Derivatives and Hedging Activities

Hedging Activities. As a financial intermediary, the Bank is exposed to interest rate risk. This risk arises from a variety of financial instruments that the Bank enters into on a regular basis in the normal course of its business. The Bank enters into interest rate swap, swaption, cap and forward rate agreements (collectively, interest rate exchange agreements) to manage its exposure to changes in interest rates. The Bank may use these instruments to adjust the effective maturity, repricing frequency, or option characteristics of financial instruments to achieve risk management objectives. The Bank has not entered into any credit default swaps or foreign exchange-related derivatives, nor is it currently a party to any swaptions or forward rate agreements.

The Bank uses interest rate exchange agreements in two ways: either by designating the agreement as a fair value hedge of a specific financial instrument or firm commitment or by designating the agreement as a hedge of some defined risk in the course of its balance sheet management (referred to as an “economic hedge”). For example, the Bank uses interest rate exchange agreements in its overall interest rate risk management activities to adjust the interest rate sensitivity of consolidated obligations to approximate more closely the interest rate sensitivity of its assets (both advances and investments), and/or to adjust the interest rate sensitivity of advances or investments to approximate more closely the interest rate sensitivity of its liabilities. In addition to using interest rate exchange agreements to manage mismatches between the coupon features of its assets and liabilities, the Bank also uses interest rate exchange agreements to manage embedded options in assets and liabilities, to preserve the market value of existing assets and liabilities, to hedge the duration risk of prepayable instruments, to offset interest rate exchange agreements entered into with members (the Bank serves as an intermediary in these transactions), and to reduce funding costs.

The Bank, consistent with Finance Agency regulations, enters into interest rate exchange agreements only to reduce potential market risk exposures inherent in otherwise unhedged assets and liabilities or to act as an intermediary between its members and the Bank’s derivative counterparties. The Bank is not a derivatives dealer and it does not trade derivatives for short-term profit.

At inception, the Bank formally documents the relationships between derivatives designated as hedging instruments and their hedged items, its risk management objectives and strategies for undertaking the hedge transactions, and its method for assessing the effectiveness of the hedging relationships. This process includes linking all derivatives that are designated as fair value hedges to: (1) specific assets and liabilities on the statements of condition or (2) firm commitments. The Bank also formally assesses (both at the inception of the hedging relationship and on a monthly basis thereafter) whether the derivatives that are used in hedging transactions have been effective in offsetting changes in the fair value of hedged items and whether those derivatives may be expected to remain effective in future periods. The Bank uses regression analyses to assess the effectiveness of its hedges.

Investments — The Bank has invested in agency and non-agency MBS, all of which are classified as held-to-maturity. The interest rate and prepayment risk associated with these investment securities is managed through consolidated obligations and/or derivatives. The Bank may manage prepayment and duration risk presented by some investment securities with either callable or non-callable consolidated obligations or interest rate exchange agreements, including caps and interest rate swaps.

A substantial portion of the Bank’s held-to-maturity securities are variable-rate MBS that include caps that would limit the variable-rate coupons if short-term interest rates rise dramatically. To hedge a portion of the potential cap risk embedded in these securities, the Bank has entered into interest rate cap agreements. These derivatives are treated as economic hedges.

The Bank has also invested in agency and other highly rated debentures. Substantially all of the Bank's available-for-sale securities are fixed-rate debentures. To hedge the interest rate risk associated with these fixed-rate investment securities, the Bank entered into fixed-for-floating interest rate exchange agreements, which are designated as fair value hedges.

Advances — The Bank issues both fixed-rate and variable-rate advances. When appropriate, the Bank uses interest rate exchange agreements to adjust the interest rate sensitivity of its fixed-rate advances to approximate more closely the interest rate sensitivity of its liabilities. With issuances of putable advances, the Bank purchases from the member a put option that enables the Bank to terminate a fixed-rate advance on specified future dates. This embedded option is clearly and closely related to the host advance contract. The Bank typically hedges a putable advance by entering into a cancelable interest rate exchange agreement where the Bank pays a fixed coupon and receives a variable coupon, and sells an option to cancel the swap to the swap counterparty. This type of hedge is treated as a fair value hedge. The swap counterparty can cancel the interest rate exchange agreement on the call date and the Bank can cancel the putable advance and offer, subject to certain conditions, replacement funding at prevailing market rates.

