fair value of the hedging instrument. If the hedging relationship is determined not to be highly effective, hedge accounting either will not be allowed or will cease at that point. The Bank performs effectiveness testing on a monthly basis and uses statistical regression analysis techniques to determine whether a long-haul hedging relationship is highly effective.

Accounting for Ineffectiveness and Hedge De-designation

The Bank accounts for any ineffectiveness for all long-haul fair-value hedges using the dollar offset method. In the case of non-qualifying hedges that do not qualify for hedge accounting, the Bank reports only the change in

 

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fair value of the derivative. The Bank reports all ineffectiveness for qualifying hedges and non-qualifying hedges in the income statement caption “Net gains (losses) on derivatives and hedging activities” which is included in the “Other Income (Loss)” section of the income statement.

The Bank may discontinue hedge accounting for a hedging transaction (de-designation) if it fails effectiveness testing or for other asset-liability-management reasons. The Bank also treats modifications to hedged items as a discontinuance of a hedging relationship. When a hedge relationship is discontinued, the Bank will cease marking the hedged item to fair value and will amortize the cumulative basis adjustment resulting from hedge accounting. The Bank reports related amortization as interest income or expense over the remaining life of the associated hedged item. The associated derivative will continue to be marked to fair value through earnings until it matures or is terminated.

Recently Issued and Adopted Accounting Guidance

See “Note 2—Recently Issued and Adopted Accounting Guidance” to the Bank’s 2010 financial statements for a discussion of recent accounting guidance.

Legislative and Regulatory Developments

The legislative and regulatory environment for the Bank has undergone profound changes during 2010, most notably the enactment of the Dodd-Frank Act. The issuance of several proposed and final regulations from the Finance Agency as well as from other financial regulators added to the climate of rapid regulatory change. The Bank expects further significant legislative and regulatory changes in 2011 as regulations are issued to implement the Dodd-Frank Act.

Dodd-Frank Act

The Dodd-Frank Act, among other things: (1) creates an interagency oversight council (the 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. The Bank’s business operations, funding costs, rights, and obligations, and the manner in which the Bank carries out its housing finance mission may be affected by the Dodd-Frank Act. Certain regulatory actions resulting from the Dodd-Frank Act that may have a material impact on the Bank are summarized below; however, the actual effects of the Dodd-Frank Act will be known only after implementing regulations are finalized and certain determinations under the Dodd-Frank Act are made.

Derivatives Transactions. The Dodd-Frank Act provides for new statutory and regulatory requirements for derivative transactions, including those utilized by the Bank to hedge its interest rate and other risks. As a result of these requirements, certain derivative transactions will be required to be cleared through a third-party central clearinghouse and traded on regulated exchanges or new swap execution facilities. Such cleared trades are expected to be subject to initial and variation margin requirements established by the clearinghouse and its clearing members. While clearing swaps should reduce counterparty credit risk, the margin requirements for cleared trades have the potential of making derivative transactions more costly and less attractive as risk management tools for the Bank. The Dodd-Frank Act will also change the regulatory landscape for derivative transactions that are not subject to mandatory clearing requirements (uncleared trades). While the Bank expects to continue to enter into uncleared trades on a bilateral basis, such trades are expected to be subject to new regulatory requirements, including new mandatory reporting requirements and, potentially, new minimum margin and capital requirements imposed by bank and other federal regulators. Any such margin and capital requirements could adversely impact the liquidity and pricing of certain uncleared derivative transactions entered into by the Bank, making uncleared trades more costly and less attractive as risk management tools for the Bank.

