Item 1.
Business.
COMPANY INFORMATION
Organizational Structure
The FHLBank is a regional wholesale bank that provides financial products and services to our member financial institutions. We are one of 12 District Banks in the FHLBank System; our region, known as the Fifth District, comprises Kentucky, Ohio and Tennessee. The U.S. Congress chartered the FHLBank System in the Federal Home Loan Bank Act of 1932 (the FHLBank Act) to improve liquidity in the U.S. housing market. Each District Bank is a government-sponsored enterprise (GSE) of the United States of America and operates as a separate entity with its own stockholders, employees, and Board of Directors. A GSE combines private sector ownership with public sector sponsorship. The FHLBanks are not government agencies and are exempt from federal, state, and local taxation (except real property taxes). The U.S. government does not guarantee, directly or indirectly, the debt securities or other obligations of the FHLBank System.
The FHLBank System also includes the Federal Housing Finance Agency (Finance Agency) and the Office of Finance. The Finance Agency is an independent agency in the executive branch of the U.S. government that regulates the FHLBanks, the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac). The Finance Agency oversees the conservatorships of Fannie Mae and Freddie Mac. The Office of Finance is a joint office of the District Banks established and regulated by the Finance Agency to facilitate the issuing and servicing of the FHLBank System's Consolidated Obligations.
In addition to being GSEs, the FHLBanks are cooperative institutions. This means that our stockholders are also our primary customers. Private-sector financial institutions voluntarily become members of our FHLBank and purchase capital stock in order to gain access to products and services. Only members can purchase capital stock. All Fifth District federally insured depository institutions, insurance companies that engage in residential housing finance, and community development financial institutions that meet standard eligibility requirements are permitted to apply for membership. By law, an institution is permitted to be a member of only one Federal Home Loan Bank, although a holding company through its subsidiaries may have memberships in more than one District Bank.
We require each member to own capital stock as a condition of membership and to hold additional stock above the membership stock amount when utilizing certain services. We issue, redeem, and repurchase capital stock only at its stated par value of $100 per share. By law, our stock may not be publicly traded.
The combination of public sponsorship and private ownership that drives our business model is reflected in the composition of our 17-member Board of Directors, all of whom our members elect. Ten directors are officers and/or directors of our member institutions, while the remaining directors are independent directors who represent the public interest.
The number of our members has been relatively stable in the last 10 years, ranging between 720 and 760. At the end of 2011, we had 741 members. As of December 31, 2011, we had 193 full-time employees and 3 part-time employees. Our employees are not represented by a collective bargaining unit.
Mission and Corporate Objectives
The FHLBank's mission is to support housing finance by providing financial intermediation between our member stockholders and the capital markets in order to facilitate and expand the availability of financing and flow of credit for housing and community lending throughout the Fifth District. We provide members with competitive services and a competitive return on their FHLBank capital investment through quarterly dividend payments. We finance our operations mostly by raising private-sector capital from member stockholders and by issuing high-quality debt in the capital markets with other FHLBanks. Our primary services include a reliable, readily available, low-cost source of funds called Advances and purchases of mortgage loans sold by our qualifying members. An important component of our mission related to public sector sponsorship is providing affordable housing programs and activities to support members in their efforts to assist low- and moderate- income people and communities.
Our corporate objectives are to:
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operate safely and soundly, remain able to raise funds in the capital markets, and optimize our counterparty and deposit ratings;
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expand business activity with members;
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earn and pay a stable long-term competitive return on members' capital stock;
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maximize the effectiveness of contributions to Housing and Community Investment programs; and
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maintain effective corporate governance processes.
To accomplish these objectives, we operate with a risk averse philosophy. We strive to maintain a conservative risk profile that will ensure we operate safely and soundly, promote prudent growth in Mission Asset Activity, consistently generate competitive earnings, and protect the par value of members' capital stock investment. We believe our business is financially sound, conservatively managed, and well capitalized on a risk-adjusted basis.
We practice this risk averse philosophy in many ways:
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We make conservative investment choices.
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We use derivatives only to hedge individual assets and liabilities, not for macro balance sheet hedging.
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We believe we operate with moderate market risk, limited credit risk, and virtually no residual liquidity risk, operational risk or capital impairment risk.
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We normally operate with less financial leverage than regulatorily permitted.
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We have not repurchased excess stock to bolster dividend rates.
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We have significantly increased retained earnings in the last ten years.
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We create a working and operating environment that emphasizes a stable employee base.
Member stockholders derive value from two sources: the competitive prices, terms, and characteristics of our products, and competitive dividend return on their capital investment. In order to maximize these two sources of membership value, we strike a balance between offering more attractively priced products, which tend to lower dividend payments, and paying attractive dividends. We believe members' investment in our capital stock is comparable to investing in high-grade short-term, or adjustable-rate, money market instruments or in adjustable-rate preferred equity instruments. Therefore, we structure our risk exposure so that earnings tend to move in the same direction as changes in short-term market rates, which furnishes member stockholders a degree of predictability on their dividend returns. One measure of this success in paying competitive dividends is that relatively few member stockholders have historically chosen, absent mergers and consolidations, to withdraw from membership or to request redemption of their stock held in excess of minimum requirements.
The guiding principles of being risk averse and balancing the two sources of membership value are motivated by the FHLBank's cooperative business model, in which stockholders and customers are the same entities, and the constant par value of stockholders' capital investment. Stockholder value and customer value both accrue from attractive products and services and a competitive dividend return on capital stock. The cooperative business model, as well as the FHLBank's straightforward business model and close regulatory oversight, imparts a strong incentive to operate with a conservative risk profile and to emphasize a long-term performance orientation.
Business Activities
Our principal activity is making readily available, competitively priced and fully collateralized Advances to members. Together with the issuance of collateralized Letters of Credit, Advances constitute our “Credit Services” business. As a secondary business line, we purchase qualifying residential mortgages through the Mortgage Purchase Program and hold them as portfolio investments. This program offers members a competitive alternative to the traditional secondary mortgage market. Together, these product offerings constitute our “Mission Asset Activity.”
In addition, through various Housing and Community Investment programs, we assist members in serving very low-, low-, and moderate-income housing markets and community economic development. These programs provide Advances at below-market rates of interest, as well as direct grants and subsidies, and can help members satisfy their regulatory requirements under the Community Reinvestment Act.
To a more limited extent, we also offer members various correspondent services that assist them in their administration of operations.
To help us achieve our mission, we invest in highly-rated debt instruments of financial institutions and the U.S. government and in mortgage-related securities. In practice, these investments normally include shorter-term liquidity instruments and longer-term mortgage-backed securities. Investments furnish liquidity, help us manage market risk exposure, enhance earnings, and (through the purchase of mortgage-related securities) support the housing market.
Our primary source of funding and liquidity is through participation in the issuance of the FHLBank System's unsecured debt securities - Consolidated Obligations - in the capital markets. A secondary source of funding is our capital. Obligations are the joint and several obligations of all 12 FHLBanks, backed only by the financial resources of these institutions. A critical component of the success of the System's operations is its ability to maintain a comparative advantage in funding, which is due largely to its GSE status. We regularly issue Obligations under a wide range of maturities, structures, and amounts, and at relatively favorable spreads to benchmark market interest rates (represented by U.S. Treasury securities and the London InterBank Offered Rate (LIBOR)) compared with many other financial institutions. We also execute cost-effective derivative transactions to help hedge market risk exposure. These capabilities enable us to offer members a wide range of Mission Asset Activity and enable members to access the capital markets, through their activities with the FHLBank, in ways that they may be unable to do without our services.
Ratings of Nationally Recognized Statistical Rating Organizations
The System's comparative advantage in funding is acknowledged in its excellent credit ratings from nationally recognized statistical rating organizations (NRSROs). Moody's Investors Service (Moody's) currently assign, and historically has assigned, the System's Obligations the highest ratings available: long-term debt is rated Aaa and short-term debt is rated P-1. It also assigns a Prime-1 short-term bond rating on each FHLBank. It affirmed these ratings in 2011. This action was taken based on Moody's expectation that the respective long-term ratings are unlikely to fall below the AA level and that the FHLBanks have sufficient asset liquidity for business operations in the event there would be any short-term disruptions in the short-term debt markets.
On August 5, 2011, Standard & Poor's downgraded the long-term sovereign rating of the United States from AAA to AA+ with a negative outlook and affirmed the A-1+ short-term rating. In conjunction with this action, on August 8, Standard & Poor's lowered the ratings (among other government-sponsored enterprises) on the FHLBank System's senior unsecured long-term debt and the counterparty rating on our FHLBank from AAA to AA+ with a negative outlook. The ratings actions on the FHLBank System (as well as other government-sponsored enterprises) reflect the downgrade of the United States because in the application of Standard & Poor's Government Related Entities criteria, FHLBank ratings are constrained by the long-term sovereign rating of the United States.
The agencies' rationales for the System's and our ratings include the FHLBank System's status as a GSE, the joint and several liability for Obligations, excellent overall asset quality, extremely strong capacity to meet our commitments to pay timely principal and interest on debt, strong liquidity, conservative use of derivatives, adequate capitalization relative to our risk profile, a stable capital structure, and the fact that no FHLBank has ever defaulted on repayment of, or delayed return of principal or interest on, any Obligation.
A credit rating is not a recommendation to buy, sell or hold securities. A rating organization may revise or withdraw its ratings at any time, and each rating should be evaluated independently of any other rating. We cannot predict what future actions, if any, a rating organization may take regarding the System's and our ratings.
Sources of Earnings
Our major source of revenue is interest income earned on Advances, Mortgage Purchase Program notes, and investments. Major items of expense are:
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interest paid on Consolidated Obligations and deposits to fund assets;
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costs of providing below-market-cost Advances and direct grants and subsidies under the Affordable Housing Program; and
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non-interest expenses (i.e., other expenses on the Statements of Income).
The largest component of earnings is net interest income, which equals interest income minus interest expense. We derive net interest income from the interest rate spread earned on assets and the use of financial leverage. Each of these can vary over time with changes in market conditions, including most importantly interest rates, business conditions and our risk management activities. The interest rate spread is the difference between the interest we earn on assets and the interest we pay on liabilities. Financial leverage results from funding a portion of interest-earning assets with capital on which we do not pay interest.
Regulatory Oversight
The Finance Agency is headed by a director (the Director) who has sole authority to promulgate Agency regulations and to make other Agency decisions. The Finance Agency is charged with ensuring that each FHLBank carries out its housing and community development finance mission, remains adequately capitalized, operates in a safe and sound manner, and complies with Finance Agency Regulations.
To carry out these responsibilities, the Finance Agency conducts on-site examinations at least annually of each FHLBank, as well as periodic on- and off-site reviews, and receives monthly information on each FHLBank's financial condition and operating results. While an individual FHLBank has substantial discretion in governance and operational structure, the Finance Agency maintains broad supervisory and regulatory authority. In addition, the Comptroller General has authority to audit or examine the Finance Agency and the FHLBanks, to decide the extent to which the FHLBanks fairly and effectively fulfill the purposes of the FHLBank Act, and to review any audit, or conduct its own audit, of the financial statements of an FHLBank.
BUSINESS SEGMENTS
We manage the development, resource allocation, product delivery, pricing, credit risk management, and operational administration of our Mission Asset Activity in two business segments: Traditional Member Finance and the Mortgage Purchase Program. Traditional Member Finance includes Credit Services, Housing and Community Investment, Investments, some correspondent and deposit services, and other financial products of the FHLBank. See the “Segment Information” section of “Results of Operations” in Item 7 and Note 19 of the Notes to Financial Statements for more information on our business segments, including their results of operations.
Traditional Member Finance
Credit Services
Features. Advances provide members competitively priced sources of funding to manage their asset/liability and liquidity needs. Advances can both complement and be alternatives to retail deposits, other wholesale funding sources, and corporate debt issuance. We strive to facilitate efficient, fast, and continual access to funds for our members, which we believe provides them with substantial benefits. In most cases members can access funds on a same-day basis.
Each member is required to supply us with a security interest in eligible collateral with an estimated value in excess of total Advances and Letters of Credit. Collateral is comprised primarily of 1-4 family residential mortgage loans. We believe that the combination of conservative collateral policies and risk-based credit underwriting activities effectively mitigate all credit risk associated with Advances. We have never experienced a credit loss on Advances, nor have we ever determined it necessary to establish a loss reserve. Item 7's “Quantitative and Qualitative Disclosures About Risk Management” and Notes 9 and 11 of the Notes to Financial Statements have more detail on our credit risk management of member borrowings.
Letters of Credit are collateralized contractual commitments we issue on a member's behalf to guarantee its performance to third parties. A Letter of Credit may obligate us to make direct payments to a third party, in which case it is treated as an Advance to the member. The most popular use of Letters of Credit is as collateral supporting public unit deposits, which are deposits held by governmental units at financial institutions. We earn fees on Letters of Credit based on the actual notional amount of the Letters utilized.
We price 13 standard Advance programs every business day and several other standard programs on demand. We also offer customized, non-standard Advances that fall under one of the standard programs. Having diverse programs gives members the flexibility to choose and customize their borrowings according to size, maturity, interest rate, interest rate index (for adjustable-rate coupons), interest rate options, and other features.
Advance Programs. Repurchase based (REPO) Advances are short-term, fixed-rate instruments structured similarly to repurchase agreements from investment banks, with one principal difference. Members collateralize their REPO Advances through our normal collateralization process, instead of being required to pledge specific securities as would be required in a repurchase agreement. A majority of REPO Advances outstanding tend to have overnight maturities.
LIBOR Advances have adjustable interest rates typically priced off 1- or 3-month LIBOR indices. Generally, prepayment is permitted without a fee if it is made on a repricing date.
Regular Fixed Rate Advances have terms of three months to 30 years, with interest normally paid monthly and principal repayment normally at maturity. Members may choose to purchase call options on these Advances, although in the last 5 years, balances with call options have been at or close to zero.
Putable and Convertible Advances are fixed- or adjustable-rate Advances that provide us an option to terminate the Advance (for the Putable) or an option to convert it to a LIBOR Advance (for the Convertible), usually after an initial “lockout” period. Most have fixed-rates with long-term original maturities. Selling us these options enables members to secure lower rates on Putable/Convertible Advances compared to Regular Fixed Rate Advances with the same final maturity. Although we stopped offering Convertible Advances at the beginning of 2006, we still have outstanding balances.
Mortgage-Related Advances are fixed-rate, amortizing Advances with final maturities of 5 to 30 years. Some of these Advances, at the choice of the member, provide members with prepayment options without fees.
We also offer several other Advance programs that have smaller outstanding balances.
Advance Prepayment Fees. For many Advance programs, Finance Agency Regulations require us to charge members prepayment fees for early termination of principal when the early termination results in an economic loss to us. We do not charge prepayment fees for certain Advance programs. Some Advance programs are structured as non-prepayable, such as REPO Advances.
We determine prepayment fees using standard present-value calculations that make us economically indifferent to the prepayment. The prepayment fee equals the present value of the estimated profit that we would have earned over the remaining life of the prepaid Advance. If a member prepays principal on an Advance that we have hedged with an interest rate swap, we may also assess the member a fee to compensate us for the cost we incur in terminating the swap before its stated final maturity.
Housing and Community Investment
Our Housing and Community Investment Programs include the Affordable Housing Program and various housing and community economic development-related Advance programs. We fund the Affordable Housing Program with an accrual equal to 10 percent of our previous year's regulatory income, mandated by the Financial Institutions Reform, Recovery and Enforcement Act of 1989 (FIRREA). See Note 15 of the Notes to Financial Statements for a complete description of the Affordable Housing calculation.
The Affordable Housing Program provides funds by partnering with members and housing organizations. The Program consists of a competitive program and a homeownership set-aside program, called the Welcome Home Program. Under the competitive program, we distribute funds in the form of either grants or below-market rate Advances to members that apply and successfully compete in semiannual offerings. Under the Welcome Home Program, funds are normally available beginning in March until they have been fully committed. For both programs, the income of qualifying individuals or households must be 80 percent or less of the area median income. Up to 35 percent of the Affordable Housing accrual is set aside for the Welcome Home Program and the remainder allocated to the competitive program.
Our Board of Directors also may allocate funds to voluntary housing programs, which it reviews annually. In 2010, the Board allocated $1.0 million for the Carol M. Peterson Housing Fund. The funds are primarily used as grants to pay for accessibility rehabilitation and emergency repairs for special needs and elderly homeowners.
Two other housing programs that fall outside the auspices of the Affordable Housing Program are the Community Investment Program and the smaller Economic Development Program. Advances under the former program have rates equal to our cost of funds, while Advances under the latter program have rates equal to our cost of funds plus three basis points. Members use the Community Investment Program to serve housing needs of low- and moderate-income people and, under certain conditions, community economic development projects; they use the Economic Development Program exclusively for economic development projects.
Investments
We hold both liquidity investments, most of which normally have short-term maturities, and longer-term investments. Liquidity investments are comprised of overnight and term Federal funds, certificates of deposit, bank notes, bankers' acceptances, commercial paper, securities purchased under agreements to resell, debt securities issued by the U.S. government or its agencies and debt securities issued by the International Bank for Reconstruction and Development. We also may place deposits with the Federal Reserve Bank.