A small portion of the Bank’s variable-rate advances are subject to interest rate caps that would limit the variable-rate coupons if short-term interest rates rise above a predetermined level. To hedge the cap risk embedded in these advances, the Bank generally enters into interest rate cap agreements. This type of hedge is treated as a fair value hedge.

The Bank may hedge a firm commitment for a forward-starting advance through the use of an interest rate swap. In this case, the swap will function as the hedging instrument for both the firm commitment and the subsequent advance. The carrying value of the firm commitment will be included in the basis of the advance at the time the commitment is terminated and the advance is issued. The basis adjustment will then be amortized into interest income over the life of the advance.

The Bank enters into optional advance commitments with its members. In an optional advance commitment, the Bank sells an option to the member that provides the member with the right to enter into an advance at a specified fixed rate and term on a specified future date, provided the member has satisfied all of the customary requirements for such advance. Optional advance commitments involving Community Investment Program (“CIP”) and Economic Development Program (“EDP”) advances with a commitment period of three months or less are currently provided at no cost to members. The Bank may hedge an optional advance commitment through the use of an interest rate swaption. In this case, the swaption will function as the hedging instrument for both the commitment and, if the option is exercised by the member, the subsequent advance. These swaptions are treated as economic hedges.

Consolidated Obligations — While consolidated obligations are the joint and several obligations of the FHLBanks, each FHLBank is the primary obligor for the consolidated obligations it has issued or assumed from another FHLBank. The Bank generally enters into derivative contracts to hedge the interest rate risk associated with its specific debt issuances.

To manage the interest rate risk of certain of its consolidated obligations, the Bank will match the cash outflow on a consolidated obligation with the cash inflow of an interest rate exchange agreement. With issuances of fixed-rate consolidated obligation bonds, the Bank typically enters into a matching interest rate exchange agreement in which the counterparty pays fixed cash flows to the Bank that are designed to mirror in timing and amount the cash outflows the Bank pays on the consolidated obligation. In this transaction, the Bank pays a variable cash flow that closely matches the interest payments it receives on short-term or variable-rate assets, typically one-month or three-month LIBOR. These transactions are treated as fair value hedges. On occasion, the Bank may enter into fixed-for-floating interest rate exchange agreements to hedge the interest rate risk associated with certain of its consolidated obligation discount notes. The derivatives associated with the Bank’s discount note hedging are treated as economic hedges. The Bank may also use interest rate exchange agreements to convert variable-rate consolidated obligation bonds from one index rate (e.g., the daily effective federal funds rate) to another index rate (e.g., one-month or three-month LIBOR); these transactions are treated as economic hedges.

The Bank has not issued consolidated obligations denominated in currencies other than U.S. dollars.

Balance Sheet Management — From time to time, the Bank may enter into interest rate basis swaps to reduce its exposure to changing spreads between one-month and three-month LIBOR. In addition, to reduce its exposure to reset risk, the Bank may occasionally enter into forward rate agreements. These derivatives are treated as economic hedges.

Intermediation — The Bank offers interest rate swaps, caps and floors to its members to assist them in meeting their hedging needs. In these transactions, the Bank acts as an intermediary for its members by entering into an interest rate exchange agreement with a member and then entering into an offsetting interest rate exchange agreement with one of the Bank’s approved derivative counterparties. All interest rate exchange agreements related to the Bank’s intermediary activities with its members are accounted for as economic hedges.

Accounting for Derivatives and Hedging Activities. The Bank accounts for derivatives and hedging activities in accordance with the guidance in Topic 815 of the FASB’s Accounting Standards Codification (“ASC”) entitled “Derivatives and Hedging” (“ASC 815”). All derivatives are recognized on the statements of condition at their fair values, including accrued interest receivable and payable. For purposes of reporting derivative assets and derivative liabilities, the Bank offsets the fair value amounts recognized for derivative instruments (including the right to reclaim cash collateral and the obligation to return cash collateral) where a legally enforceable right of setoff exists.