The Dodd-Frank Act will require swap dealers and certain other large users of derivatives to register as “swap dealers” or “major swap participants,” as the case may be, with the Commodity Futures Trading Commission (CFTC) and/or the SEC. Based on proposed rules jointly issued by the CFTC and SEC, it seems unlikely that the

 

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Bank will be required to register as a major swap participant, although this remains a possibility. It also seems unlikely that the Bank will be required to register as a “swap dealer” with respect to the derivative transactions that it enters into with dealer counterparties for the purpose of hedging and managing its interest rate risk, which constitute the great majority of the Bank’s derivative transactions. However, based on the proposed rules, it is possible that the Bank could be required to register with the CFTC as a “swap dealer” based on the intermediated “swaps” that it enters into with its members. The scope of the term “swap” in the Dodd-Frank Act has not yet been addressed in proposed regulations and could include certain advances with embedded derivative features. Designation as a swap dealer may subject the Bank to significant additional regulation and cost.

Oversight Council Authority to Supervise and Regulate Certain Nonbank Financial Companies. On February 11, 2011 the Board published a notice of proposed rulemaking to establish the criteria for determining whether a company is “predominantly engaged in financial activities” and to define the term “significant nonbank financial company” for purposes of certain provisions of Title I of the Dodd-Frank Act. The proposed rule generally provides that a company is predominantly engaged in financial activities if the consolidated annual gross financial revenues, or total financial assets, of the company represent 85 percent or more of the financial institution’s consolidated annual gross revenues, or consolidated total assets, in that fiscal year. The proposed rule would define a significant nonbank financial company as (1) any nonbank financial company supervised by the Board; and (2) any other nonbank financial company that had $50.0 billion or more in total consolidated assets as of the end of its most recently completed fiscal year. Comments on the proposed rule are due by March 30, 2011.

FDIC Proposed Rule on Orderly Liquidation Authority. On January 25, 2011, the FDIC issued an interim final rule with a request for comments, among other things, to clarify how the FDIC would treat certain creditor claims under the new orderly liquidation authority established by the Dodd-Frank Act. The Dodd-Frank Act provides for the appointment of the FDIC as receiver for a covered financial company in instances where the failure of the company and its liquidation under other insolvency or bankruptcy procedures could pose a significant risk to the financial stability of the United States. The interim final rule establishes, among other things, (1) procedures for submitting, allocating priority among, and valuing secured and unsecured creditor claims against the covered financial company’s assets; and (2) the FDIC’s ability to continue key operations, services and transactions to maximize the value of the covered financial company’s assets and avoid a disorderly collapse in the market place. These procedures may affect the Bank’s ability to terminate a financial contract after a counterparty has been placed into receivership and may impact the processing of the Bank’s claims, if any, against the counterparty’s assets. The interim final rule became effective January 25, 2011 and comments on the rule are due March 28, 2011.

Significant Finance Agency Regulatory Actions

Reporting of Fraudulent Financial Instruments. On January 27, 2010, the Finance Agency issued a final rule, effective February 26, 2010, that requires an FHLBank to notify the Director of any fraud or possible fraud occurring in connection with a loan, a series of loans or other financial instruments that the FHLBank has purchased or sold, including AHP grants, advances collateral, and individual loans backing MBS. The FHLBank must notify the Director promptly after identifying such fraud or after the FHLBank is notified about such fraud by law enforcement or other government authority. The rule also requires each FHLBank to establish and maintain internal controls and procedures and an operational training program to assure the FHLBank has an effective system to detect and report such fraud.

FHLBank Directors’ Eligibility, Elections, Compensation and Expenses. On April 5, 2010, the Finance Agency issued a final rule implementing two separate proposed rules on director elections and director compensation, respectively. Under the final rule, the redesignation of a directorship to a new state prior to the end of the term as a result of the annual designation of FHLBank directorships causes the original directorship to terminate and creates a new directorship to be filled by an election of the members. The final rule also repeals the statutory caps on the annual compensation that can be paid to FHLBank directors and allows each FHLBank to pay its directors

 

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reasonable compensation and expenses, subject to the authority of the Director to object to, and to prohibit prospectively, compensation and/or expenses that the Director determines are not reasonable. The final rule became effective May 5, 2010.