We are also permitted by Finance Agency Regulations to purchase the following other investments, most of which have longer-term original maturities:
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mortgage-backed securities and collateralized mortgage obligations supported by mortgage securities (together, referred to as mortgage-backed securities) and issued by GSEs or private issuers;
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asset-backed securities collateralized by manufactured housing loans or home equity loans and issued by GSEs or private issuers; and
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marketable direct obligations of certain government units or agencies (such as state housing finance agencies) that supply needed funding for housing or community lending and that do not exceed 20 percent of our regulatory capital.
We have never purchased any asset-backed security and historically have limited our purchases of privately-issued mortgage-backed securities to a small percentage of our total investments. Per regulation, the total investment in mortgage-backed securities and asset-backed securities may not exceed, on a book value basis, 300 percent of previous month-end regulatory capital on the day we purchase the securities. (See the “Capital Resources” section below for the definition of regulatory capital.)
The investments portfolio helps achieve our corporate objectives in the following ways:
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Liquidity management. As their name implies, liquidity investments help us manage liquidity and support our ability to fund most Advances on the same day members request them. We can structure short-term debt issuances so that the liquidity investments mature sooner than this debt, providing a source of contingent liquidity. We also may be able to transform certain investments to cash without a significant loss of value.
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Earnings enhancement. The investments portfolio assists with earning a competitive return on capital, which also increases our commitment to Housing and Community Investment programs.
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Market risk management. Liquidity investments help stabilize earnings because they typically earn a relatively stable spread to the cost of debt issued to fund them, with less market risk than mortgage assets.
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Debt issuance management. Maintaining a short-term liquidity investment portfolio can help us participate in attractively priced debt issuances, on an opportunistic basis. We can temporarily invest proceeds from debt issuances in short-term liquid assets and quickly access them to fund demand for Mission Asset Activity, rather than having debt issuances dictated solely by the timing of member demand.
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Support of housing market. Investment in mortgage-backed securities and state housing finance agency bonds directly supports the residential mortgage market by providing capital and financing for mortgages.
We strive to ensure our investment purchases have a moderate degree of market risk and limited credit risk, which tends to lower the returns we can expect to earn on these securities. We believe that a philosophy of purchasing investments with a high degree of market or credit risk would be inconsistent with our GSE status, Finance Agency Regulations and our internal policies. Our internal policies specify general guidelines for, and relatively tight constraints on, the types, amounts, and risk profile of investments we are permitted to hold and the maximum amount of credit risk exposure we are permitted to have with eligible counterparties. We are permitted to invest only in the instruments of counterparties with high credit ratings, and because of our investment policies and practices, we believe all of our investments have high credit quality. We have never had a credit loss or credit-related write down of any investment security. Item 7's “Quantitative and Qualitative Disclosures About Risk Management” has more detail on our credit risk management of investments.
Deposits
We provide a variety of deposit programs, including demand, overnight, term and Federal funds, which enable depositors to invest idle funds in short-term liquid assets. We accept deposits from members, other FHLBanks, any institution to which we offer correspondent services, and other government instrumentalities. The rates of interest we pay on deposits are subject to change daily based on comparable money market interest rates. The balances in deposit programs tend to vary positively with the amount of idle funds members have available to invest as well as the level of short-term interest rates. Deposits have represented a small component of our funding in recent years, typically between one and two percent of our funding sources.
Mortgage Purchase Program (Mortgage Loans Held for Portfolio)
Features and Benefits of the Mortgage Purchase Program
Finance Agency Regulations permit the FHLBanks to purchase and hold specified mortgage loans from their members. We offer the Mortgage Purchase Program, which directly supports our public policy mission of supporting housing finance. By selling mortgage loans to us, members can increase their balance sheet liquidity and reduce their interest rate and mortgage prepayment risks. Our Program, along with similar programs at other FHLBanks, promotes a greater degree of competition among mortgage investors. It also enables small- and medium-sized community-based financial institutions to use their existing relationship with us to participate more effectively in the secondary mortgage market. Finally, the Program enhances our long-term profitability on a risk-adjusted basis, which augments the return on member stockholders' capital investment.
Under the Mortgage Purchase Program, we purchase two types of loans: qualifying conforming fixed-rate conventional 1-4 family residential loans and residential mortgages fully guaranteed by the Federal Housing Administration (FHA). Members approved to sell us loans are referred to as Participating Financial Institutions (PFIs).We hold purchased mortgage loans on our balance sheet and account for them as mortgage loans held for portfolio. Although we are permitted to purchase qualifying mortgage loans originated within any state or territory of the United States, we currently do not purchase loans originated in New York, Massachusetts, Maine, Rhode Island or New Jersey due to features of those states' Anti-Predatory Lending laws that are less restrictive than we prefer.
A “conventional” mortgage refers to a non-government-guaranteed mortgage. A “conforming” mortgage refers to the maximum amount permissible to be lent as a regular prime (i.e., non-jumbo, non-subprime) mortgage. For 2012, the Finance Agency established that limit at $417,000, the same as 2006-2011, with loans originated in a limited number of high-cost cities and counties receiving higher conforming limits. Our policies prohibit us from purchasing conforming mortgages subject to these higher amounts.
Loan Purchase Process
A Master Commitment Contract is negotiated with each PFI, in which the PFI agrees to make a best efforts attempt to sell us a specific dollar amount of loans generally over a period of up to 12 months. We purchase loans pursuant to a Mandatory Delivery Contract, which is a legal commitment we make to purchase, and a PFI makes to deliver, a specified dollar amount of mortgage loans, with a forward settlement date, at a specified range of mortgage note rates and prices. Shortly before delivering the loans that will fill in the Mandatory Delivery Contract, the PFI must submit loan level detail including underwriting information. We apply procedures through the automated Loan Acquisition System designed to screen out loans that do not comply with our policies. Our underwriting guidelines generally mirror those of Fannie Mae and Freddie Mac for conforming conventional loans, although our guidelines and pool composition requirements are more conservative in a number of ways in order to further limit credit risk exposure. PFIs are required to make certain representations and warranties against our underwriting guidelines on the loans they sell to us. If loans are sold in breach of those representations and warranties, we have the contractual right to require the PFI to repurchase those loans.
Allocation of Activities and Risks Between Members and the FHLBank
A unique feature of the Mortgage Purchase Program is that it separates the various activities and risks associated with residential mortgage lending for conventional loans. We manage the funding of the loans, interest rate risk (including prepayment risk), and liquidity risk. PFIs manage marketing, originating and, in most cases, servicing. PFIs may either retain servicing or sell it to a qualified and approved third-party servicer (also referred to as a PFI). Because PFIs manage and bear most of the credit risk, they do not pay us a guarantee fee to transfer credit risk. The conventional Program has a feature, the Lender Risk Account, that helps us manage residual credit risk. The Lender Risk Account is a purchase-price holdback that PFIs may receive back from us, starting five years from the loan purchase date, for managing credit risk to pre-defined acceptable levels of exposure on loan pools they sell to us. Actual loan losses are deducted against the amount we return to the PFI. The Lender Risk Account provides PFIs with a strong incentive to sell us high quality performing mortgage loans. We believe we bear no credit risk on purchased FHA loans due to the explicit FHA guarantee.
Credit risk exposure is mitigated for conventional loans through underwriting and pool composition requirements and by applying layered credit enhancements. These enhancements, which apply after a homeowner's equity is exhausted, include (in order of priority) primary mortgage insurance (when applicable), the Lender Risk Account, and Supplemental Mortgage Insurance (when applicable) that the PFI purchases from one of our approved third-party providers naming us as the beneficiary.
Beginning in February 2011, we made changes in our credit enhancement structure that we believe further mitigate our credit risk exposure. We discontinued use of Supplemental Mortgage Insurance for new loan purchases and replaced it with expanded use of the Lender Risk Account and aggregation of loan purchases into larger pools to provide diversification in credit risk exposure. These changes were motivated by the deterioration in the housing and mortgage markets in 2007-2010. One result of this deterioration has been that the providers of supplemental mortgage insurance used in the Mortgage Purchase Program now have ratings below the double-A rating required by a Finance Agency Regulation. In addition, the insurers continually increased the cost of purchasing supplemental mortgage insurance, which threatened our ability to competitively price mortgages in the Program. These credit enhancement changes maintain compliance with the Program's legal, accounting, and other regulatory requirements, preserve the Program's favorable credit risk profile, and enable the Program to continue as a beneficial business activity for our members.
The totality of the credit enhancements, which we determine through use of a third-party default model, have historically protected, and continue to protect, us against credit risk exposure on each conventional loan down to approximately a 50 percent “loan-to-value” level at the time of origination, subject, in certain cases, to an aggregate stop-loss feature in the Supplemental Mortgage Insurance policy. Item 7's “Quantitative and Qualitative Disclosures About Risk Management” has more detail on our credit risk management of the Mortgage Purchase Program.
Earnings from the Mortgage Purchase Program
We generate earnings in the Program from monthly interest payments minus the cost of funding and the cost of hedging the Program's interest rate risk. Interest income on each loan is computed as the mortgage note rate multiplied by the loan's principal balance:
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minus servicing costs (0.25 percent for conventional loans and 0.44 percent for FHA loans);
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minus the cost of Supplemental Mortgage Insurance (as applicable); and
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adjusted for the amortization of purchase premiums or the accretion of purchase discounts and for the amortization or accretion of fair value adjustments on commitments.
For new loan purchases, we consider the cost of the Lender Risk Account when we set conventional loan prices and evaluate the Program's expected return. The pricing of each structure depends on a number of factors and is specific to the PFI and to the loan pool. We do not receive fees or income for retaining the risk of losses in excess of any credit enhancements.
CONSOLIDATED OBLIGATIONS
Our primary source of funding is through participation in the sale of Consolidated Obligations. There are two types of Obligations: Consolidated Bonds (Bonds) and Consolidated Discount Notes (Discount Notes). We participate in the issuance of Bonds for three purposes:
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to finance and hedge intermediate- and long-term fixed-rate Advances and mortgage assets;
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to finance and hedge short-term, LIBOR-indexed adjustable-rate Advances, and swapped Advances, typically by synthetically transforming fixed-rate Bonds to adjustable-rate LIBOR funding through the execution of interest rate swaps; and
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to acquire liquidity.
Bonds may have fixed or adjustable (i.e., variable) rates of interest. Fixed-rate Bonds are either noncallable or callable. Generally, our adjustable-rate Bonds use LIBOR for interest rate resets. In the last three years, we have not issued step-up Bonds, range Bonds, zero coupon Bonds or other similarly complex instruments. The maturity of Bonds typically ranges from one year to 20 years. We participate in the issuance of Discount Notes to fund short-term Advances, adjustable-rate Advances, swapped Advances, liquidity investments, and a portion of longer-term fixed-rate assets. Discount Notes have maturities from one day to one year, with most of ours normally maturing within three months.
There are frequent changes in the interest rates and prices of Obligations and in their interest cost relationship to other products such as U.S. Treasury securities and LIBOR. Interest costs are affected by a multitude of factors including (but not limited to): overall economic and credit conditions; credit ratings of the FHLBank System; investor demand and preferences for our debt securities; the level of interest rates and the shape of the U.S. Treasury curve and the LIBOR swap curve; and the supply, volume, timing, and characteristics of debt issuances by the FHLBanks, other GSEs, and other highly rated issuers.
Finance Agency Regulations govern the issuance of Consolidated Obligations. The Office of Finance services Obligations, prepares the FHLBank System's quarterly and annual combined financial statements, serves as a source of information for the FHLBanks on capital market developments, and administers the Resolution Funding Corporation (REFCORP). REFCORP was established by Congress to provide funding for the resolution and disposition of insolvent savings institutions. The FHLBank's obligations to REFCORP were fulfilled in 2011.
We have the primary liability for our portion of Obligations, i.e., those issued on our behalf for which we receive the proceeds. However, we also are jointly and severally liable with the other 11 FHLBanks for the payment of principal and interest on all Obligations. If we do not pay the principal or interest in full when due on any Obligation issued on our FHLBank's behalf, we are prohibited from paying dividends or redeeming or repurchasing shares of capital stock. If another FHLBank were unable to repay its participation in an Obligation for which it is the primary obligor, the Finance Agency could call on each of the other FHLBanks to repay all or part of the Obligation. The Finance Agency has never invoked this authority.
An FHLBank may not issue individual debt securities without Finance Agency approval.
LIQUIDITY
The FHLBank's operations require a continual and substantial amount of liquidity to provide members access to timely Advance funding and mortgage loan sales in all financial environments and to meet financial obligations (primarily maturing Consolidated Obligations) as they come due in a timely and cost-efficient manner. Liquidity risk is the risk that we will be unable to satisfy these obligations or to meet the Advance and Mortgage Purchase Program funding needs of members in a timely and cost-efficient manner. Liquidity requirements are significant because Advance balances can be highly volatile, many have short-term maturities, and we strive to offer access to Advances on the same day members request them. We regularly monitor liquidity risks and the investment and cash resources available to meet liquidity needs, as well as statutory and regulatory liquidity requirements.
Because Obligations have favorable credit ratings and because the FHLBank System is one of the largest sellers of debt in the worldwide capital markets, the System historically has been able to satisfy its liquidity needs through flexible debt issuance across a wide range of structures at relatively favorable spreads to benchmark market interest rates. This was the case even during the severe financial crisis of late 2008 and early 2009.
Besides proceeds from debt issuances, we also raise liquidity via our liquidity investment portfolio and the ability to sell certain investments without significant accounting consequences. Our sources of asset liquidity include cash, maturing Advances, maturing investments, principal paydowns of mortgage assets, the ability to sell certain investments, and interest payments received. Uses of liquidity include repayments of Obligations, issuances of new Advances, purchases of loans under the Mortgage Purchase Program, purchases of investments, and payments of interest.
CAPITAL RESOURCES
Capital Plan
Basic Characteristics
Our Capital Plan enables us to efficiently expand and contract capital needed to capitalize assets in response to changes in the membership base and their credit needs. We have always offered only one class of capital stock, Class B, which is conditionally redeemable upon a member's five-year advance written notice. The Capital Plan permits us to issue shares of capital stock only under the following circumstances:
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as required for an institution to become a member or maintain membership;
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as required for a member to capitalize Mission Asset Activity; and
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to pay stock dividends.
Under Finance Agency Regulations, regulatory capital is composed of all capital stock (including stock classified as mandatorily redeemable), retained earnings, general loss allowances, and other amounts from sources the Finance Agency determines are available to absorb losses. Currently, our regulatory capital consists of capital stock and retained earnings. Under the Gramm-Leach-Bliley Act of 1999 (GLB Act), permanent capital equals Class B stock plus retained earnings and is available to absorb financial losses.
GAAP capital excludes mandatorily redeemable capital stock, while regulatory capital includes it. Mandatorily redeemable capital stock is accounted for as a liability on our Statements of Condition and related dividend payments are accounted for as interest expense. The classification of some capital stock as a liability has no effect on our safety and soundness, liquidity position, market risk exposure, or ability to meet interest payments on our participation in Obligations. Mandatorily redeemable capital stock is fully available to absorb losses until the stock is redeemed or repurchased. See Note 17 of the Notes to Financial Statements for more discussion of mandatorily redeemable capital stock.
The GLB Act also requires us to satisfy three capital requirements, the most important of which is a minimum 4.00 percent regulatory capital-to-assets ratio. Capital requirements are further discussed in the “Capital Adequacy” section of Item 7's “Quantitative and Qualitative Disclosures About Risk Management.”
The Capital Plan enables us to efficiently obtain new stock to capitalize asset growth, thereby maintaining a prudent amount of financial leverage. It also enables us to deploy excess capital into Mission Assets. When Mission Asset Activity contracts, it permits us, at our option, to repurchase capital stock in a timely and prudent manner, thereby maintaining adequate profitability. Additionally, the concept of “cooperative capital” explained below better aligns the interests of heavy users of our products with light users by enhancing the dividend return.
Membership Stock, Activity Stock, Excess Stock, and Cooperative Capital
Our Capital Plan ties the amount of each member's required capital stock to both the amount of the member's assets (membership stock) and the amount and type of its Mission Asset Activity with us (activity stock). Membership stock is required to become a member and maintain membership. The amount required currently ranges from 0.15 percent to 0.03 percent of each member's total assets, with a minimum of $1 thousand and a maximum of $25 million for each member, which was reduced in 2011 from the previous limit of $50 million.
In addition to its membership stock, a member may be required to purchase and hold activity stock to capitalize its Mission Asset Activity. For purposes of the Capital Plan, Mission Asset Activity includes the principal balance of Advances, guaranteed funds and rate Advance commitments (GFR), and the principal balance of loans and commitments in the Mortgage Purchase Program that occurred after implementation of the Capital Plan.
The FHLBank must capitalize all Mission Asset Activity with capital stock at a rate of at least four percent. By contrast, each member must maintain an amount of Class B activity stock within the range of minimum and maximum percentages for each type of Mission Asset Activity. The current percentages are as follows:
If a member's capitalization of Mission Asset Activity falls to the minimum percentage, it must purchase additional stock to capitalize further Mission Asset Activity. If a member owns more stock than is needed to satisfy its membership stock requirement and the maximum activity stock percentage for its Mission Asset Activity, we designate the remaining stock as the member's excess capital stock. We are permitted to repurchase excess capital stock at any time, subject to the terms and conditions of the Capital Plan.