Changes in the fair value of a derivative that is effective as — and that is designated and qualifies as — a fair value hedge, along with changes in the fair value of the hedged asset or liability that are attributable to the hedged risk (including changes that reflect gains or losses on firm commitments), are recorded in current period earnings. Any hedge ineffectiveness (which represents the amount by which the change in the fair value of the derivative differs from the change in the fair value of the hedged item attributable to the hedged risk) is recorded in other income (loss) as “net gains (losses) on derivatives and hedging activities.” Net interest income/expense associated with derivatives that qualify for fair value hedge accounting under ASC 815 is recorded as a component of net interest income. An economic hedge is defined as a derivative hedging specific or non-specific assets or liabilities that does not qualify or was not designated for hedge accounting under ASC 815, but is an acceptable hedging strategy under the Bank’s Risk Management Policy. These hedging strategies also comply with Finance Agency regulatory requirements prohibiting speculative derivative transactions. An economic hedge by definition introduces the potential for earnings variability as changes in the fair value of a derivative designated as an economic hedge are recorded in current period earnings with no offsetting fair value adjustment to an asset or liability. Both the net interest income/expense and the fair value changes associated with derivatives in economic hedging relationships are recorded in other income (loss) as “net gains (losses) on derivatives and hedging activities.” Cash flows associated with derivatives are reported as cash flows from operating activities in the statements of cash flows, unless the derivatives contain an other-than-insignificant financing element, in which case the cash flows are reported as cash flows from financing activities.

If hedging relationships meet certain criteria specified in ASC 815, they are eligible for hedge accounting and the offsetting changes in fair value of the hedged items may be recorded in earnings. The application of hedge accounting generally requires the Bank to evaluate the effectiveness of the hedging relationships on an ongoing basis and to calculate the changes in fair value of the derivatives and related hedged items independently. This is commonly known as the “long-haul” method of hedge accounting. Transactions that meet more stringent criteria qualify for the “shortcut” method of hedge accounting in which an assumption can be made that the change in fair value of a hedged item exactly offsets the change in value of the related derivative. The Bank considers hedges of committed advances to be eligible for the shortcut method of accounting as long as the settlement of the committed advance occurs within the shortest period possible for that type of instrument based on market settlement conventions, the fair value of the swap is zero at the inception of the hedging relationship, and the transaction meets all of the other criteria for shortcut accounting specified in ASC 815. The Bank has defined the market settlement convention to be five business days or less for advances. The Bank records the changes in fair value of the derivative and the hedged item beginning on the trade date.

The Bank may issue debt, make advances, or purchase financial instruments in which a derivative instrument is “embedded” and the financial instrument that embodies the embedded derivative instrument is not remeasured at fair value with changes in fair value reported in earnings as they occur. Upon execution of these transactions, the Bank assesses whether the economic characteristics of the embedded derivative are clearly and closely related to the economic characteristics of the remaining component of the financial instrument (i.e., the host contract) and whether a separate, non-embedded instrument with the same terms as the embedded instrument would meet the definition of a derivative instrument. When it is determined that (1) the embedded derivative possesses economic characteristics that are not clearly and closely related to the economic characteristics of the host contract and (2) a separate, stand-alone instrument with the same terms would qualify as a derivative instrument, the embedded derivative is separated from the host contract, carried at fair value, and designated as either (1) a hedging instrument in a fair value hedge or (2) a stand-alone derivative instrument pursuant to an economic hedge. However, if the entire contract were to be measured at fair value, with changes in fair value reported in current earnings, or if the Bank could not reliably identify and measure the embedded derivative for purposes of separating that derivative from its host contract, the entire contract would be carried on the statement of condition at fair value and no portion of the contract would be separately accounted for as a derivative.

The Bank discontinues hedge accounting prospectively when: (1) management determines that the derivative is no longer effective in offsetting changes in the fair value of a hedged item; (2) the derivative and/or the hedged item expires or is sold, terminated, or exercised; (3) a hedged firm commitment no longer meets the definition of a firm commitment; or (4) management determines that designating the derivative as a hedging instrument in accordance with ASC 815 is no longer appropriate.

When fair value hedge accounting for a specific derivative is discontinued due to the Bank’s determination that such derivative no longer qualifies for hedge accounting treatment, the Bank will continue to carry the derivative on the statement of condition at its fair value, cease to adjust the hedged asset or liability for changes in fair value, and amortize the cumulative basis adjustment on the formerly hedged item into earnings over its remaining term using the level-yield method. In all cases in which hedge accounting is discontinued and the derivative remains outstanding, the Bank will carry the derivative at its fair value on the statement of condition, recognizing changes in the fair value of the derivative in current period earnings.