Office of Finance. On May 3, 2010, the Finance Agency issued a final rule, effective June 2, 2010, regarding the board of directors of the Office of Finance. The final rule expanded the Office of Finance board of directors from three members to 17 members, including the president of each of the 12 FHLBanks and five independent directors. The five independent directors will serve as the Office of Finance’s audit committee and the rule gives the audit committee increased authority over the form and content of the information that the FHLBanks provided to the Office of Finance for use in the FHLBanks’ combined financial reports.

FHLBank Investments. On May 4, 2010, the Finance Agency issued a notice of proposed rulemaking that would consolidate all existing regulations and authority for investments and other transactions into one rule. The notice of proposed rulemaking requested comment on whether additional limitations on an FHLBank’s MBS investments, including its private-label MBS investments, should be adopted as part of a final regulation and whether with respect to private-label MBS investments such limitations should be based on the amount of an FHLBank’s retained earnings. Comments were due July 6, 2010.

Conservatorship and Receivership. On July 9, 2010, the Finance Agency issued a notice of proposed rulemaking to establish a framework for conservatorship and receivership operations for Fannie Mae and Freddie Mac, both of which are currently in conservatorship, and the FHLBanks, which are subject to the conservatorship and receivership authority of the Finance Agency. The proposed rule includes provisions that describe the basic authorities of the Finance Agency when acting as conservator or receiver, including the enforcement and repudiation of contracts and the priorities of claims for contract parties and other claimants, largely in parallel to the conservatorship and receivership rules applicable to the FDIC. Comments were due September 7, 2010.

Voluntary FHLBank Mergers. On November 26, 2010, the Finance Agency issued a notice of proposed rulemaking that would permit, but not require, any two or more FHLBanks voluntarily to merge, provided that (1) such FHLBanks have agreed upon the terms of the proposed merger and the board of directors of each such FHLBank has authorized the execution of the merger agreement; (2) such FHLBanks jointly submit a merger application to the Finance Agency for preliminary approval; (3) the members of each such FHLBank are provided with certain disclosures regarding the proposed merger and the members ratify the merger agreement; and (4) the Finance Agency grants final approval of the merger. Comments were due January 25, 2011.

Community Development Loans; Secured Lending. On December 9, 2010, the Finance Agency issued a final rule that (1) implements the Housing Act provision allowing community financial institutions to secure advances from FHLBanks with community development loans; (2) reorganizes the advances and new business activities regulations; and (3) deems all secured extensions of credit by an FHLBank to a member of any FHLBank to be an advance subject to applicable Finance Agency regulations on advances. The final rule clarifies that it was not intended to prohibit an FHLBank’s derivatives activities with members or other obligations that may create a credit exposure to an FHLBank but that do not arise from the FHLBank’s lending of cash funds.

FHLBank Members. On December 27, 2010, the Finance Agency issued an advance notice of proposed rulemaking, which notice provides that the Finance Agency is reviewing its regulations on FHLBank membership to ensure such regulations maintain the statutorily required nexus between FHLBank membership and the housing and community development mission of the FHLBanks. To reinforce that nexus, the notice suggests expanding three existing requirements for initial membership to ongoing membership requirements: (1) the requirement that a member have at least 10 percent of its total assets in residential mortgage loans; (2) the requirement that a member make long-term home mortgage loans; and (3) the requirement that a member have a home financing policy consistent with sound and economical home financing. The Finance Agency seeks comment on ways to improve the standards for the home financing policy requirement, as well as other suggestions for improving the membership-mission nexus. Comments are due March 28, 2011.

 

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Minority and Women Inclusion. On December 28, 2010, the Finance Agency issued a final rule requiring each FHLBank to promote diversity and the inclusion of women, minorities and individuals with disabilities in all activities. The rule requires, among other things, each FHLBank to either establish an Office of Minority and Women Inclusion or designate an office to be responsible for carrying out the rule’s requirements at every level of the organization including management, employment and contracting. Additionally, the rule requires the Bank to make certain periodic reports on its compliance with the rule to the Director.