If an individual member's excess stock reaches zero, the Capital Plan normally permits us, within certain limits, to capitalize additional Mission Asset Activity of that member with excess stock owned by other members at the maximum percentage rate. This feature, called “cooperative capital,” enables us to more effectively utilize our capital stock. A member's use of cooperative capital reduces the ratio of its activity stock to its Mission Asset Activity for each type of Mission Asset Activity. When this ratio reaches the minimum activity stock percentage for all types of Mission Asset Activity, the member must capitalize additional Mission Asset Activity of a given type by purchasing capital stock at that asset type's minimum percentage rate. When the member's use of cooperative excess reaches $100 million or the FHLBank's excess stock is fully utilized, the member must capitalize additional Mission Asset Activity by purchasing capital stock at the maximum percentage rate.
Retained Earnings
Retained earnings are important to protect members' capital stock investment against the risk of impairment and to enhance our ability to pay stable and competitive dividends when earnings may be volatile in light of the risks we face. Impairment risk is the risk that members would have to write down the par value of their capital stock investment in our FHLBank as a result of their analysis of ultimate recoverability. An extreme situation of earnings instability, in which losses exceeded the amount of our retained earnings for a period of time determined to be other-than-temporary, could result in a determination that the value of our capital stock was impaired.
Our Retained Earnings Policy sets forth a range for the amount of retained earnings we believe is needed to mitigate impairment risk and augment dividend stability in light of the risks we face. The upper end of the minimum retained earnings requirement is currently $350 million, based on mitigating all of our combined risks under stress scenarios to at least a 99 percent confidence level. Given the recent financial and regulatory environment, we have been carrying a greater amount of retained earnings in the last several years than required by the Policy. At the end of 2011, our retained earnings totaled $444 million. We believe the current amount of retained earnings is sufficient to protect our capital stock against impairment risk and to provide the opportunity for dividend stability.
The 12 Federal Home Loan Banks entered into a Joint Capital Enhancement Agreement (the “Capital Agreement”) in February 2011. The Capital Agreement provides that upon satisfaction of the FHLBanks' obligations to make payments related to REFCORP, each FHLBank will, on a quarterly basis, allocate at least 20 percent of its net income to a restricted retained earnings account (the “Account”) up to a maximum level described below. The 20 percent reserve allocation to the Account is similar to what has been required under REFCORP. In August 2011, the Finance Agency certified that the FHLBanks had fully satisfied their REFCORP obligation. Starting in the third quarter of 2011, we began to allocate 20 percent of our net income to the Account, which is not available to be distributed as dividends except under certain limited circumstances. The Capital Agreement does not limit the ability to use our retained earnings outside of the Account to pay dividends.
Each FHLBank is required to build its Account to an amount equal to one percent of the most recent-quarter's average carrying value (excluding certain fair value adjustments) of its share of Consolidated Obligations. Based on historical earnings levels, we expect that it will take many years to achieve the one percent requirement.
Although we have always maintained compliance with our capital requirements, the Capital Agreement will enhance risk mitigation by building a larger capital buffer over time to absorb unexpected losses, if any, that we may experience. Therefore, the Capital Agreement will result in additional protection against impairment risk to stockholders' capital investment. We
believe the Capital Agreement will also provide even greater certainty to investors about our ability to pay principal and interest on Consolidated Obligations, augment the stability of members' returns on their capital investment, and strengthen the long-term viability of the Affordable Housing Program, which will receive increased contributions as a result of this change.
USE OF DERIVATIVES
Finance Agency Regulations and FHLBank policies establish guidelines for the execution and use of derivative transactions. We are prohibited from trading in or the speculative use of derivatives and have limits on the amount of credit risk to which we may be exposed. Most of our derivatives activity involves interest rate swaps, some of which may include options. We account for all derivatives at their fair values.
Similar to our participation in debt issuances, derivatives help us hedge market risk created by Advances and mortgage commitments. Derivatives related to Advances most commonly hedge either:
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below-market rates and/or the market risk exposure on Putable and Convertible Advances, and certain other Advances, for which members have sold us options embedded within the Advances; or
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Regular Fixed Rate Advances when it may not be as advantageous to issue Obligations or when it may improve our market risk management.
We also use derivatives to hedge the market risk created by commitment periods of Mandatory Delivery Contracts in the Mortgage Purchase Program.
Other derivatives related to Consolidated Obligation Bonds help us intermediate between the normal preferences of capital market investors for intermediate- and long-term fixed-rate debt securities and the normal preferences of our members for shorter-term or adjustable-rate Advances. We can satisfy the preferences of both groups by issuing long-term fixed-rate Bonds and entering into an interest rate swap that synthetically converts the Bonds to an adjustable-rate LIBOR funding basis that matches up with the short-term and adjustable-rate Advances, thereby preserving a favorable interest rate spread.
Because we have a cooperative business model, our Board of Directors has emphasized the importance of minimizing earnings volatility, including volatility from the use of derivatives. Accordingly, our strategy is to execute derivatives that we expect to be highly effective hedges of market risk exposure. Therefore, the volatility in the market value of equity and earnings from our use of derivatives has historically tended to be moderate. In this context, we have not executed derivatives, nor do we currently plan to do so, to hedge market risk exposure outside of specifically identified assets or liabilities. We believe that the economic benefits of using derivatives to hedge at the level of the entire balance sheet instead of individual instruments would generally be less than the increased hedging costs and risks, which include potentially higher earnings volatility.
RISK MANAGEMENT
Our FHLBank faces various risks that could affect the ability to achieve our mission and corporate objectives. We categorize risks into 1) business/strategic risk, 2) regulatory/legislative risk), 3) market risk (also referred to as interest rate or prepayment risk), 4) capital adequacy, 5) credit risk, 6) funding/liquidity risk, 7) accounting risk, and 8) operational risk (including fraud risk). Our Board of Directors establishes corporate objectives regarding risk philosophy, risk tolerances, and financial performance expectations. We have numerous Board-adopted policies and processes that address risk management. These policies establish risk tolerances, limits, and guidelines, must comply with all Finance Agency Regulations, and are designed to achieve continual safe and sound operations. The Board delegates day-to-day responsibility for managing and controlling most of these risks to senior management. Our cooperative business model, corporate objectives, and strong regulatory oversight provide us clear incentives to minimize risk exposures to the extent possible. Risk management practices are infused throughout all of our business activities.
Our policies and operating practices are designed to limit risk exposures from ongoing operations in the following broad ways:
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by anticipating potential business risks and appropriate responses;
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by defining permissible lines of business;
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by limiting the kinds of assets we are permitted to hold in terms of their credit risk exposure and the kinds of hedging and financing arrangements we are permitted to use;
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by limiting the amount of market risk and capital risk to which we are permitted to be exposed;
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by specifying very conservative tolerances for credit risk posed by Advances;
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by specifying capital adequacy minimums; and
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by requiring strict adherence to internal controls and operating procedures, adequate insurance coverage, and comprehensive Human Resources policies, procedures, and strategies.
We actively manage risk exposures on a departmental basis and through a company-wide enterprise risk management framework. We also manage risk via regular reporting to and discussion with the Board of Directors and its committees, particularly the Finance and Risk Management Committee and the Audit Committee, as well as by continuous discussion and decision-making among key personnel across the FHLBank.
COMPETITION
Numerous economic and financial factors influence the use of Advances by our members as a competitive alternative for their balance sheet funding needs. The most important factor that affects Advance demand is the general availability of competitively-priced local retail deposits, which most members view as their primary funding source. In addition, both small and large members typically have access to brokered deposits, repurchase agreements and public unit deposits, each of which presents a competitive alternative to Advances. Larger members also have greater access to other competitive sources of funding and asset/liability management facilitated via the national and global credit markets. These sources include subordinated debt, interbank loans, covered bonds, interest rate swaps, options, bank notes, and commercial paper.
An important source of competition for Advances exists from the various ongoing fiscal and monetary stimuli initiated by the federal government to combat the continued difficulties in the housing market and broader economy. These government actions, and their effects on our business, are discussed in Item 1A's “Risk Factors” and in Item 7's “Executive Overview" and "Conditions in the Economy and Financial Markets."
The holding companies of some of our large asset members have membership(s) in other FHLBanks through affiliates chartered in other FHLBank Districts. Others could initiate memberships in other Districts. The competition among FHLBanks for the business of multiple-membership institutions is similar to the FHLBanks' competition with other wholesale lenders and other mortgage investors. We compete with other FHLBanks on the offerings and pricing of Mission Asset Activity, earnings and dividend performance, collateral policies, capital plans, and members' perceptions of our relative safety and soundness. Some members may also evaluate benefits of diversifying business relationships among FHLBank memberships. We regularly monitor, to the extent possible, these competitive forces among the FHLBanks.
The primary competitors for loans we purchase in the Mortgage Purchase Program are other housing GSEs, government agencies (Ginnie Mae), other FHLBanks, private issuers, and, beginning in 2009, the U.S. government. We compete primarily based on price, products, and services. Fannie Mae and Freddie Mac in particular have long-established and efficient programs and are the dominant purchasers of residential conforming fixed-rate conventional mortgages. In addition, a number of private financial institutions have well-established securitization programs, although they may not currently be as active as historically. The Program also may compete with the Federal Reserve to the extent it purchases mortgage-backed securities.
For debt issuance, the FHLBank System competes with issuers in the national and global debt markets, including most importantly the U.S. government and other GSEs. Competitive factors include, but are not limited to, interest rates offered; the amount of debt offered; the market's perception of the credit quality of the issuing institutions and the liquidity of the debt; the types of debt structures offered; and the effectiveness of debt marketing activities.
TAX STATUS
We are exempt from all federal, state, and local taxation other than real property taxes. However, any cash dividends we issue are taxable to members and do not benefit from the corporate dividends received exclusion. Notes 1, 15, and 16 of the Notes to Financial Statements have additional details regarding the assessments for the Affordable Housing Program and REFCORP.
Item 1A.
Item 1A. Risk Factors.
The following are the most important risks we currently face. The realization of one or more of the risks could negatively affect our results of operations, financial condition, and, at the extreme, the viability of our business franchise. The effects could include reductions in Mission Asset Activity, lower earnings and dividends, and, in extreme situations, impairment of our capital or an inability to participate in issuances of Consolidated Obligations. The risks identified below are not the only risks we face. Additional risks not presently known or which we currently deem immaterial may also impact our business, and the risks identified may adversely affect our business in ways not anticipated.
An economic downturn could further reduce Mission Asset Activity and profitability.
Member demand for Mission Asset Activity depends in part on the general health of the economy and business conditions. Because our business tends to be cyclical, a recessionary economy, or an economy characterized by stagflation in which growth is weak but inflation high, normally lowers the amount of Mission Asset Activity, can decrease profitability and can cause stockholders to request redemption of a portion of their capital or request withdrawal from membership (both referred to here as “request withdrawal of capital”). These unfavorable effects are more likely to occur and be more severe if a weak economy is accompanied by significant changes in interest rates, stresses in the housing market, elevated competitive forces, or changes in the legislative and regulatory environment relative to the FHLBank System. All of these factors existed in the last three years, which negatively impacted balances of Mission Asset Activity. Although our profitability relative to short-term interest rates continued to be favorable and there was no unfavorable impact on our capitalization, another recession or continued weak recovery from the recession of 2007-2009 could further decrease Mission Asset balances and ultimately erode profitability. As discussed in another risk factor, an extremely severe economic downturn, especially if combined with significant disruptions in housing conditions or other external events, could result in additional and substantial credit losses in the Mortgage Purchase Program and, at the extreme, credit losses on other assets.
The recently elevated competitive environment could further decrease Mission Asset Activity, earnings and, capitalization.
We operate in a highly competitive environment for our Mission Asset Activity and debt issuance. Increased competition can decrease the amount of Mission Asset Activity outstanding and narrow net spreads on that activity, both of which can reduce profitability and cause stockholders to request withdrawal of capital. Historically, our chief competition has been from other wholesale lenders and debt issuers, including other GSEs. Since late 2008, a substantial source of competition has come from the federal government's actions to stimulate the economy, especially the actions of the Federal Reserve System in its policies of low interest rates and quantitative easing. Among other effects, these actions have significantly expanded liquidity available to members, which lowered our Advance demand. We cannot predict how long these negative effects will continue or how much more severe the effects could be. However, we expect overall Advance demand will remain weak until the government reduces these initiatives, in particular the liquidity stimulus, by tightening monetary policy and winding down its purchases of mortgage-backed securities.
Potential GSE reform considered by the U.S. government could unfavorably affect our business model, financial condition, and results of operations.
The FHLBank System's regulator, the Finance Agency, also regulates Fannie Mae and Freddie Mac. The federal government placed Fannie Mae and Freddie Mac into conservatorship in September 2008, which is continuing. While there is agreement that a permanent financial and political solution for Fannie Mae and Freddie Mac must be implemented, no consensus has evolved around any of the various options proposed to date, and no legislation has been proposed. Because all the GSEs share a common regulator and general housing mission, the FHLBanks could be subject to legislation related to the ultimate disposition of Fannie Mae and Freddie Mac. There are significant differences between the FHLBank System and Fannie Mae and Freddie Mac, including the System's focus on lending as opposed to guaranteeing mortgages and our distinctive cooperative business model. However, future legislation could inadequately account for
these differences and, which could imperil the ability of the FHLBanks to continue operating effectively within their current business model or could change the System's business model.
On February 11, 2011, the Department of the 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 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 that the Obama Administration supports limiting the level of Advances and reducing portfolio investments. If housing GSE reform legislation is enacted incorporating these requirements, the FHLBanks could be significantly limited in their ability to make Advances to their members and could be subject to additional limitations on their investment authority. The report also supports consideration of additional means of providing funding to housing lenders, including potentially the development of a covered bond market, which could significantly compete with Advances.
We believe the legislative uncertainty surrounding GSE reform has negatively impacted Mission Asset Activity and decreased the maximum amount of capital investment several members our willing to make in the FHLBank System. At this time, we are unable to predict what effects GSE reform will ultimately have on the FHLBank System's business model or our financial condition and results of operations, or whether the effects will be positive or negative.
We face a heightened regulatory and legislative environment, which could continue to unfavorably affect our business model, financial condition, and results of operations.
In part because of the financial crisis of 2008-2009 and the financial challenges at Fannie Mae, Freddie Mac, and some FHLBanks (discussed below), the FHLBanks have faced heightened regulatory scrutiny in the last several years, including via numerous regulations promulgated and many more in the process of being promulgated. Some of these regulations have been and are being promulgated in response to our regulator fulfilling its obligations under the “Housing and Economic Recovery Act of 2008” (HERA). Others are related to Basel III and regulations of the Federal Deposit Insurance Corporation. This regulatory environment has raised our operating costs and imparted additional uncertainty regarding the business model under which the FHLBanks may operate in the future. We are unable at this time to predict what ultimate effects the heightened regulatory environment will have on the FHLBank System's business model or on our financial condition and results of operations.
Under the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act), the FHLBanks are subject to additional statutory and regulatory requirements for derivatives transactions and reporting. These requirements could raise expenses of transacting derivatives, negatively impact the liquidity and pricing of certain derivative transactions, harm our ability to use derivatives as effective risk mitigation tools, and reduce our ability to act as an intermediary between members and the capital markets. Together with other FHLBanks, we are participating in the development of the regulations under the Dodd-Frank Act and in the process of implementing new systems and processes to comply with the law. Until the various regulatory agencies complete the process of adopting regulations related to the Dodd-Frank Act, we cannot predict how the FHLBanks in general and our FHLBank in particular may be directly or indirectly affected by the law.
If the FHLBanks are identified as being systemically important financial institutions by the Financial Stability Oversight Council, we would be subject to supervision by the Federal Reserve Board and to heightened prudential standards, which could include, among other things, new risk-based capital, liquidity, and risk management requirements. These standards could affect our business model, financial condition, and results of operations.
Impaired access to the capital markets for debt issuance could deteriorate our liquidity, decrease the amount of Mission Asset Activity, lower earnings by raising debt costs and, at the extreme, prevent the System from meeting its financial obligations.
Our principal long-term source of funding, liquidity, and market risk management is through access to the capital markets for participation in the issuances of debt securities, and for execution of derivative transactions, both at attractive prices and yields. Access to the capital markets on favorable terms is the fundamental source of the FHLBank System's business franchise. The System's strong debt ratings, the implicit U.S. government backing of our debt, and our effective funding management are instrumental in ensuring satisfactory access to the capital markets. Our ability to access the capital markets could be affected by external events (such as general economic and financial instabilities, political instability,
wars, and natural disasters) and by our joint and several liability along with other FHLBanks for Consolidated Obligations, which exposes us to events at other FHLBanks. If our access were to be impaired for any extended period, the effect on our financial condition and results of operations could be material. At the extreme, the System's ability to achieve its mission and satisfy its financial obligations, could be threatened.
Although in 2011 we were able to access the capital markets for debt issuances on acceptable terms (even when the System's debt was downgraded by Standard & Poor's) and we believe the chance of a liquidity or funding crisis in the FHLBank System is currently very remote, we can provide no assurance that this will remain true.