When hedge accounting is discontinued because the hedged item no longer meets the definition of a firm commitment, the Bank continues to carry the derivative on the statement of condition at its fair value, removing from the statement of condition any asset or liability that was recorded to recognize the firm commitment and recording it as a gain or loss in current period earnings.

Impact of Derivatives and Hedging Activities. The following table summarizes the notional balances and estimated fair values of the Bank’s outstanding derivatives at September 30, 2013 and December 31, 2012 (in thousands).



	September 30, 2013								December 31, 2012
	Notional Amount of Derivatives		Estimated Fair Value						Notional Amount of Derivatives		Estimated Fair Value
			Derivative Assets			Derivative Liabilities					Derivative Assets			Derivative Liabilities
Derivatives designated as hedging instruments under ASC 815
Interest rate swaps
Advances	$	5,041,678	$	13,081		$	273,413		$	6,723,412	$	115		$	521,397
Available-for-sale securities	4,924,934		7,013			584,956			4,924,934		30			797,572
Consolidated obligation bonds	15,944,410		42,034			104,731			19,401,230		95,457			16,946
Interest rate caps related to advances	25,000		6			—			28,000		9			—
Total derivatives designated as hedging instruments under ASC 815	25,936,022		62,134			963,100			31,077,576		95,611			1,335,915
Derivatives not designated as hedging instruments under ASC 815
Interest rate swaps
Advances	14,800		—			45			5,292		—			59
Consolidated obligation bonds	—		—			—			650,000		969			—
Basis swaps	3,700,000		12,181			—			4,700,000		13,001			—
Intermediary transactions	110,896		4,167			3,939			104,154		7,029			6,805
Interest rate swaptions related to optional advance commitments	—		—			—			50,000		—			—
Interest rate caps
Held-to-maturity securities	4,100,000		960			—			3,900,000		295			—
Intermediary transactions	110,000		2,816			2,816			110,000		1,809			1,809
Total derivatives not designated as hedging instruments under ASC 815	8,035,696		20,124			6,800			9,519,446		23,103			8,673
Total derivatives before collateral and netting adjustments	$	33,971,718	82,258			969,900			$	40,597,022	118,714			1,344,588

Cash collateral and related accrued interest			(937		)	(893,024		)			—			(1,228,553		)
Netting adjustments			(66,880		)	(66,880		)			(104,767		)	(104,767		)
Total collateral and netting adjustments⁽¹⁾			(67,817		)	(959,904		)			(104,767		)	(1,333,320		)
Net derivative balances reported in statements of condition			$	14,441		$	9,996				$	13,947		$	11,268

_____________________________


⁽¹⁾	Amounts represent the effect of legally enforceable master netting agreements or other legally enforceable arrangements between the Bank and its derivative counterparties that allow the Bank to offset positive and negative positions as well as the cash collateral held or placed with those same counterparties.

The following table presents the components of net gains (losses) on derivatives and hedging activities as presented in the statements of income for the three and nine months ended September 30, 2013 and 2012 (in thousands).



	Gain (Loss) Recognized in Earnings for the						Gain (Loss) Recognized in Earnings for the
	Three Months Ended September 30,						Nine Months Ended September 30,
	2013			2012			2013			2012
Derivatives and hedged items in ASC 815 fair value hedging relationships
Interest rate swaps	$	601		$	(896	)	$	2,850		$	(3,213	)
Interest rate caps	(3		)	(14		)	(3		)	(88		)
Total net gain (loss) related to fair value hedge ineffectiveness	598			(910		)	2,847			(3,301		)
Derivatives not designated as hedging instruments under ASC 815
Net interest income on interest rate swaps	692			2,491			2,958			8,357
Interest rate swaps
Advances	139			2			190			50
Consolidated obligation bonds	(154		)	395			(769		)	2,653
Consolidated obligation discount notes	—			—			—			784
Basis swaps	(1,270		)	(8,383		)	(452		)	(7,878		)
Intermediary transactions	(7		)	(3		)	4			(7		)
Interest rate swaptions related to optional advance commitments	—			(199		)	—			(1,933		)
Interest rate caps
Held-to-maturity securities	(661		)	(501		)	(565		)	(3,301		)
Intermediary transactions	—			—			—			6
Total net gain (loss) related to derivatives not designated as hedging instruments under ASC 815	(1,261		)	(6,198		)	1,366			(1,269		)
Net gains (losses) on derivatives and hedging activities reported in the statements of income	$	(663	)	$	(7,108	)	$	4,213		$	(4,570	)

The following table presents, by type of hedged item, the gains (losses) on derivatives and the related hedged items in ASC 815 fair value hedging relationships and the impact of those derivatives on the Bank’s net interest income for the three and nine months ended September 30, 2013 and 2012 (in thousands).