Use of NRSRO Credit Ratings. On January 31, 2011, the Finance Agency issued an advanced notice of proposed rulemaking that would implement a provision in the Dodd-Frank Act requiring all federal agencies to remove regulations that require use of NRSRO credit ratings in the assessment of a security. The notice seeks comment regarding certain specific Finance Agency regulations applicable to the FHLBanks, including risk-based capital requirements, prudential requirements, investments and COs. Comments were due March 17, 2011.

Private Transfer Fee Covenants. On February 8, 2011, the Finance Agency issued a notice of proposed rulemaking that would restrict the FHLBanks from acquiring, or taking security interests in, mortgage loans and securities with underlying mortgage loans encumbered by private transfer fee covenants. An exception would exist for transfer fee covenants that pay a private transfer fee to a homeowners association, condominium, cooperative or certain other tax-exempt organizations that use the private transfer fees for the direct benefit of the property. The foregoing restrictions would apply only to mortgages on properties encumbered by private transfer fee covenants created on or after February 8, 2011, and to such securities backed by such mortgages, and to securities issued after that date and backed by revenue from private transfer fees regardless of when the covenants were created. The FHLBanks would be required to comply with the regulation within 120 days of the publication of the final rule. Comments are due April 11, 2011.

Additional Developments

Final SEC Rule on Money Market Reform. On March 4, 2010, the SEC published a final rule effective May 5, 2010 amending the rules governing money market funds under the Investment Company Act. These amendments have resulted in certain tightened liquidity requirements, such as maintaining certain financial instruments for short-term liquidity; reducing the maximum weighted-average maturity of portfolio holdings and improving the quality of portfolio holdings. The final rule includes overnight FHLBank discount notes in the definition of “daily liquid assets” and “weekly liquid assets” and encompasses FHLBank discount notes with remaining maturities of up to 60 days in the definition of “weekly liquid assets.” This rule has resulted in an increase in investor preference for FHLBank CO bonds and discount notes of shorter maturities.

Housing Finance Reform. On February 11, 2011, Treasury and the U.S. Department of Housing and Urban Development issued a report to Congress on Reforming America’s Housing Finance Market. The report primarily focused on Fannie Mae and Freddie Mac by providing options for the long-term structure of housing finance. The report recognized the vital role the FHLBanks play in helping financial institutions access liquidity and capital to compete in an increasingly competitive marketplace and noted that the Obama Administration would work, in consultation with the Finance Agency and Congress, to restrict the areas of mortgage finance in which Fannie Mae, Freddie Mac and the FHLBanks operate so that overall government support of the mortgage market is substantially reduced. Specifically, with respect to the FHLBanks, the report stated the Obama Administration supports limiting the level of advances to large financial institutions that have greater access to capital markets than small and medium sized financial institutions, and reducing the FHLBanks’ portfolio investments.

CFTC Proposed Rule on Eligible Investments for Derivatives Clearing Organizations. On November 3, 2010, the CFTC issued a proposed rule which, among other changes, would eliminate the ability of futures commissions merchants and derivatives clearing organizations to invest customer funds in securities of GSEs or U.S. government corporations that are not explicitly guaranteed as to principal and interest by the U.S. federal government. Currently, GSE securities are eligible investments under CFTC regulations. The proposed change may impact adversely demand for FHLBank consolidated obligations. Comments on the proposed rule were due December 3, 2010.

 

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Basel Committee on Banking Supervision Capital Framework. On September 12, 2010, the oversight body of the Basel Committee on Banking Supervision (Basel Committee) announced agreement concerning increased capital standards for internationally-active banks. The capital standards would increase the minimum common equity requirements based on risk-weighted assets, with an additional capital conservation buffer requirement. In addition, national regulators could impose an additional capital buffer to protect against excess credit growth. The Basel Committee also proposed a liquidity coverage ratio that would be phased in for internationally active depository institutions on January 1, 2015, as well as a net stable funding ratio for internationally active depository institutions expected to be established by January 1, 2018.