We are exposed to credit risk that, if realized, could materially affect our ability to pay members a competitive dividend.
We believe we have a minimal overall amount of residual credit risk exposure related to Credit Services, purchases of investments, and transactions in derivatives and a moderate amount of credit risk exposure related to the Mortgage Purchase Program. However, we can make no assurances that credit losses will not materially affect our financial condition or results of operations. An extremely severe and prolonged economic downturn, especially if combined with continued significant disruptions in housing conditions, could result in credit losses on our assets that could impair our financial condition or results of operations.
The FHLBank is a collateral-based asset lender for Advances and Letters of Credit. Although Advances are overcollateralized and we have a perfected first lien position on all pledged loan collateral, most members are on a blanket lien status for Advances which, because it does not require specific loan collateral to be delivered, imparts a degree of uncertainty as to what types of loans members have pledged to collateralize their Advances and what their market values are.
We recorded a provision for credit losses in the Mortgage Purchase Program for the first time in 2010 primarily because of the increase in defaults on loans in the Program, as a result of the sharp declines in home prices and difficult economic conditions of the last four years. The increase in defaults has resulted in the exhaustion of, or estimated exhaustion of, credit enhancements on some loans in certain mortgage pools. Adverse economic scenarios involving further significant reductions in home prices and sustained elevated levels of unemployment could substantially increase our credit losses in the portfolio.
Some of our liquidity investments are unsecured, as are all of the uncollateralized portions of interest rate swaps. Although we make unsecured liquidity investments in and transact derivatives with highly rated, investment-grade institutions, have conservative limits on dollar and maturity exposure to each institution, and have strong credit underwriting practices, failure of an investment or derivative counterparty with which we have a large unsecured position could have a material adverse effect on our financial conditions and results of operations.
Changes in interest rates and mortgage prepayment speeds could significantly reduce our ability to pay members a competitive dividend from current earnings.
Sharp increases in interest rates, especially short-term rates, or sharp decreases in long-term interest rates could threaten the competitiveness of dividend rates relative to member stockholders' alternative investment choices. A major way that interest rate movements can lower profitability is via changes in mortgage prepayment speeds that we have not fully hedged with Consolidated Obligations, including the effects of amortizing purchase premiums of mortgage assets. Exposure to unhedged changes in mortgage prepayment speeds is one of our largest ongoing risks. In some extremely stressful scenarios, changes in interest rates and prepayment speeds could result in dividends being below stockholders' expectations for an extended period of time. In such a situation, members could engage in less Mission Asset Activity and could request withdrawal of capital.
Spreads on assets to funding costs may narrow because of changes in market conditions and competitive factors, resulting in lower profitability.
Spreads on many of our assets tend to be narrow compared to those of many other financial institutions due to our cooperative business model, resulting in relatively lower profitability. Market conditions could cause asset spreads, and therefore our profitability, to decrease substantially. This could result in lower dividends, reductions in Mission Asset Activity, and members' requests to withdraw their capital.
The concentration of Mission Asset Activity and capital among a small number of members could reduce dividend rates available if several large members were to withdraw or sharply reduce their activity.
A few members provide the majority of our Mission Asset Activity and capital. These members could decrease their Mission Asset Activity and the amount of their FHLBank capital stock as a result of merger and acquisition activity or their reduced demand for Mission Assets. At December 31, 2011, one current member, U.S. Bank, N.A., held over 10 percent of the FHLBank's Advances and one current member PFI, Union Savings Bank, had accounted for over 10 percent of the outstanding Mortgage Purchase Program principal balance. Our business model is structured to be able to absorb sharp changes in our Mission Asset Activity because we can undertake commensurate reductions in liability balances and capital and because of our relatively low operating expenses. However, a significant reduction in Mission Asset Activity from large members (resulting from either membership withdrawals or reduced demand for our products) could sufficiently affect profitability to threaten our ability to pay competitive dividends.
Financial difficulties at other FHLBanks could require us to provide financial assistance to another FHLBank, which could adversely affect our results of operations or our financial condition.
Each FHLBank has a joint and several liability for principal and interest payments on Consolidated Obligations, which are backed only by the financial resources of the FHLBanks. Although, no FHLBank has ever defaulted on its principal or interest share of an Obligation, there can be no assurance that this will continue to be the case. In the last four years, several FHLBanks experienced issues with capital adequacy and profitability, although the concerns appeared to lessen in 2011. Financial performance issues could require our FHLBank to provide financial assistance to one or more other FHLBanks, for example, by making a payment on an Obligation on behalf of another FHLBank. Such assistance could adversely affect our financial condition, earnings, ability to pay dividends, or redeem or repurchase capital stock.
Members face increased regulatory scrutiny, especially from the FDIC, which could further decrease Mission Asset Activity and lower profitability.
In response to the financial crisis and elevated number of financial institution failures, members' regulators have heightened regulatory requirements and scrutiny, especially in the areas of capitalization, assessments of asset classifications, reliance on Advances for funding and interest rate risk management. We believe these activities have resulted in members' decreased use of Advances. The Federal Deposit Insurance Corporation (FDIC) has made changes, or has proposed to make changes, in several of its practices that has reduced or could reduce members' ability or preferences to engage in Mission Asset Activity. These practices include raising deposit insurance coverage levels; providing guarantees to unsecured debt issuance of insured depository institutions; and requiring certain depository institutions to include Advances when calculating their deposit insurance premiums.
The Basel Committee on Banking Supervision (the Basel Committee) has developed a new capital regime for internationally active banks. Banks subject to the new regime will be required to have increased amounts of capital, with core capital being more strictly defined to include only common equity and other capital assets that are able to fully absorb losses. While it is uncertain how the new capital regime and other standards being developed by the Basel Committee, such as liquidity standards, will be implemented by the U.S. regulatory authorities, the new regime could require some of our members to divest assets in order to comply with the regime's more stringent capital and liquidity requirements, thereby tending to decrease Advance demand. The proposed liquidity requirements may adversely impact Advance demand and investor demand for Consolidated Obligations because it limits the ability of members to fully include Advances and Consolidated Obligations in required liquidity calculations. The latter could raise our debt costs and, in turn, raise the Advance rates we are able to offer members, thereby harming the ability to fulfill our business model.
Changes in relevant accounting standards could materially increase earnings volatility and consequently reduce the quality of members' capital investment, the amount of Mission Asset Activity and the amount of capital.
To date, we believe there have been no material effects on our Mission Asset Activity, capitalization, or earnings because of our application of accounting standards, especially those related to accounting for derivatives and hedging activities and accounting for premiums and discounts. Although unlikely to occur, changes in certain accounting standards could increase earnings volatility, causing less demand for Mission Asset Activity and stockholders to request withdrawal of capital. Under current accounting rules, earnings volatility could also increase if we began to execute more derivatives involving economic or macro hedges or if we significantly increased the amount of mortgage assets with premiums or discounts.
Our financial condition and results of operations could suffer if we are unable to hire and retain skilled key personnel.
The success of our business mission depends, in large part, on the ability to attract and retain key personnel. Competition for qualified people can be intense. Should we be unable to hire or retain effective key personnel, our financial condition and results of operations could be harmed.
Failures or interruptions in our internal controls, information systems and other operating technologies could harm our financial condition, results of operations, reputation, and relations with members.
Control failures, including those over financial reporting, or business interruptions with members and counterparties could occur from human error, fraud, breakdowns in computer systems and operating processes, or natural or man-made disasters. We rely heavily on internal and third-party computer systems. If a significant credit or operational risk event were to occur, it could materially damage our financial condition and results of operations. We may not be able to foresee, prevent, mitigate, reverse or repair the negative effects of any such failure or interruption.
Item 1B.
Item 1B. Unresolved Staff Comments.
None.
Item 2.
Item 2. Properties.
Our offices are located in 70,879 square feet of leased space in downtown Cincinnati, Ohio. We also maintain a leased, fully functioning, back-up facility in suburban Cincinnati. Additionally, we lease a small office in Nashville, Tennessee for the area marketing representative. We believe that our facilities are in good condition, well maintained, and adequate for our current needs.
Item 3.
Item 3. Legal Proceedings.
We are subject to various pending legal proceedings arising in the normal course of business. Management does not anticipate that the ultimate liability, if any, arising out of these matters will have a material adverse effect on our financial condition or results of operations.
Item 4.
Item 4. Mine Safety Disclosures.
Not applicable.
PART II
Item 5.
Item 5.
Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.
By law our stock is not publicly traded, only our members (and former members with a withdrawal notice pending) may own our stock. The par value of our capital stock is $100 per share. As of December 31, 2011, we had 741 stockholders and 31 million shares of capital stock outstanding, all of which were Class B Stock.
We paid quarterly dividends in 2011 and 2010 as outlined in the table below.
Generally, our Board of Directors has discretion to declare or not declare dividends and to determine the rate of any dividend declared. Our dividend declaration policy states that dividends for a quarter are declared and paid from retained earnings after the close of a calendar quarter and are based on average stock balances for the then closed quarter.
A Finance Agency Capital Rule prohibits an FHLBank from issuing new excess capital stock to members, either by paying stock dividends or otherwise, if before or after the issuance the amount of member excess capital stock exceeds or would exceed one percent of the FHLBank's assets. Excess capital stock for this regulatory purpose is calculated as the aggregate of capital stock owned that is in excess of all membership and Mission Asset Activity requirements (as defined in our Capital Plan). In accordance with this Rule, we paid cash dividends in each quarter of 2011 and 2010. Our Board, and we believe our members, continue to have a stated preference for dividends in the form of stock.
We may not declare a dividend if, at the time, we are not in compliance with all of our capital requirements. We also may not declare or pay a dividend if, after distributing the dividend, we would fail to meet any of our capital requirements or if we determine that the dividend would create a safety and soundness issue for the FHLBank. See Note 17 of the Notes to the Financial Statements for additional information regarding our capital stock.
RECENT SALES OF UNREGISTERED SECURITIES
From time to time we provide Letters of Credit in the ordinary course of business to support members' obligations issued in support of unaffiliated, third-party offerings of notes, bonds or other securities. We did not provide such credit support during 2011. We provided $21 million and $203 million of such credit support during 2010 and 2009, respectively. To the extent that these Letters of Credit are securities for purposes of the Securities Act of 1933, their issuance is exempt from registration pursuant to section 3(a)(2) thereof.
Item 6.
Item 6. Selected Financial Data.
The following table presents selected Statement of Condition information, Statement of Income data and financial ratios for the five years ended December 31, 2011.
(1)
Investments include interest bearing deposits in banks, securities purchased under agreements to resell, Federal funds sold, trading securities, available-for-sale securities, and held-to-maturity securities.
(2)
Dividend payout ratio is dividends declared in the period as a percentage of net income.
(3)
Weighted average dividend rates are dividends paid in stock and cash divided by the average number of shares of capital stock eligible for dividends.
(4)
Net interest margin is net interest income before provision for credit losses as a percentage of average earning assets.
(5)
Regulatory capital ratio is period-end regulatory capital (capital stock, mandatorily redeemable capital stock and retained earnings) as a percentage of period-end total assets.
Item 7.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations.
EXECUTIVE OVERVIEW
Financial Condition
Mission Asset Activity
The following table summarizes our financial condition.
The year 2011 brought a continuation of the trends in our financial condition experienced since Mission Asset Activity peaked in the fourth quarter of 2008. Our business is cyclical and Mission Asset Activity normally stabilizes or declines in difficult macro-economic conditions, when financial institutions have ample liquidity, or when there is significant growth in the money supply.
A weak economy brought slow growth in new consumer, mortgage and commercial loans, which resulted in members' on-going subdued demand for Advances throughout 2011. In addition, significant government funding and liquidity programs continued to be available to members. We would expect to see increased Advance demand when one or more of the following occur: the economy improves; the Federal Reserve System's monetary policy tightens; or the government's liquidity programs wind down.
Total assets at December 31, 2011 were $60.4 billion, 16 percent lower than at year-end 2010, with the reduction led by declines in investment balances. However, average asset balances in 2011 were only $2.1 billion lower than 2010's average. The decline in average asset balances resulted from decreases in members' Advance demand and loan balances in the Mortgage Purchase Program. These were partially offset by higher average investment balances.
The ending balance of Mission Asset Activity (comprising Advances, Letters of Credit, and the Mortgage Purchase Program) was $40.9 billion at December 31, 2011 compared to $44.1 billion at year-end 2010. The principal balance of Advances fell six percent in 2011 to end the year at $27.8 billion. Advance principal balances averaged $28.6 billion in 2011, a decrease of nine percent from 2010's average. Although there was daily, monthly, and quarterly volatility in Advance balances in 2011, the trend during the year pointed to a stabilization of Advance demand compared to 2009 and 2010.
The principal balance of mortgage loans held for portfolio (the Mortgage Purchase Program) was $7.8 billion at December 31, 2011, an increase of $0.1 billion (one percent) from year-end 2010. During 2011, the FHLBank purchased $2.0 billion of mortgage loans, while principal paydowns totaled $1.9 billion. In addition, at the end of 2011, there were $431 million of mandatory delivery contracts outstanding.
Despite the recent years' difficulties in the economy and housing market and lower overall Mission Asset Activity, we continued to fulfill our mission of providing reliable and favorably priced wholesale funding to our members. As of December 31, 2011, members funded on average 3.6 percent of their assets with Advances, the penetration rate was relatively stable with almost 75 percent of members holding Mission Asset Activity, and the number of active sellers and participants in the Mortgage Purchase Program remained at elevated levels compared to years prior to 2010.
Other Assets
The balance of investments at December 31, 2011 was $21.9 billion, a decrease of $11.4 billion (34 percent), from year-end 2010. The reduction resulted primarily from our decision to decrease short-term investment holdings in the last four months of the year due to narrower spreads available and fewer eligible counterparties available for these types of investments. The year-end balance also reflected $2.0 billion in funds held in deposits at the Federal Reserve due to the extremely low yields available on short-term investments. Average investment balances in 2011 were $30.0 billion, an increase of six percent from 2010's average. Total investments at December 31, 2011 included $11.2 billion of mortgage-backed securities and $10.7 billion of other instruments, which are mostly short-term liquidity investments held to support members' funding needs, provide liquidity against the potential inability to access capital markets for debt issuances, and augment earnings. All but one of our mortgage-backed securities held at year end were issued and guaranteed by Fannie Mae, Freddie Mac or a U.S. agency.
Capital
Capital adequacy continued to be strong in 2011, exceeding all minimum regulatory capital requirements. The amounts of GAAP and regulatory capital changed only one percent between year-end 2010 and year-end 2011. The GAAP capital-to-assets ratio at December 31, 2011 was 5.89 percent, while the regulatory capital-to-assets ratio was 6.37 percent. Both ratios were well above the regulatory required minimum of 4.00 percent. Regulatory capital includes mandatorily redeemable capital stock accounted for as a liability under GAAP.
Retained earnings were $444 million at December 31, 2011, of which $12 million were restricted retained earnings. Total retained earnings increased $6 million from year-end 2010. We believe that the amount of retained earnings is sufficient to protect against impairment risk of capital stock and to provide the opportunity for dividend stability.
Housing and Community Investment
Based on our earnings, we added $17 million in 2011 for future use in the Affordable Housing Program. These monies will be awarded to members in 2012, continuing the trend of adding to the available funds each quarter since the inception of the program in 1990, during which time we have awarded $444 million for nearly 59,000 housing units. In addition to the Affordable Housing Program, the FHLBank continues its voluntary housing program with a commitment of $1 million to help pay for accessibility rehabilitation and emergency repairs for special needs and elderly homeowners.
Results of Operations
The table below summarizes our results of operations.
The ROE spreads to 3-month LIBOR and the Federal funds effective rate are two market benchmarks we believe stockholders use to assess the competitiveness of return on their capital investment. In 2011, these ROE spreads were substantially below those in 2010 and 2009, yet continued to represent competitive returns to stockholders. We paid stockholders a 4.50 percent annualized cash dividend in the first two quarters and a 4.00 percent annualized cash dividend in the third and fourth quarters.
The primary factor contributing to the decline in profitability in 2011 compared to 2010 was the relatively weak economy, which led to ongoing reductions in long-term interest rates and reductions in balances of Mission Asset Activity. The primary negative factors on net income are listed below in estimated order of impact:
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Net amortization expense related to purchased premiums on mortgage assets increased significantly ($41 million in 2011), as lower mortgage rates accelerated actual and projected prepayment speeds.
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Lower yields on total interest-earning assets, a portion of which are funded with interest-free capital reduced interest income by $17 million in 2011. The lower yield resulted mostly from the continued repricing of new mortgage assets in the historically low interest rate environment.
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The average balance on loans in the Mortgage Purchase Program and mortgage-backed securities decreased $1.3 billion. These assets normally earn wider spreads than most of our other assets.
▪
Spreads earned on new mortgage assets narrowed compared to spreads earned on mortgage assets that were paid down.
▪
Net gains on derivatives, which are primarily unrealized market value changes, decreased $10 million in 2011, also due mostly to the lower interest rate environment.
Positive factors partially offset the negative factors as discussed below in estimated order of impact:
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We retired a significant amount of relatively high-cost Consolidated Obligation Bonds before their final maturities and replaced them with new Obligations at substantially lower interest costs.