Hedged Item	Gain (Loss) on Derivatives			Gain (Loss) on Hedged Items			Net Fair Value Hedge Ineffectiveness ⁽¹⁾			Derivative Net Interest Income (Expense)⁽²⁾

Three Months Ended September 30, 2013
Advances	$	11,284		$	(11,539	)	$	(255	)	$	(32,660	)
Available-for-sale securities	(13,603		)	14,650			1,047			(20,117		)
Consolidated obligation bonds	10,041			(10,235		)	(194		)	29,898
Total	$	7,722		$	(7,124	)	$	598		$	(22,879	)

Three Months Ended September 30, 2012
Advances	$	(14,908	)	$	14,353		$	(555	)	$	(39,967	)
Available-for-sale securities	(51,566		)	51,536			(30		)	(18,275		)
Consolidated obligation bonds	3,550			(3,875		)	(325		)	34,945
Total	$	(62,924	)	$	62,014		$	(910	)	$	(23,297	)

Nine Months Ended September 30, 2013
Advances	$	173,158		$	(173,037	)	$	121		$	(107,868	)
Available-for-sale securities	152,903			(150,404		)	2,499			(60,327		)
Consolidated obligation bonds	(140,643		)	140,870			227			91,822
Total	$	185,418		$	(182,571	)	$	2,847		$	(76,373	)

Nine Months Ended September 30, 2012
Advances	$	(18,117	)	$	17,006		$	(1,111	)	$	(128,105	)
Available-for-sale securities	(147,513		)	147,067			(446		)	(52,232		)
Consolidated obligation bonds	(35,113		)	33,369			(1,744		)	123,386
Total	$	(200,743	)	$	197,442		$	(3,301	)	$	(56,951	)

_____________________________


⁽¹⁾	Reported as net gains (losses) on derivatives and hedging activities in the statements of income.


⁽²⁾	The net interest income (expense) associated with derivatives in ASC 815 fair value hedging relationships is reported in the statements of income in the interest income/expense line item for the indicated hedged item.

Credit Risk Related to Derivatives. The Bank is subject to credit risk due to the risk of nonperformance by counterparties to its derivative agreements. The Bank manages derivative counterparty credit risk through the use of master netting agreements or other similar collateral exchange arrangements, credit analysis, and adherence to the requirements set forth in the Bank’s Risk Management Policy and Finance Agency regulations. The Bank has transacted the vast majority of its interest rate exchange agreements bilaterally with large financial institutions under master netting agreements (as of September 30, 2013, the notional balance of transactions with bilateral counterparties totaled $32 billion). Some of these institutions (or their affiliates) buy, sell, and distribute consolidated obligations. The remainder of the Bank's interest rate exchange agreements have been cleared through a third-party central clearinghouse (as of September 30, 2013, the notional balance of cleared transactions totaled $2 billion). With cleared transactions, the Bank is exposed to credit risk in the event that the clearinghouse or the clearing member fails to meet its obligations to the Bank.

The notional amount of interest rate exchange agreements does not reflect the Bank’s credit risk exposure, which is much less than the notional amount. The Bank's net credit risk exposure is based on the current estimated cost, on a present value basis, of replacing at current market rates all interest rate exchange agreements with individual counterparties, if those counterparties were to default, after taking into account the value of any cash and/or securities collateral held or remitted by the Bank. For counterparties with which the Bank is in a net gain position, the Bank has credit exposure when the collateral it is holding (if any) has a value less than the amount of the gain. For counterparties with which the Bank is in a net loss position, the Bank has credit exposure when it has delivered collateral with a value greater than the amount of the loss position. The net exposure on derivative agreements is presented in Note 10. Based on the netting provisions and collateral requirements associated with its derivative agreements and the creditworthiness of its derivative counterparties, Bank management does not currently anticipate any credit losses on its derivative agreements.