Risk Management

The Bank’s lending, investment, and funding activities and the use of derivative hedge instruments expose the Bank to a number of risks, including any one or more of the following:

 

 

Market risk, which is the risk that the market value, or estimated fair value, of the Bank’s portfolio will decline as a result of changes in interest rates

 

 

Liquidity risk, which is the risk that the Bank will be unable to meet its obligations as they come due or meet the credit needs of its members and associates in a timely and cost-efficient manner

 

 

Credit risk, which is the risk that the market value of an obligation will decline as a result of deterioration in creditworthiness, or that the amount will not be realized

 

 

Operational risk, which is the risk of loss resulting from inadequate or failed internal processes, people or systems, or from external events, as well as reputation and legal risks associated with business practices or market conduct that the Bank may undertake

 

 

Business risk, which is the risk of an adverse effect on the Bank’s profitability resulting from external factors that may occur in both the short term and long term.

The Bank’s board of directors establishes the risk management philosophies for the Bank and works with management to align the Bank’s objectives to those philosophies. To manage the Bank’s risk exposure, the Bank’s board of directors has adopted the RMP. The RMP governs the Bank’s approach to managing the above risks. The Bank’s board of directors reviews the RMP annually and formally re-adopts the RMP at least once every three years. It also reviews and approves amendments to the RMP from time to time as necessary. In addition to the RMP, the Bank also is subject to Finance Agency regulations and policies regarding risk management.

To ensure compliance with the RMP, the Bank has established multiple internal management committees to provide oversight over these risks. The Bank produces a comprehensive risk assessment report on an annual basis that is reviewed by the board of directors.

Market Risk

General

The Bank is exposed to market risk in that changes in interest rates and spreads can have a direct effect on the value of the Bank’s assets and liabilities. As a result of the volume of its interest-earning assets and interest-bearing liabilities, the component of market risk having the greatest effect on the Bank’s financial condition and results of operations is interest-rate risk.

Interest-rate risk represents the risk that the aggregate market value or estimated fair value of the Bank’s asset, liability, and derivative portfolios will decline as a result of interest-rate volatility or that net earnings will be affected significantly by interest-rate changes. Interest-rate risk can occur in a variety of forms. These include repricing risk, yield-curve risk, basis risk, and option risk. The Bank faces repricing risk whenever an asset and a

 

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liability reprice at different times and with different rates, resulting in interest-margin sensitivity to changes in market interest rates. Yield-curve risk reflects the possibility that changes in the shape of the yield curve may affect the market value of the Bank’s assets and liabilities differently because a liability used to fund an asset may be short-term while the asset is long-term, or vice versa. Basis risk occurs when yields on assets and costs on liabilities are based on different bases, such as LIBOR, versus the Bank’s cost of funds. Different bases can move at different rates or in different directions, which can cause erratic changes in revenues and expenses. Option risk is presented by the optionality that is embedded in some assets and liabilities. Mortgage assets represent the primary source of option risk.

The primary goal of the Bank’s interest-rate risk measurement and management efforts is to control the above risks through prudent asset-liability management strategies so that the Bank may provide members with dividends that consistently are competitive with existing market interest rates on alternative short-term and variable-rate investments. The Bank attempts to manage interest-rate risk exposure by using appropriate funding instruments and hedging strategies. Hedging may occur at the micro level, for one or more specifically identified transactions, or at the macro level. Management evaluates the Bank’s macro hedge position and funding strategies on a daily basis and makes adjustments as necessary.

The Bank measures its potential market risk exposure in a number of ways. These include asset, liability, and equity duration analyses; earnings forecast scenario analyses that reflect repricing gaps; and convexity characteristics under assumed changes in interest rates, the shape of the yield curve, and market basis relationships. The Bank establishes tolerance limits for these financial metrics and uses internal models to measure each of these risk exposures at least monthly.