▪
Net amortization expense of premium/discounts and concession costs on Consolidated Bonds decreased $18 million, primarily because we retired fewer Consolidated Bonds prior to their maturities in 2011 than in 2010.
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The FHLBank System's REFCORP obligation was satisfied at the end of the second quarter 2011. REFCORP, which had been recorded as a reduction to net income, has been replaced with a 20 percent allocation of net income to restricted retained earnings. This change increased earnings by $11 million.
▪
The average spread between LIBOR-indexed assets (mostly Advances) and short-term Discount Note debt widened. We use Discount Notes to fund a substantial amount of LIBOR-indexed assets. This spread widened especially in the fourth quarter of 2011 related to the financial turmoil in Europe.
▪
The net gains on held-to-maturity securities, which occurred from the sales of certain mortgage-backed securities, increased $8 million.
Business Outlook
This section summarizes the business outlook and what we believe are our current major risk exposures. Item 1A's “Risk Factors” has a detailed discussion of risk factors that could affect our corporate objectives, financial condition, and results of operations. "Quantitative and Qualitative Disclosures About Risk Management” provides details on current risk exposures. Many of the issues related to our financial condition, results of operations, and liquidity discussed throughout this document relate directly to the ongoing effects of the weak economic recovery after the 2008-2009 recession and financial crisis and to the federal government's actions to stimulate economic growth.
Strategic/Business Risk
Advances. We cannot predict the future trend of Mission Asset Activity because it depends on, among other things, the state of the economy, conditions in the housing markets, the government's liquidity programs, the willingness and ability of financial institutions to expand lending, and regulatory initiatives that could affect demand for our Mission Asset Activity. When improvements occur in economic conditions, including expansion of members' loan demand from a stronger recovery, tightening in the Federal Reserve System's monetary policy, and/or the winding down of the government's liquidity programs, we would expect Advance demand to grow. Additionally, there is also a substantial amount ($4.8 billion) of Advances held by nonmembers that will pay down over the next several years.
We are concerned about several regulatory initiatives that could affect Advance demand. One ruling already implemented increased FDIC assessments for large financial institutions that utilize Advances, effectively raising the cost of borrowing from
an FHLBank. Potential regulatory changes that could affect our business include: limitations on Advance lending to large financial institutions; prohibition under Basel III for institutions to incorporate unused FHLBank System borrowing capacity as sources of liquidity; development of a covered bond market; and members' implementation of the Dodd-Frank Wall Street Reform and Consumer Protection Act.
Mortgage Purchase Program. Our strategy for the Mortgage Purchase Program is for moderate growth, with a prudent limit on the Program's size relative to capital to help ensure that our exposure to market and credit risk remains consistent with our conservative risk management principles. We will continue to emphasize the business model of recruiting community financial institution members to the Program and increasing the number of regular sellers. We could continue to experience moderate growth in the intermediate term based on the low level of mortgage rates that promote mortgage refinancing activity, several new mid-sized sellers joining the Program, and continued activity with our two largest sellers. However, the Program's balances continue to be pressured by the stresses in the housing markets. Higher mortgage rates would likely also slow growth.
The primary regulation currently affecting growth of balances in the Mortgage Purchase Program is that if our purchases in a calendar year exceed $2.5 billion, we are required to enact affordable housing goals for the Program. We believe these would be operationally costly to administer and could harm the Program's credit risk exposure.
Regulatory and Legislative Risk
The FHLBank System currently faces heightened legislative and regulatory risks and uncertainties, which we believe has affected, and could continue to affect, Mission Asset Activity and capitalization. These risks are discussed above and in Item 1A's “Risk Factors.”
Market Risk and Profitability
Market risk exposure was moderate during 2011, well within policy limits, and consistent with the normal historical range.
Based on the totality of our market risk analysis, we expect that profitability, defined as the level of ROE compared with short-term market rates, will remain competitive unless interest rates would change by extremely large amounts in a short period of time. Decreases in long-term interest rates, even up to 2.00 percentage points (which would put fixed-rate mortgages at two percent or less), would still result in ROE being above market interest rates. However, sharp reductions in long-term rates could result in an immediate large accelerated recognition of amortization of mortgage asset premiums, which could negatively impact our results of operations.
We believe that profitability would not become uncompetitive unless long-term rates were to increase immediately and permanently by 4.00 percentage points or more combined with short-term rates increasing to at least eight percent. Such large changes in interest rates would not result in negative earnings, unless these rate environments occurred quickly, lasted for a long period of time, and were coupled with very unfavorable changes in other market and business variables or our business model. We believe such a scenario is extremely unlikely to occur.
Capital Adequacy
The 12 Federal Home Loan Banks entered into a Joint Capital Enhancement Agreement (the “Capital Agreement”) in February 2011. The Capital Agreement bolsters each FHLBank's capital adequacy by allocating that portion of each FHLBank's earnings historically paid to satisfy its REFCORP obligation to a separate restricted retained earnings account at that FHLBank which is not available to be distributed as dividends. In August 2011, the Finance Agency certified that the FHLBanks had fully satisfied their REFCORP obligation. In accordance with the Capital Agreement, starting in the third quarter of 2011, we began to allocate 20 percent of net income to a separate restricted retained earnings account, which totaled $12 million at year-end.
We have always maintained compliance with our capital requirements, and we believe that the current amount of total retained earnings is sufficient to protect against impairment risk of capital stock and to provide the opportunity for dividend stability. The Capital Agreement will enhance risk mitigation by building a larger capital buffer over time to absorb unexpected losses, if any, that we may experience. Therefore, the Capital Agreement is expected to result in additional protection against impairment risk to stockholders' capital investment. We believe the Capital Agreement will also provide even greater certainty to investors about the FHLBank's ability to pay principal and interest on Consolidated Obligations, augment the stability of members' returns on their capital investment, and strengthen the long-term viability of the Affordable Housing Program, which will receive increased contributions as a result of this change.
Credit Risk
We continued in 2011 to experience limited overall credit risk exposure from offering Advances, making investments, and executing derivative transactions. Consistent with previous years, the FHLBank required no loss reserve for Advances and considered no investments to be other-than-temporarily impaired at any point in 2011. We believe policies and procedures related to credit underwriting, Advance collateral management, and transactions with investment and derivative counterparties continue to fully mitigate these risks.
The FHLBank is a collateral-based asset lender for Advances and Letters of Credit. We have robust policies, strategies and processes designed to identify, manage and mitigate credit risk on Credit Services. Advances are overcollateralized and we have a perfected first lien position on all pledged loan collateral, as well as conservative policies and procedures related to managing credit risk on Advances. We do not expect any losses from Advances or Letters of Credit.
The Mortgage Purchase Program is comprised of conforming fixed-rate conventional loans and loans fully insured by the Federal Housing Administration. Credit enhancements on the Program's conventional loans have historically protected the FHLBank against credit losses down to approximately a 50 percent loan-to-value level (based on value at origination). Actual Program delinquencies on conventional loans are well below national averages on similar loans. However, beginning in 2010, credit risk exposure in the Mortgage Purchase Program increased, reflecting the sharp decline in home prices in many areas of the country since 2006 and the resulting increase in loan defaults. The cumulative combination of these factors resulted in losses exceeding the credit enhancements in place on certain pools. At the end of 2011, the allowance for credit losses in the Program was $21 million. We believe the portfolio's credit risk will remain moderate and manageable. However, in an adverse scenario of further large reductions in home prices, sustained elevated levels of unemployment, or failure of one or more mortgage insurance providers, credit losses experienced in the portfolio net of credit enhancements could increase significantly.
We believe we face limited credit risk exposure in our investments. Based on our analysis, we did not consider any investments to be other-than-temporarily impaired in 2011, as in prior years. At the end of 2011 all except one mortgage-backed security were issued and guaranteed by Fannie Mae or Freddie Mac, which we believe have the backing of the U.S. government, or by the National Credit Union Administration, which issues guaranteed securities.
Liquidity investments are either unsecured, guaranteed by the U.S. government, or secured (i.e., collateralized). Although a majority of liquidity investments are unsecured, we invest in the debt securities of highly rated, investment-grade institutions, have conservative limits on dollar and maturity exposure to each institution, and have strong credit underwriting practices. We believe our exposure within investment activity to European sovereign debt is limited.
Finally, we collateralize most of the credit risk exposure resulting from interest rate swap transactions; only the uncollateralized portion, which is normally relatively small, of our derivative asset position represents unsecured exposure.
Funding and Liquidity Risk
Our liquidity position remained ample and strong during 2011, as did our overall ability to fund operations through Consolidated Obligation issuances at acceptable terms, availability, and interest costs. While there can be no assurances, the possibility of a funding or liquidity crisis in the FHLBank System that would impair our FHLBank's ability to access the capital markets, service debt or pay competitive dividends is considered to be remote. Although the government continues to face serious fiscal challenges and Standard & Poor's downgraded the United States in August 2011 and subsequently the FHLBank System's debt to AA+, the System continues to experience uninterrupted access on acceptable terms to the capital markets for its debt issuance and funding needs. Investors continue to favor the System's debt issuances; spreads on the System's longer-term Consolidated Obligations to U.S. Treasury rates and LIBOR did not change materially; and, after experiencing modest and temporary increases in late July and early August, the System's short-term debt costs returned by mid-August to the historically normal range.
CONDITIONS IN THE ECONOMY AND FINANCIAL MARKETS
Effect of Economy and Financial Markets on Mission Asset Activity
The primary external factors that affect our Mission Asset Activity and earnings are the general state and trends of the economy and financial institutions, especially in our Fifth District; conditions in the financial, credit, mortgage, and housing markets; interest rates; and competitive alternatives to our products, such as retail deposits and other sources of wholesale funding. To date, the economic recovery from the recession and financial crisis of 2008-2009 has been weak by historical standards.
Some indications of the weak economy include only modest growth in gross domestic product since the end of the recession, lackluster consumer and business demand, sluggish loan growth at depository institutions, small reductions in unemployment rates, ongoing distress in housing markets, and continued financial difficulties experienced by many of our members that are making them hesitant to increase lending. Some observers are concerned that the United States may be in a period of slow growth or face substantial emerging risks of entering another recession. It is clear that the economy is in a prolonged period of de-leveraging consumer and commercial debt that had been built up over many years, especially mortgage debt.
The weak economic recovery has resulted in minimal growth, or even reductions, in new consumer, mortgage and commercial loans, which has limited members' demand for Advances and wholesale funding in general. From September 30, 2010 to September 30, 2011 (the most recent data period available), Fifth District depository institutions' aggregate loan portfolios grew only $6.7 billion (1.2 percent) while their aggregate deposit balances increased $37.1 billion (6.1 percent); and aggregate loan portfolios rose $2.1 billion in the first three quarters of 2011. All of the loan growth and almost all of the deposit growth came from our largest member and borrower (U.S. Bank, N.A.). Excluding the impact of this member, aggregate loans fell $1.3 billion (0.4 percent) in the 12-month period ending September 30, 2011 while aggregate deposits grew only $7.1 billion (1.7 percent).
Also continuing to significantly lower demand for our credit services is the substantial liquidity still being made available to depository institutions by the federal government in an attempt to stimulate economic growth, extending a practice that began in late 2008. The government's activities are being led by the Federal Reserve System and its quantitative easing programs, which have resulted in an historic expansion of its balance sheet and in the banking system holding extremely large and unprecedented levels of excess reserves instead of using the liquidity to expand lending.
Analysis of this and other data suggests that the sluggish economy is impacting our Advance growth mostly through reduced lending growth by our members. We have no reason to believe that these trends changed materially during the first quarter of 2012, although we have seen indications of a stabilization of Advance demand.
In addition, many financial institutions, as well as other companies, appear uncertain as to the future political environment conditions, including the federal government's fiscal challenges and the effect of the substantial and still-evolving changes in the financial regulatory environment. Some of the actual and potential regulatory changes are identified in the "Executive Overview." We believe these sources of uncertainty are likely another factor constraining economic activity and, therefore, our Advance demand.
To the extent the challenging economic and monetary conditions continue, we expect Advance activity across our membership to remain slow. The weak economy and housing market also negatively affected Mortgage Purchase Program balances in 2011, to a lesser degree, resulting in relatively subdued refinancings of mortgage loans and small amounts of new loan originations, compared to the amount of this activity that would be expected in more normal conditions.
Interest Rates
Trends in market interest rates affect members' demand for Mission Asset Activity, earnings, spreads on assets, funding costs and decisions in managing the tradeoffs in our market risk/return profile. The following table presents key market interest rates (obtained from Bloomberg L.P.).
(1)
Simple average of current coupon rates of Fannie Mae and Freddie Mac mortgage-backed securities.
(2)
Simple weekly average of 125 national lenders' mortgage rates for prime borrowers having a 20 percent down payment as surveyed and published by Freddie Mac.
Short-term rates remained at historic lows. The Federal Reserve maintained the overnight Federal funds target and effective rates between zero and 0.25 percent, with other short-term rates generally consistent with their historical relationships to Federal funds. In the fourth quarter, the spread between short-term LIBOR and our Discount Note funding costs widened due to concerns with the financial conditions in Europe. This benefited our earnings because we fund a significant amount of adjustable-rate LIBOR-indexed assets with Discount Notes. Intermediate- and long-term rates showed a substantial downward trend across each quarter, especially in the third quarter.
The trends in interest rates had several impacts on our 2011 results of operations, as discussed in the "Executive Overview" and the "Results of Operations." Although it cannot perfectly control most interest rates, the Federal Reserve has indicated that it currently plans to hold certain short-term rates at or near zero until at least the end of 2014, although this could change if their forecast of slow economic growth and subdued inflation changes. As discussed in the "Executive Overview" and "Market Risk" section of "Quantitative and Qualitative Disclosures About Risk Management," we believe our market risk profile is positioned to remain moderate and our profitability competitive, across a wide range of interest rate and business environments.
Despite the declines in intermediate- and long-term rates during 2011, which overall negatively impacted our earnings, the interest rate environment remained favorable for our FHLBank's results of operations in terms of the longer-term trend level of profitability (ROE) compared to the levels of interest rates. This difference, or spread, averaged 3.55 percentage points (relative to three-month LIBOR) in 2011 and 4.33 percentage points in 2010. In the ten years prior to 2011, this spread averaged 3.18 percentage points.
The rate environment has been a net benefit to our relative profitability for several reasons:
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In general, lower market rates raise our relative ROE compared to market rates.
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The lower intermediate- and long-term rates have provided us the opportunity to retire many Consolidated Bonds before their final maturities and replace them with lower cost Obligations.
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Earnings generated from funding assets with interest-free capital have not decreased as much as the reduction in overall interest rates because long-term assets do not reprice immediately to the lower rates.
However, if interest rates remain low for a prolonged period of time, as suggested by the Federal Reserve's indications, the earnings we can generate from funding assets with interest-free capital will continue to decline.
ANALYSIS OF FINANCIAL CONDITION
Credit Services
Credit Activity and Advance Composition
The tables below show annual and quarterly trends in Advance balances by major programs and in the notional amount of Letters of Credit.
(1)
As a percentage of total Advances principal.
(2)
Related interest rate swaps executed to hedge these Advances convert them to an adjustable-rate tied to LIBOR.
(3)
Excludes Putable/Convertible Advances where the related put/conversion options have expired. Such Advances are classified based on their current terms.
The lower level of Advance balances experienced in 2009 and 2010 continued in 2011. However, Advances stabilized in 2011. In the last six months of 2011, there were signs of a turnaround in Advance demand, as some months showed increases in month-end or daily average balances. The year-end Advance balance was affected by $1,000 million in maturing Advances held by a former member.
However, it is too soon to predict whether Advances will grow substantially in 2012 because it is not clear whether the economy's growth rate will substantially increase. Furthermore, the Federal Reserve is continuing to provide an extraordinary amount of liquidity to financial institutions. An additional factor putting downward pressure on Advance balances is that former members hold $4,756 million (17 percent), of which approximately 65 percent are scheduled to mature by the end of 2013. These will pay down without opportunity for replacement with new Advances by former members. "Executive Overview" and "Conditions in the Economy and Financial Markets" above, discuss in more detail reasons for the trends in Advance balances.
Members reduced their available lines in the Letters of Credit program by $1,961 million in 2011. The lines fell principally because of decreased activity from a few large members who heavily use Letters of Credit and whose usage can be volatile. We earn fees on Letters of Credit based on the actual notional amount of the Letters utilized, which normally is less than the available lines.
Our pricing of Advance products relative to funding costs did not materially change in 2011 from the last several years.
Advance Usage
The following table presents Advances outstanding by member type. Commercial banks continued in 2011 to hold the largest proportion of Advances. This reflects both the number of commercial bank members (see "Membership and Stockholders" below) and the fact that there are more large commercial banks than large members with other charter types in the Fifth District.
The following tables present principal balances for our top five Advance borrowers. Advances continued to be concentrated, with the concentration ratio of the top five borrowers fluctuating in the range of 50 to 65 percent in the last several years. We believe that having large members who actively use our Mission Asset Activity augments the value of membership to all members because it enables us to improve operating efficiency, increase financial leverage, possibly enhance dividend returns, obtain more favorable funding costs, and provide competitively priced Mission Asset Activity.
(1)Former member.
The following table shows the unweighted average ratio of each member's Advance balance to its most-recently available figures for total assets (which are on a one quarter lag).
Continuing a trend from the last several years and consistent with the trends in balances, Advance usage ratios declined in 2011, although the rate of decline slowed noticeably in the last three quarters. Larger members, which we designate as those having assets over $1.0 billion, showed a slight uptick in the usage ratio in the fourth quarter. Despite the difficult economic environment and significant levels of financial institution liquidity, our membership still funded over 3.5 percent of their assets with Advances.
Mortgage Purchase Program (Mortgage Loans Held for Portfolio)
The table below shows principal paydowns and purchases for each of the last two years.
The principal loan balance in the Mortgage Purchase Program grew $51 million (one percent) in 2011. Principal purchases more than doubled in 2011 over 2010 due to the declines in mortgage rates (which prompted an increase in net loan refinancings among our sellers), an increase in the number of regular sellers, and renewed activity with our two largest sellers. These favorable factors offset the amount of principal paydowns in 2011's lower mortgage rate environment. However, purchase volumes were still impacted by the continued difficulties in the housing and mortgage markets.
The following table shows the percentage of principal balances from PFIs supplying five percent or more of total principal and the percentage of principal balances from all other PFIs.
(1)Former member.
The unpaid principal balance supplied by sellers providing less than five percent of balances increased by $226 million (11 percent) and by the end of the year these sellers accounted for 30 percent of total unpaid principal. Our focus for the Program continues to be on recruiting community-based members to sell us mortgage loans and on increasing the number of regular sellers. The number of regular sellers remains at a relatively high level compared to historical trends, and a substantial number of other members either are actively interested in joining the Program or are in the process of joining.
We closely track the refinancing incentives of our mortgage assets because the option for homeowners to change their principal payments normally represents almost all of our market risk exposure. The $1,924 million of principal paydowns in 2011 equated to a 20 percent annual constant prepayment rate, modestly lower than 2010's 22 percent rate.
The Program’s composition of balances, by loan type and original final maturity, did not change materially in 2011 versus the prior several years. At the end of the year, the Program was comprised of 77 percent 30-year mortgages and 21 percent 15-year mortgages. Conventional loans made up 85 percent of the portfolio, with the remainder being government-guaranteed FHA loans. The weighted average mortgage note rate fell from 5.46 percent at the end of 2010 to 5.09 percent at the end of 2011. This decrease reflected prepayments of higher rate mortgages and purchases of lower rate mortgages. As in the last three years, yields earned on new mortgage loans in the Program, relative to funding costs, continued to provide acceptable risk-adjusted returns due in part to the steep Consolidated Obligation yield curve. We did not substantially change the Program's pricing practices in 2011.
Housing and Community Investment
In 2011, we accrued $17 million of earnings for the Affordable Housing Program, which can be awarded to members in 2012. This amount represents a $3 million (16 percent) decrease from 2010, due to 2011's lower income.
Including funds recaptured or de-obligated from previous years' offerings, we had $29 million of funds available for the Affordable Housing Program in 2011. De-obligated funds represent Affordable Housing projects for which we committed funds in prior years but which used fewer subsidies than originally anticipated or were for projects that did not go forward. Funds are also recaptured from non-compliant projects in accordance with Finance Agency Regulations. We redeploy Affordable Housing Program funds if they are not used for the purposes intended.
Of the total funds available in 2011 for the Affordable Housing Program, $22 million was awarded through two competitive offerings, for which we approved 54 applications. Funds totaling $7 million were awarded to 157 members through the Welcome Home Set-Aside Program to assist homeowners with down payments and closing costs. In total, almost one-quarter of members received approval for funding under the Affordable Housing Program. In addition, in 2011, our Board continued to authorize $1 million in funding for one voluntary housing program.
Our activities to support affordable housing also include offering Advances with below-market interest rates at or near zero profit for us. At the end of 2011, Advance balances related to the Affordable Housing Program declined slightly to $149 million due to higher demand for affordable housing subsidy in the form of grants. Community Investment and Economic Development Program Advances declined to $336 million, which reflected the overall decline in demand for Advances.
Investments
We hold a substantial amount of investments in order to provide liquidity, enhance earnings, help manage market risk, and, in the case of mortgage-backed securities, help support the housing market. We hold both shorter-term investments, which we refer to as "liquidity investments" because most of them serve to augment asset liquidity, and longer-term mortgage-backed securities. It is normal for daily balances of the liquidity portfolio to experience substantial fluctuation in response to market conditions, supply, and spreads available relative to funding costs.
In 2011, as in 2010, we maintained average balances in liquidity investments at higher levels compared to our long-term historical experience. This reflected both a decision to hold more asset liquidity and a desire to offset a portion of earnings lost from the declines in Mission Asset Activity balances over the last three years. Beginning in the second half of 2010 and continuing in 2011, in order to bolster asset liquidity, we increased purchases of short-term trading securities, including U.S. Treasury obligations and debt securities of Fannie Mae and Freddie Mac. There was a resulting decrease in other short-term investments which include interest bearing deposits, securities purchased under agreements to resell, and overnight Federal funds sold.
The book balance of the liquidity portfolio averaged $18,411 million in 2011, compared to $16,358 million in 2010. The balance at December 31, 2011 was $10,737 million compared to $21,654 million at the end of 2010. We lowered the balance of liquidity investments during the last four months of 2011 due to narrower spreads available and fewer eligible counterparties available for these types of investments. The year-end balance also reflected $2,034 million in funds held in deposits at the Federal Reserve.
Our ongoing strategy for mortgage-backed securities is to maximize their holdings close to the regulatory maximum of three times capital, subject to the availability of securities that we believe provide us favorable risk/return tradeoffs. The book balance of the mortgage-backed securities portfolio averaged $11,100 million in 2011. The book balance at year end was $11,204 million (down $453 million, four percent, from the end of 2010), which amounted to a multiple of regulatory capital of 2.91, slightly below the regulatory limit of three times capital.
The portfolio at year-end consisted of $9,684 million of securities issued by Fannie Mae or Freddie Mac (of which $1,535 million were floating-rate securities), $1,501 million of floating-rate securities issued by the National Credit Union Administration, $17 million of fixed-rate private-label mortgage-backed securities, and $2 million of securities issued by Ginnie Mae.
Purchases during the year were concentrated in floating-rate securities, with the year-end balance totaling $3,036 million. This practice was driven by our assessment that these types of securities had a more favorable risk/return tradeoff compared to fixed-rate securities, especially when considering the relatively high premium prices of many fixed-rate securities which require amortization. We continued to own no pass-through mortgage-backed securities comprised of 30-year fixed-rate collateral. Because over 75 percent of Mortgage Purchase Program loans have 30-year original terms, purchasing pass-throughs with shorter than 30-year original terms is one way we diversify mortgage assets to help manage market risk exposure.
The table below shows principal purchases, paydowns and sales of our mortgage-backed securities for each of the last two years.
The $3,699 million of principal paydowns in 2011 equated to a 28 percent annual constant prepayment rate, modestly lower than 2010's 30 percent rate. The principal sales were comprised of small balance securities that had less than 15 percent of the original acquired principal outstanding at the time of the sale. As in the last three years, yields earned in 2011 on new mortgage-backed securities, relative to funding costs, offered acceptable risk-adjusted returns due in part to the steep Consolidated Obligation yield curve and attractive yields on floating-rate securities relative to their market risk exposure.
Consolidated Obligations
The table below presents the ending and average balances of our participations in Consolidated Obligations.
(1)
Includes unamortized premiums/discounts, fair value option valuation adjustments, hedging and other basis adjustments.
(2)
The 12 FHLBanks have joint and several liability for the par amount of all of the Consolidated Obligations issued on their behalves. The par amount of the outstanding Consolidated Obligations of all 12 FHLBanks was (in millions) $691,868 and $796,374 at December 31, 2011 and 2010, respectively.
Balances of total Obligations fluctuate in accordance with changes in the amount of total assets. Changes to the mix of Obligations fluctuate in response to relative changes in short-term versus long-term assets, relative changes in fixed-rate and adjustable-rate assets, decisions on market risk management (particularly the amount of funding of longer-term assets with short-term Obligations), and differences in relative costs of various Obligations. We fund short-term and adjustable-rate Advances, Advances hedged with interest rate swaps, and most liquidity investments with a combination of Discount Notes, unswapped adjustable-rate Bonds, and swapped fixed-rate Bonds (which effectively create short-term funding). We fund long-term assets principally with unswapped fixed-rate Bonds, in order to effectively reduce market risk exposure.
The $10,709 million decrease in the total ending balance of Consolidated Obligations corresponded to the decrease in total assets (mostly short-term liquidity investments) and the relatively stable amount of deposits and capital. The more modest $1,425 million decrease in the average balance of Obligations reflected the smaller decrease ($2,079 million) in total average assets than ending total assets.
The increase in the average balance of Discount Notes was due primarily to the substitution of Discount Notes for other types of Obligations, as the cost of Discount Notes in 2011 tended to be more favorable compared to that of swapped funding, adjustable-rate Obligations and similar-maturity unswapped fixed-rate Bonds. The decrease in Discount Notes on an ending-balance basis reflected the lower amount of total assets at year-end.
The decrease in the average and ending balance of unswapped fixed-rate Bonds reflected greater use of Discount Notes to fund mortgage assets, primarily because we substantially increased purchases of floating-rate mortgage-backed securities, which we fund with Discount Notes.
Long-term Consolidated Obligation Bonds normally have an interest cost at a spread above U.S. Treasury securities and below LIBOR. After being wider and more volatile than normal throughout 2009, the spreads and volatility were at levels comparable to historical averages in 2010 and 2011, which benefited our earnings. For discussion of the cost of Discount Note funding relative to LIBOR, which in the last two years has been a major driver of earnings, see the “Net Interest Income” section of “Results of Operations.”
The following table shows the allocation on December 31, 2011 of unswapped fixed-rate Bonds according to their final remaining maturity and next call date (for callable Bonds). The allocations were similar compared to those of the last several years. We believe that the allocations of Bonds among these classifications provide effective mitigation of market risk exposure to both higher and lower mortgage rates.
Deposits
Members' deposits with us are normally a relatively minor source of low-cost funding. Total interest bearing deposits at December 31, 2011 were $1,067 million, a decrease of $370 million (26 percent) from year-end 2010. The average balance of total interest bearing deposits in 2011 was $1,238 million, a decrease of $398 million (24 percent) from the 2010 average balance.
Deposit balances, which can change substantially based on the actions of a few larger members, fell over the last year despite members' substantial increase in excess reserves and their stagnant loan demand. We believe this may be due to the higher interest rates that the Federal Reserve currently offers on member deposits compared to those we can offer at acceptable profitability.
Derivatives Hedging Activity and Liquidity
Our use of and accounting for derivatives is discussed in the "Effect of the Use of Derivatives on Net Interest Income" section in "Results of Operations." Liquidity is discussed in the "Liquidity Risk" section in “Quantitative and Qualitative Disclosures About Risk Management.” We did not change our strategy of using derivatives solely to manage market risk exposure in 2011.
Capital Resources
The GLB Act and Finance Agency Regulations specify limits on how much we can leverage capital by requiring that we maintain, at all times, at least a 4.00 percent regulatory capital-to-assets ratio. A lower ratio indicates more leverage. If financial leverage increases too much, or becomes too close to the regulatory limit, we have discretionary ability within our Capital Plan to enact changes to ensure capitalization remains strong and in compliance with regulatory limits. The following tables present capital amounts and capital-to-assets ratios, on both a GAAP and regulatory basis.
We consider the regulatory capital-to-assets ratio to be a better representation of financial leverage than the GAAP ratio because the GAAP ratio treats mandatorily redeemable capital stock as a liability, although it provides the same function as GAAP capital stock and retained earnings in protecting investors in our debt.
Our capital base was relatively stable in 2011, with the amount of regulatory capital changing only $42 million year over year. Similarly, average GAAP and regulatory financial leverage, as represented by the average capital-to-assets ratio in which a lower ratio indicates more leverage, did not change materially in 2011. Financial leverage was lower at the end of 2011 due to the smaller balance of total assets at year-end 2011.
The following table attributes the small change in 2011 in the regulatory capital stock balance.
The $96 million of repurchases, which were of mandatorily redeemable stock, resulted from the termination and withdrawal of several memberships due to mergers with financial institutions outside our Fifth District and from several members' requests for redemption of their excess stock balances. The FHLBank can repurchase mandatorily redeemable excess capital stock at any time within five years from the date a membership terminates or a request for redemption is made. Based on communications with members, we have no reason to believe the redemption requests represented members' concern about our FHLBank's financial condition or performance.
The table below shows the amount of excess capital stock.
The amount of excess capital stock rose in 2011. This was due to the reduction in Mission Asset Activity and to our action to decrease the maximum amount of membership stock a member must hold from $50 million to $25 million, which resulted in a transfer from membership stock to primarily excess stock (some was transferred to activity stock) for eight members.
A Finance Agency Regulation prohibits us from paying stock dividends if the amount of our regulatory excess stock (defined by the Finance Agency to include stock used cooperatively) exceeds one percent of our total assets on a dividend payment date. Since the end of 2008, we have exceeded the regulatory threshold and, therefore, have been required to pay cash dividends. Until Advances grow again by a large amount, we expect to continue paying cash dividends.
Retained earnings at December 31, 2011 totaled $444 million, which included $12 million added to restricted retained earnings in the third and fourth quarters. Total retained earnings increased $6 million in 2011.
Membership and Stockholders
In 2011, we added 16 new member stockholders and lost 10, ending the year at 741. The new members comprised of eight credit unions, four insurance companies, two commercial banks, and two community development financial institutions. With regard to the 10 institutions that are no longer members, eight merged into other members in our district, one merged into an institution outside our district, and one withdrew from membership. The impact on our earnings and mission asset activity from these membership changes was negligible. We estimate there are approximately 50 eligible non-member institutions remaining in our district with assets of at least $100 million.
In 2011, there were no material changes in the allocation of membership by state, charter type, or asset size. At the end of 2011, the composition of membership by state was Ohio with 324, Kentucky with 217, and Tennessee with 200.
The following table provides the number of member stockholders by charter type.
The following table provides the ownership of capital stock by charter type.
Credit union members hold relatively less stock than their membership proportion because they tend to be smaller than the average member and borrow less. Insurance company members hold relatively more stock than their membership proportion because they tend to be larger than the average member and borrow more.
The following table provides a summary of member stockholders by asset size.
(1)
The December 31 membership composition reflects members' assets as of September 30.
Most members are small financial institutions, with 83 percent having assets up to $500 million. As noted elsewhere, having larger members, such as those with assets over $1 billion, is critical to helping achieve our mission objectives, including providing valuable products and services to all members.
RESULTS OF OPERATIONS
Components of Earnings and Return on Equity
The following table is a summary income statement for each of the last three years. Each ROE percentage is computed by dividing income or expense for the category by the average amount of stockholders' equity for the period.
(a)
The ROE amounts have been computed using dollars in thousands. Accordingly, recalculations based upon the disclosed amounts (millions) in this table may produce nominally different results.
The primary factor contributing to the decline in profitability since 2009 was the relatively weak economy, which led to ongoing reductions in long-term interest rates and reductions in balances of Mission Asset Activity. In addition, 2009 earnings had benefited substantially from wider LIBOR spreads to Discount Note funding costs as a result of the financial crisis of 2008-2009.
Net Interest Income
The largest component of net income has historically been net interest income. We manage net interest income within the context of managing tradeoffs between market risk and return. Effective risk/return management requires us to focus principally on the relationships among assets and liabilities that affect net interest income, rather than individual balance sheet and income
statement accounts in isolation. Our ROE normally is lower than that of many other financial institutions because of the cooperative wholesale business model, the moderate overall risk profile and the management of our balance sheet that results in a positive correlation of dividends to short-term interest rates.
Components of Net Interest Income
We generate net interest income from two components, described below.
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Net interest rate spread. This component equals the balance of total earning assets multiplied by the difference between the book yield on interest-earning assets and the book cost of interest-bearing liabilities. It is composed of net (amortization)/accretion, prepayment fees on Advances, and all other earnings from interest-earning assets net of funding costs. The latter is the largest component and represents the coupon yields of interest-earning assets net of the coupon costs of Consolidated Obligations and deposits.
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Earnings from funding assets with interest-free capital (“earnings from capital”). Because yields on assets funded with interest-free capital change when market interest rates move, earnings from capital funding move in the same direction as rate changes. We deploy much of our capital in short-term and adjustable-rate assets in order to help ensure that ROE moves in the same direction as short-term interest rates and to help control market risk exposure. One way to compute earnings from capital is the average capital balance multiplied by the average cost of interest-bearing liabilities. Because of our relatively low net interest rate spread compared to other financial institutions, we normally derive a substantial proportion of net interest income from deploying capital to fund assets.
The following table shows the major components of net interest income for each of the last three years. Reasons for the variance in net interest income between the two comparison periods are discussed below.
(1)
Includes (amortization)/accretion of premiums/discounts on mortgage assets and Consolidated Obligations and deferred transaction costs (concession fees) for Consolidated Obligations.