Use of Derivatives

The Bank enters into derivatives to reduce the interest-rate risk exposure inherent in otherwise unhedged assets and funding positions. The Bank does not engage in speculative trading of these instruments. The Bank’s management attempts to use derivatives to reduce interest-rate exposure in the most cost-efficient manner. The Bank’s derivative position includes interest-rate swaps, options, swaptions, interest-rate cap and floor agreements, and forward contracts. These derivatives are used to adjust the effective maturity, repricing frequency, or option characteristics of financial instruments to achieve risk-management objectives. Within its risk management strategy, the Bank uses derivative financial instruments in two ways:

 

1. As a fair-value hedge of an underlying financial instrument or a firm commitment. For example, the Bank uses derivatives to reduce the interest-rate net sensitivity of consolidated obligations, advances, investments, and mortgage loans by, in effect, converting them to a short-term interest rate, usually based on LIBOR. The Bank also uses derivatives to manage embedded options in assets and liabilities, and to hedge the market value of existing assets and liabilities. The Bank reevaluates its hedging strategies from time to time and may change the hedging techniques used or adopt new strategies as deemed prudent.

 

2. As an asset-liability management tool, for which hedge accounting is not applied (non-qualifying hedge). The Bank may enter into derivatives that do not qualify for hedge accounting. As a result, the Bank recognizes the change in fair value and interest income/expense of these derivatives in the “Other Income (Loss)” section of the income statement as “Net gains (losses) on derivatives and hedging activities” with no offsetting fair-value adjustments of the hedged asset, liability, or firm commitment. Consequently, these transactions can introduce earnings volatility.

 

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The following table summarizes the notional amounts of derivative financial instruments (in millions).

 

                 As of December 31,  
                 2010      2009  

Hedged Item / Hedging Instrument

  

Hedging Objective

   Hedge Accounting
Designation
     Notional
Amount
     Notional
Amount
 

    Advances

                               

Pay fixed, receive variable interest rate swap (without options)

  

Converts the advance’s fixed rate to a variable rate index.

    
 
Fair value
hedges
  
  
   $ 13,632       $ 15,579   
       
 
Non-qualifying
hedges
  
  
     100         100   

Pay fixed, receive variable interest rate swap (with options)

  

Converts the advance’s fixed rate to a variable rate index and offsets option risk in the advance.

    
 
Fair value
hedges
  
  
     50,519         72,683   
       
 
Non-qualifying
hedges
  
  
     1,241         1,340   

Pay variable with embedded features, receive variable interest rate swap (non-callable)

  

Reduces interest rate sensitivity and repricing gaps by converting the advance’s variable rate to a different variable rate index and/or offsets embedded option risk in the advance.

    
 
Fair value
hedges
  
  
     413         521   

Pay variable with embedded features, receive variable interest rate swap (callable)

  

Reduces interest rate sensitivity and repricing gaps by converting the advance’s variable rate to a different variable rate index and/or offsets embedded option risk in the advance.

    
 
Fair value
hedges
  
  
     323         533   

Pay variable, receive variable basis swap

  

Reduces interest rate sensitivity and repricing gaps by converting the advance’s variable rate to a different variable rate index.

    
 
Non-qualifying
hedges
  
  
     216         323   
            Total         66,444         91,079   

    Investments

                               

Pay fixed, receive variable interest rate swap

  

Converts the investment’s fixed rate to a variable rate index.

    
 
Non-qualifying
hedges
  
  
     2,950         3,168   

Pay variable, receive variable interest rate swap

  

Converts the investment’s variable rate to a different variable rate index.

    
 
Non-qualifying
hedges
  
  
     50         50   
            Total         3,000         3,218   

    Consolidated Obligation Bonds

                               

Receive fixed, pay variable interest rate swap (without options)

  

Converts the bond’s fixed rate to a variable rate index.

    
 
Fair value
hedges
  
  
     38,310         54,511   
       
 
Non-qualifying
hedges
  
  
     2,850         2,427   

Receive fixed, pay variable interest rate swap (with options)

  

Converts the bond’s fixed rate to a variable rate index and offsets option risk in the bond.

    
 
Fair value
hedges
  
  
     21,962         28,145   
       
 
Non-qualifying
hedges
  
  
     —