(2)
These components of net interest rate spread have been segregated here to display their relative impact.
(3)
Net interest margin is net interest income before provision for credit losses as a percentage of average total interest earning assets.
Earnings From Capital. The reduction in earnings from capital for both comparison periods was due to the continuing trend of reductions in market interest rates, especially long-term rates. As assets matured or paid down, they were replaced with new assets at lower yields. The effect on earnings from this factor in both 2011 and 2010 was primarily due to declines in average yields on mortgage assets. As shown in the "Average Balance Sheet and Rates" table, the average rate on earning assets fell 0.30 percentage points in 2011 (compared to 2010) and 0.19 percentage points in 2010 (compared to 2009).
Net Amortization/Accretion. Net amortization/accretion (generally referred to as "amortization") includes recognition of premiums and discounts paid on purchases of mortgage assets (which include loans in the Mortgage Purchase Program and investments in mortgage-backed securities) and premiums, discounts and concessions paid on most Consolidated Bonds.
Net mortgage amortization can be highly volatile because it is recorded, and adjusted monthly, in accordance with actual and expected principal paydowns to approximate a level yield. Amortization is accelerated when mortgage paydowns speed up (normally in response to lower mortgage rates) and decelerated when they slow down (normally in response to higher mortgage rates). Interest rates also affect the amortization of Bond concessions by changing the amount of Bonds we call before maturity. When Bonds are called, remaining concessions are recognized immediately.
The amount of mortgage assets with premium balances increased substantially in 2010 and 2011, primarily because we purchased more mortgage-backed securities (with above market coupons) at premium prices than in the past. Conditions prevailing in the mortgage markets, especially in 2010, limited the availability and risk-return attractiveness of such securities with prices closer to par or at discounts. Our mortgage assets had a net premium balance of $161 million at December 31, 2011.
The $24 million increase to total net amortization during 2011 resulted from the larger premium balance and substantial reductions in mortgage rates in the third quarter. Mortgage amortization increased by $41 million in 2011 compared to 2010. These amounts were partially offset by an $18 million reduction in Bond amortization, primarily because we retired fewer Bonds before their final maturities than in the prior year.
Although average rates on mortgages and Bonds were moderately lower in 2010 than in 2009, the 2010 change in net amortization was relatively small. This is because, in 2010, the increase in mortgage net amortization from faster prepayment speeds was offset by lower amortization on Bonds, as we called fewer Bonds in 2010 than in 2009.
Prepayment Fees on Advances. Fees for members' early repayment of certain Advances are designed to make us economically indifferent to whether members hold Advances to maturity or repay them before maturity. Prepayments in one period do not necessarily indicate a trend that will continue in future periods. Although Advance prepayment fees can be, and in the past have been, significant, they were relatively modest in each of the last three years.
Other Components of Net Interest Rate Spread. Excluding net amortization and prepayment fees, the other components of the net interest rate spread increased by $17 million (seven percent) in 2011 versus 2010, while it decreased by $96 million (29 percent) in 2010 versus 2009. Several factors, discussed below in estimated approximate order of impact from largest to smallest, were primarily responsible for the changes in the net interest spread due to other components.
2011 Versus 2010
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Re-issuing called Consolidated Bonds at lower debt costs-Favorable: In the last six months of 2010 and all of 2011, reductions in intermediate- and long-term interest rates enabled us to call $10.6 billion of unswapped Bonds before their final maturities and replace them with new Consolidated Obligations, most at substantially lower rates than the Bonds called. Most of the Bonds called funded mortgage assets. The Bonds called in the second half of 2010 benefited our earnings for all of 2011.
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Trading securities-Favorable: In 2011, we began holding a large amount of investments in short-term trading securities (including instruments of the U.S. Treasury and government-sponsored enterprises) in order to enhance asset liquidity and manage counterparty credit risk. Many of the trading securities were purchased with above-market coupon rates, which resulted in an estimated $19 million increase in net interest income in 2011. However, this was offset by earnings reductions in other non-interest income (specifically, net unrealized market value losses on trading securities), with the resulting combined earnings from the trading securities reflecting at-market rates. See “Non-Interest Income and Non-Interest Expense” below for a discussion of the net losses on trading securities.
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Decrease in mortgage asset balances-Unfavorable: The average principal balance on loans in the Mortgage Purchase Program and mortgage-backed securities decreased $1.3 billion. These assets normally earn wider spreads than most of our other assets.
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Narrower net spreads on new mortgage assets-Unfavorable: In 2011, we purchased $5.8 billion of new mortgage assets. Net spreads relative to funding costs on the purchased assets were on average narrower than the net spreads that had been earned on the mortgages that paid down.
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Wider portfolio spreads on LIBOR-indexed assets-Favorable: We use Discount Notes to fund a large amount (normally between $10 billion and $20 billion) of LIBOR-indexed assets (mostly Advances). In 2011, the average portfolio spread between LIBOR and Discount Notes widened approximately eight basis points which increased interest income rose approximately $10 million. This spread widened especially in the fourth quarter of 2011 related to the financial turmoil in Europe.
2010 Versus 2009
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Narrower portfolio spreads on LIBOR Advances-Unfavorable: In 2010, the average portfolio spread on LIBOR-indexed Advances relative to Discount Note funding costs was close to the 18 to 20 basis points historical average. In 2009, however, the spread was abnormally wider -- in some months more than 100 basis points -- because the financial market disruptions of 2008 and 2009 raised the cost of inter-bank lending (represented by LIBOR) relative to other short-term interest costs such as our Discount Notes. The narrowing of this spread in 2010 decreased interest income approximately $40 million.
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Re-issuing called Consolidated Bonds at lower debt costs-Favorable: Reductions in intermediate- and long-term interest rates in 2010 enabled us to call over $10 billion of unswapped Bonds before their final maturities. By contrast, the amount of mortgage paydowns, which we reinvested in assets with lower rates, was substantially less ($6.5 billion) than the amount of Bonds called.
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Lower balances of Advances and mortgage assets-Unfavorable: The average principal balance of interest-earnings assets declined by $15.2 billion in 2010. Most of the reduction occurred from a $12.2 billion decrease in the principal balance of Advances and a $1.6 billion decrease in the principal balance of mortgage assets. Because our mortgage assets normally have substantially wider spreads than Advances, the reduction in earnings from the lower balance of mortgage assets was approximately the same as that from Advances.
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Lower net spreads on new mortgage assets-Unfavorable: In 2010, we purchased $5.4 billion of new mortgage assets. Net spreads relative to funding costs on the purchased assets were on average narrower than the net spreads that had been earned on the mortgage principal that paid down.
Average Balance Sheet and Rates
The following table provides average rates and average balances for major balance sheet accounts, which determine the changes in the net interest rate spread. All data include the impact of interest rate swaps, which we allocate to each asset and liability category according to their designated hedging relationship. The changes in the net interest rate spread and net interest margin in 2011 versus 2010 and in 2010 versus 2009 occurred mostly from the net impact of the factors discussed above in “Components of Net Interest Income.”
(1
)
Amounts used to calculate average rates are based on dollars in thousands. Accordingly, recalculations based upon the disclosed amounts (millions) may not produce the same results.
(2
)
Non-accrual loans are included in average balances used to determine average rate.
(3
)
Includes certificates of deposit and bank notes that are classified as available-for-sale securities.
(4
)
Includes available-for-sale securities based on their amortized costs. The yield information does not give effect to changes in fair value that are reflected as a component of stockholders' equity for available-for-sale securities.
(5
)
The average balance amounts include the rights or obligations to cash collateral, which are included in the fair value of derivative assets or derivative liabilities on the Statements of Condition at period end.
(6
)
Net interest margin is net interest income before provision for credit losses as a percentage of average total interest earning assets.
2011 Versus 2010
The average rate on both total earning assets and interest-bearing liabilities decreased, driven by lower average rates on long-term assets and long-term liability accounts, which include mortgage loans held for portfolio, mortgage-backed securities, and unswapped fixed-rate Consolidated Bonds. As the long-term assets and liabilities mature or are paid down over time, new long-term assets and liabilities are put on the balance sheet at lower rates, which cumulatively builds over time to reduced portfolio rates. The much higher amortization of mortgage purchase premiums in 2011, discussed above, also contributed to the declines in average rates on earnings assets.
Average rates on our short-term and adjustable-rate assets and liabilities experienced small fluctuations, within the range of normal movements consistent with the relatively stable short-term rate environment. However, short-term LIBOR rose moderately in the fourth quarter. This resulted in a small increase in the average rate on the swapped Consolidated Obligation liability account and the adjustable-rate Bonds account, which are both tied to short-term LIBOR.
The average rate on other investments showed a comparatively larger change, for two reasons. First, we held a larger amount of short-term liquidity investments that had longer final maturities than the typical liquidity investment we purchase and the yield curve for liquidity investments is upward sloping. Second, many of these investments were trading securities purchased with above market coupons purchased at premiums, with corresponding market value adjustments reflected in other non-interest income as losses to the securities' fair values, as discussed further in "Non-Interest Income and Non-Interest Expense."
2010 Versus 2009
Average rates on Advances, short-term borrowings (mostly Discount Notes), adjustable-rate Bonds, and swapped Bonds decreased mostly because of the declines in short-term LIBOR. Average rates on Federal funds sold and other interest-bearing deposits in banks were comparatively stable because the Federal Reserve had dropped the overnight Federal funds rate to its current level by the end of 2008 and deposit rates tended to experience corresponding reductions. Average rates on other investments increased modestly because we purchased instruments in that account with longer maturities in 2010 than in 2009. Average rates on mortgage loans held for portfolio (the Mortgage Purchase Program), mortgage-backed securities, and unswapped fixed-rate Consolidated Bonds decreased because of reductions in average rates on instruments having intermediate- and long-term maturities.
Volume/Rate Analysis
Changes in both average balances (volume) and interest rates influence changes in net interest income. The following table summarizes these changes and trends in interest income and interest expense.
(1)
Volume changes are calculated as the change in volume multiplied by the prior year rate.
(2)
Rate changes are calculated as the change in rate multiplied by the prior year average balance.
(3)
Changes that are not identifiable as either volume-related or rate-related, but rather are equally attributable to both volume and rate changes, have been allocated to the volume and rate categories based upon the proportion of the absolute value of the volume and rate changes.
Effect of the Use of Derivatives on Net Interest Income
The following table shows the effect of using derivatives on net interest income. The table does not show the effect on earnings from the non-interest components of derivatives related to market value adjustments; this is provided in the next section “Non-Interest Income and Non-Interest Expense.”
Most of our derivatives synthetically convert the intermediate- and long-term fixed interest rates on certain Advances and Consolidated Obligation Bonds to adjustable-coupon rates tied to short-term LIBOR (mostly three-month). These adjustable-rate coupons normally carry lower interest rates than the fixed rates. The use of derivatives lowered net interest income in each of the last three years primarily because the Advances that were swapped to short-term LIBOR had higher fixed interest rates than the Bonds that were swapped to short-term LIBOR. This reduction in earnings was acceptable because it enabled us, as
designed, to significantly lower market risk exposure by resulting in a much closer match of actual cash flows between assets and liabilities than would occur otherwise.
See Item 1 and the section “Use of Derivatives in Market Risk Management” in “Quantitative and Qualitative Disclosures About Risk Management” for further information on our use of derivatives.
Provision for Credit Losses
After experiencing no mortgage loan credit losses prior to 2010, actual and incurred losses occurred in 2010 and 2011 from the build-up effect of the sharp decline in home prices and other economic variables that affect mortgage defaults and the resulting increase in loan foreclosures in many areas of the country. In 2011, charge-offs on loans in the Mortgage Purchase Program totaled $3.9 million and we recorded a $12.6 million provision for future credit losses in the Program. The provision in 2010 ($13.6 million) was similar to that in 2011, although charge-offs in 2010 ($1.5 million) were less than in 2011.
The additional provision in 2011 was based on our assessment of further incurred losses as a result of a larger number of loans estimated to contain incurred losses, continued modest declines in historical home prices, and periodic updates to housing data used in the third-party default model we employ. The increase in the number of loans with incurred losses has been impacted by a slow process in servicers resolving foreclosed loans. The data update particularly involved higher loss severities expected for loans in foreclosure, based on actual observations of increasing loss severities due to delays in servicers processing foreclosures. Further information is in the "Credit Risk - Mortgage Purchase Program" section in "Quantitative and Qualitative Disclosures About Risk Management" and Note 11 of the Notes to Financial Statements.
Non-Interest Income and Non-Interest Expense
The following table presents non-interest income and non-interest expense.
(1)
Amounts used to calculate percentages are based on dollars in thousands. Accordingly, recalculations based upon the disclosed amounts (millions) may not produce the same results.
The net gains on held-to-maturity securities in each year occurred from our sales of certain mortgage-backed securities. Each of the securities sold had less than 15 percent of the original acquired principal outstanding at the time of the sale.
The decrease in other non-interest (loss) income in 2011 was mostly due to losses on trading securities. As discussed above in “Components of Net Interest Income,” these losses were driven by certain securities purchased with above-market coupon rates and, therefore, prices above par. The related premiums paid are reflected as mark-to-market losses to the securities as their fair values approach par at maturity.
We continue to maintain a sharp focus on controlling operating costs. The decrease in compensation and benefits in 2011 reflected lower pension funding costs as compared to 2010. Total other expenses rose only $1 million in 2011, after falling $3 million in 2010.
Detail on Net Gains (Losses) on Derivatives and Hedging Activities
(1)
Includes only those gains or losses on financial instruments held at fair value that have an economic derivative "assigned."
The changes in net gains (losses) on derivatives and hedging activities primarily represented unrealized market value adjustments, which resulted principally from the trend reductions in interest rates and secondarily from amortization of certain market value gains. The amount of income volatility in derivatives and hedging activities in the last three years was modest, well within the range of normal historical fluctuation relative to the notional amount of derivatives, and consistent with the close hedging relationships of our derivative transactions. In each of the three years shown, the market value adjustment, as a percentage of notional derivatives principal, was less than 0.05 percentage points.
REFCORP and Affordable Housing Program Assessments
Until the third quarter of 2011, assessments against earnings had included a REFCORP obligation and expenses for the Affordable Housing Program. The FHLBank System's REFCORP obligation was satisfied at the end of the second quarter of 2011. Under the Capital Agreement agreed to by all 12 FHLBanks, REFCORP, which had been recorded as reduction to net income, has been replaced with a 20 percent allocation of net income to restricted retained earnings. See Item 1's "Capital Resources" and the "Executive Overview" for more information. The restricted retained earnings are not recorded in the income statement and are not available to be distributed as dividends to stockholders. This change resulted in an $11 million increase in 2011 net income and a corresponding reduction in assessments. There has been no change in our Affordable Housing Program.
In 2011, assessments totaled $37 million and lowered ROE by 1.03 percentage points. In 2010, assessments totaled $62 million and lowered ROE by 1.74 percentage points. The smaller impact of assessments on ROE in 2011 was due to the lower 2011 earnings and the replacement of REFCORP with restricted retained earnings.
Analysis of Quarterly ROE
The following table summarizes the components of 2011's quarterly ROE and provides quarterly ROE for 2010 and 2009.
Quarterly ROE in 2011 ranged from 2.07 percent to 4.80 percent, even though one of the main drivers of earnings, short-term interest rates, was stable. Because quarterly ROE was significantly higher than short-term interest rates, we were able to distribute quarterly dividends to stockholders that were less volatile than ROE. Except for the third quarter, 2011's quarterly ROE was in a relatively narrow range of 0.52 percentage points.
ROE in the third quarter of 2011 was negatively impacted mostly by a large increase in net mortgage premium amortization due to the declines in mortgage rates in that quarter. In the fourth quarter, the wider spread between LIBOR and Discount Note funding costs offset the unfavorable impact of net mortgage premium amortization on ROE. In addition, in the third and fourth quarters of 2011, total ROE was favorably impacted by approximately 1.00 percentage points from the termination of REFCORP assessments and implementation of the Joint Capital Agreement, which does not affect ROE. The assessments in those two quarters included only the accrual for the Affordable Housing Program.
Segment Information
Note 19 of the Notes to Financial Statements presents information on our two operating business segments. We manage financial operations and market risk exposure primarily at the level, and within the context, of the entire balance sheet, rather than exclusively at the level of individual segments. Under this approach, the market risk/return profile of each segment may not match, or possibly even have the same trends as, what would occur if we managed each segment on a stand-alone basis. The table below summarizes each segment's operating results for each of the last three years.
(1)
Amounts used to calculate returns are based on numbers in thousands. Accordingly, recalculations based upon the disclosed amounts (millions) may not produce the same results.
Traditional Member Finance Segment
The decrease in 2011's net income and ROE primarily reflected the following factors, each of which is discussed in more detail above: higher amortization of purchased premiums related to mortgage-backed securities; lower yields on assets funded with interest-free capital; narrower net spreads on new mortgage-backed securities; and reductions in unrealized gains on derivatives market values. These factors were almost fully offset by calls of Consolidated Bonds that funded mortgage-backed securities and their replacement with lower cost debt, a modest widening of the average LIBOR to Discount Note spread; and increased gains from sales of mortgage-backed securities.
Mortgage Purchase Program Segment
The profitability of the Mortgage Purchase Program continued to be at a substantial level over market interest rates, with a moderate amount of market risk and credit risk. In 2011, the Program averaged 11 percent of total average assets but accounted for 28 percent of earnings. The decrease in the Program's ROE during 2011 reflected the larger amortization of purchase premiums, additional provision for credit losses, and narrower spreads on new loans in the Program compared to spreads earned on assets that paid down. These factors were partially offset by replacing called Bonds funding Program loans with lower cost debt.
The segment's ROE for both 2011 and 2010 was below its historical average ROE, especially in 2011. This was due primarily to a large amount of amortization, as mortgage rates declined substantially in both years. Without the additional volatility in amortization, the segment's ROE in 2011 would have been 13-15 percent, in line with historical average ROE.
Compared to the Traditional Member Finance segment, the Mortgage Purchase Program segment can exhibit more earnings volatility relative to short-term interest rates and more credit risk exposure, but also provides the opportunity for enhanced risk-adjusted returns which can augment earnings. As discussed elsewhere, although mortgage assets are the largest source of our market risk, we believe that we have historically managed the risk prudently and that these assets do not excessively elevate the balance sheet's overall market risk exposure.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT RISK MANAGEMENT
Market Risk
Overview
Market risk exposure is the risk that net income and the value of stockholders' capital investment in the FHLBank may decrease, and that profitability may be uncompetitive as a result of changes and volatility in the market environment and business conditions. Along with business/strategic risk, market risk is normally one of our largest residual risks. We attempt to minimize market risk exposure within a prudent range while earning a competitive return on members' capital stock investment. There is normally a tradeoff between long-term market risk exposure and shorter-term exposure. Effective management of both components is important in order to attract and retain members and capital and to support Mission Asset Activity.
The primary challenges in managing market risk exposure arise from 1) the tradeoff between earning a competitive return and correlating profitability with short-term interest rates and 2) the market risk exposure of owning mortgage assets. Mortgage assets grant homeowners prepayment options that tend to change unfavorably for us when interest rates change. We mitigate the market risk of mortgage assets primarily with a portfolio of long-term unswapped fixed-rate callable and noncallable Consolidated Bonds that have expected cash flows similar to the aggregate cash flows expected from mortgage assets under a wide range of interest rate and prepayment environments. Because it is normally cost-prohibitive to completely mitigate mortgage prepayment risk, a residual amount of market risk normally remains after funding and hedging activities.
We analyze market risk using numerous analytical measures under a variety of interest rate and business scenarios, including stressed scenarios, and perform sensitivity analysis on the many variables that can affect market risk, using several market risk models from third-party software companies. These models employ rigorous valuation techniques for the optionality that exists in mortgage prepayments, call and put options, and caps/floors. We regularly assess the effects of different assumptions, techniques and methodologies on the measurements of market risk exposure, including comparisons to alternative models and information from brokers/dealers.
We have historically emphasized strategies aimed at ensuring a moderate level of market risk, with the goal of providing a competitive earnings stream over a multitude of market and business environments and having a relative small amount of earnings volatility. These strategies include, among others: 1) conservative management of market risk exposure, 2) controlled growth in mortgage assets and 3) accounting and hedging practices that attempt to appropriately minimize earnings volatility from use of derivatives.
Policy Limits on Market Risk Exposure
We have five sets of policy limits regarding market risk exposure, which primarily address long-term market risk exposure. We determine compliance with our policy limits at every month-end or more frequently if market or business conditions change significantly or are volatile.
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Market Value of Equity Sensitivity. The market value of equity for the entire balance sheet in two hypothetical interest rate scenarios (up 200 basis points and down 200 basis points from the current interest rate environment) must be between positive and negative 15 percent of the current balance sheet's market value of equity. The interest rate movements are “shocks,” defined as instantaneous, permanent, and parallel changes in interest rates in which every point on the yield curve is changed by the same amount.
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Duration of Equity. The duration of equity for the entire balance sheet in the current (“flat rate” or “base case”) interest rate environment must be between positive and negative six years. In addition, the duration of equity in up and down 200 basis points interest rate shocks must be within positive and negative eight years.
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Market Capitalization. The market capitalization ratio (defined as the ratio of the market value of equity to the par value of regulatory stock) must be above 95 percent in the current rate environment and must be above 85 percent in each of two stressful interest rate shocks.
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Mortgage Assets Portfolio. The net market value of the mortgage assets portfolio as a percentage of the book value of portfolio assets must be between positive and negative three percent in each of the up and down 200 basis points interest rate shocks. Net market value is defined as the market value of assets minus the market value of liabilities, with no assumed capital allocation.
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Mortgage Assets as a Multiple of Regulatory Capital. The amount of mortgage assets must be less than seven times the amount of regulatory capital.
In addition, Finance Agency Regulations and an internal policy provide controls on market risk exposure by restricting the types of mortgage loans, mortgage-backed securities and other investments we can hold. Historically, we have not purchased a large amount of mortgage-backed securities of private-label issuers, which can have more volatility in prepayment speeds and credit risk exposure than GSE mortgage-backed securities. We have tended to purchase the front-end prepayment tranches of collateralized mortgage obligations, which can have less prepayment volatility than other tranches. We also manage market risk exposure by charging members prepayment fees on many Advance programs where an early termination of an Advance would result in an economic loss to us.
Market Value of Equity and Duration of Equity - Entire Balance Sheet
Two key measures of long-term market risk exposure are the sensitivities of the market value of equity and the duration of equity to changes in interest rates and other variables, as presented in the following tables for various instantaneous and permanent interest rate shocks. Average results are compiled using data for each month end. Given the very low level of rates, the down rate shocks are nonparallel scenarios, with short-term rates decreased less than long-term rates so that no rate falls below zero.
Market Value of Equity
Duration of Equity
In 2011, the average market risk exposure to higher interest rates was moderate, well within policy limits, and consistent with long-term historical average exposure. The average market risk exposure in this period indicated more exposure to higher interest rates compared to 2010's average exposure because 2010's exposure was at low levels. However, market risk exposure to higher interest rates at December 31, 2011 was below historical average levels and below the exposure at the end of 2010. This resulted from the further reductions in long-term rates that occurred in the third and fourth quarters of 2011. When mortgage rates rise 0.50 percentage points or more, we would expect market risk exposure to further rate increases to return to levels more consistent with historical positioning.
Throughout 2011 including at year end, market risk exposure to lower rates was also moderate, well within policy limits, consistent with long-term historical average exposure, and similar to 2010's average levels. Although declines in mortgage rates would accelerate mortgage prepayment speeds and require reinvestment of asset principal paydowns at lower yields, the effect on earnings would be significantly offset by the ability to call Consolidated Bonds before their final maturities and replace them at lower funding costs. The result would be that earnings would decrease moderately and profitability would remain competitive compared with market interest rates.
The market risk metrics are computed for parallel changes in interest rates (except for down rate shocks, as explained above). If interest rates were to increase sharply, we believe based on historical movements in rates, short-term rates would increase more than longer-term rates. In this scenario, our metrics indicate that market risk exposure would be materially less than under the parallel shock scenarios provided above.
Based on the totality of our market risk analysis, we expect that profitability, defined as the level of ROE compared with short-term market rates, will remain competitive unless interest rates would change by extremely large amounts in a short period of time. Decreases in long-term interest rates even up to 2.00 percentage points (which would put fixed-rate mortgages at two percent or less) would still result in ROE being above market interest rates. However, sharp reductions in long-term rates could result in an immediate, one-time large amount of amortization of mortgage purchase premiums, which could negatively impact our results of operations for one quarter.
We believe that profitability would not become uncompetitive unless long-term rates were to increase immediately and permanently by 4.00 percentage points or more combined with short-term rates increasing to at least eight percent. Such large changes in interest rates would not result in negative earnings, unless these rate environments occurred quickly, lasted for a long period of time, and were coupled with very unfavorable changes in other market and business variables or our business model. We believe such a scenario is extremely unlikely to occur.
Market Capitalization Ratio
The ratio of the market value of equity to the par value of regulatory capital stock (called the "market capitalization ratio") indicates the theoretical net market value of portfolio assets after subtracting the theoretical net market cost of liabilities. The market capitalization ratio excludes retained earnings in the denominator and therefore shows the ability of the market value of equity to protect the value of stockholders' investment in our company.
To the extent the market capitalization ratio differs from 100 percent, it can represent potential real economic gains or losses, unrealized opportunity benefits or costs, temporary fluctuations in asset or liability prices, or market value remaining under a company liquidation under which all assets were sold and all liabilities were terminated or transferred. The ratio does not sufficiently measure the value of our company as a going concern because it does not consider franchise value, future new business activity, future risk management strategies, or the net profitability of assets after funding costs.
The following table presents the market capitalization ratios for the interest rate environments for which we have policy limits, as described above.
In 2011, the market capitalization ratios in the scenarios indicated were well above 100 percent and in compliance with our policy limits. Currently the ratios are at favorable (high) levels due to the combination of 1) the fact that retained earnings currently comprise 13 percent of regulatory capital stock, 2) we have maintained market risk exposure at moderate levels, and 3) the anomaly that market prices of mortgage assets are at elevated levels compared to prices of our Consolidated Bonds. These measures provide additional support for our assessment that we have a moderate amount of market risk exposure.
Market Risk Exposure of the Mortgage Assets Portfolio
The mortgage assets portfolio accounts for almost all of our market risk exposure because of prepayment volatility that we cannot completely hedge while maintaining positive net spreads. Sensitivities of the market value of equity for the mortgage assets portfolio under interest rate shocks (in basis points) are shown below. Average results are compiled using data for each month-end.
% Change in Market Value of Equity-Mortgage Assets Portfolio
These measures indicate that the average market risk exposure of the mortgage assets portfolio had similar trends across interest rate shocks as those of the entire balance sheet. As expected, the mortgage assets portfolio had substantially greater risk than the entire balance sheet. Market risk exposure to higher rates at December 31, 2011 was lower than that at the end of 2010. The average exposure in 2011 to higher interest rates was consistent with historical average market risk exposure and substantially greater than 2010's average exposure to higher rates.
We believe that the mortgage assets portfolio continues to have a moderate amount of market risk exposure that is consistent with our conservative risk philosophy, cooperative business model, and the risk exposure generally associated with investing in mortgage assets.
Use of Derivatives in Market Risk Management
The following table presents the notional principal amounts of the derivatives used to hedge other financial instruments classified by how we designate the hedging relationship.
In addition to issuing long-term Consolidated Bonds, an important way that we manage and hedge market risk exposure is by engaging in derivatives transactions, primarily interest rate swaps. Our hedging and risk management strategies in using derivatives did not change in 2011 compared to historical strategies, nor were there changes in the accounting treatment of new or existing derivative hedge transactions that materially impacted our results of operations. The decrease in the notional amount of Advance hedges at year-end 2011 compared to year-end 2010 corresponded to the overall reduction in Advance balances.
In 2011, we began to account for certain Bond-related derivatives using an accounting election called "fair value option," which is included in the economic hedge category in the table. There was a corresponding decrease in the "fair value hedge" election, also as indicated in the table. The differences between accounting under "fair value option" and under "fair value hedge" are that 1) the "fair value option" does not carry a risk that hedge effectiveness testing would fail, which would result in recording the derivative at its fair market value with no offsetting changes in the market value of the hedged instrument, and 2) the "fair value option" records the fair market value of the hedged instrument at its full fair value instead of only the value of hedging the benchmark interest rate (designated to be LIBOR for these swaps). This change in accounting election resulted in a negligible amount of additional unrealized earnings volatility from accounting for derivatives. See "Critical Accounting Policies and Estimates" for further discussion.
Capital Adequacy
Capital Leverage
Prudent risk management dictates that we maintain effective financial leverage to minimize risk to our capital stock while preserving profitability and that we hold an adequate amount of retained earnings. Pursuant to these objectives, Finance Agency Regulations stipulate that we must comply with three limits on capital leverage and risk-based capital.
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We must maintain at least a 4.00 percent minimum regulatory capital-to-assets ratio. This has historically been the most binding regulatory requirement.
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We must maintain at least a 5.00 percent minimum leverage ratio of capital divided by total assets, which includes a 1.5 weighting factor applicable to permanent capital. Because all of our Class B stock is permanent capital, this requirement is met automatically if we satisfy the 4.00 percent unweighted capital requirement.
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We are subject to a risk-based capital rule, as discussed below.
We have always complied with each capital requirement. The minimum regulatory capital ratio averaged 5.78 percent in 2011. The ratio at the end of 2011 was 6.37, which means that given the amount of regulatory capital, total assets could increase by approximately $35 billion before the capital-to-assets ratio would fall to 4.00 percent. This amount of growth in assets is unlikely to occur and, if it did, we would require additional amounts of capital under our Capital Plan before the 4.00 percent policy limit on capitalization would be reached.
See the “Capital Resources” section of “Analysis of Financial Condition” and Note 17 of the Notes to Financial Statements for more information on our capital adequacy.
Retained Earnings
Our Retained Earnings Policy sets forth a range for the amount of retained earnings we believe is needed to mitigate impairment risk and augment dividend stability in light of the risks we face. In 2011, the Board of Directors approved a retained earnings requirement of $350 million, based on mitigating all of our combined risks under stress scenarios to at least a 99 percent confidence level. Given the recent financial and regulatory environment, we have been carrying a greater amount of retained earnings in the last several years than required by the Policy. At December 31, 2011, we had $444 million of retained earnings. As discussed elsewhere, we will continue to bolster capital adequacy over time by allocating a portion of earnings to a separate restricted retained earnings account in accordance with the FHLBank System's Joint Capital Agreement.
Components of Capital Plan That Promote Capital Adequacy
The GLB Act and our Capital Plan promote the adequacy of our capital to absorb financial losses in three ways:
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the five-year redemption period for Class B stock;
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the option we have to call on members to purchase additional capital if required to preserve safety and soundness; and
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the limitations on our ability to honor requested redemptions of capital if we are at risk of not maintaining safe and sound operations.
These combine to give member stockholders a clear incentive to require us to minimize our risk profile.
Risk-Based Capital Regulatory Requirement
We must hold sufficient capital to protect against exposure to market risk, credit risk, and operational risk. The GLB Act and Finance Agency Regulations require total permanent capital, which includes retained earnings and the regulatory amount of Class B capital stock, to be at least equal to the amount of risk-based capital. Risk-based capital is the sum of market, credit, and operational risk-based capital as specified by the Regulations. The following table shows the amount of risk-based capital required based on the measurements, the amount of permanent capital, and the amount of excess permanent capital.
The risk-based capital requirement has historically not been a constraint on operations and we do not use it to actively manage any of our risks. It has normally ranged from 10 to 20 percent, which is significantly less than the amount of permanent capital.
Credit Risk
Overview
We assume a substantial amount of inherent credit risk exposure in our dealings with members, purchases of investments, and transactions of derivatives. For the reasons detailed below, we believe we have a minimal overall amount of residual credit risk exposure related to our Credit Services, purchases of investments, and transactions in derivatives and a moderate amount of legacy credit risk exposure related to the Mortgage Purchase Program.
Credit Services
Overview. We have policies and practices to manage credit risk exposure from our secured lending activities, which include Advances and Letters of Credit. The objective of our credit risk management is to equalize risk exposure across members and counterparties to a zero level of expected losses. Despite ongoing deterioration in the credit conditions of many of our members and in the value of some pledged collateral, which began in 2008, we believe that credit risk exposure in our secured lending activities continued to be minimal in 2011. We base this assessment on the following factors:
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a conservative approach to collateralizing credit services that results in significant over-collateralization;
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close monitoring of members' financial conditions and repayment capacities;
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a risk-focused process for reviewing and verifying the quality, documentation, and administration of pledged loan collateral;
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significant upward adjustments on collateral margins assigned to almost all of the subprime and nontraditional mortgages pledged as collateral; and
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a history of never experiencing a credit loss or delinquency on any Advance.
Because of these factors, we have never established a loan loss reserve for Advances. We expect to collect all amounts due according to the contractual terms of Advances and Letters of Credit.
Collateral. We require each member to provide us a security interest in eligible collateral before it can undertake any secured borrowing. At December 31, 2011, our policy on over-collateralization resulted in total collateral pledged of $156.8 billion with total borrowing capacity of $102.5 billion. Lower borrowing capacity results because we apply Collateral Maintenance Requirements (CMRs) to discount the value of pledged collateral in order to recognize market, credit, and liquidity risks that may affect the collateral's realizable value in the event we must liquidate it. Over-collateralization by one member is not applied to another member.
As indicated in the table below, the allocation of total pledged collateral (unadjusted for CMRs) between December 31, 2011 and December 31, 2010 did not change materially. At December 31, 2011, 79 percent of collateral was related to residential mortgage lending in single family loans and home equity lines.
(a)
Less than one percent of total pledged collateral.
We assign each member one of four levels of collateral status-Blanket, Securities, Listing, and Physical Delivery-
based in part on our credit rating (described below) that reflects our view of the member's current financial condition, capitalization, level of problem assets, and other risk factors. Under Blanket status, which is the least restrictive status and is available for lower risk institutions, the borrowing member is not required to provide loan level detail on pledged collateral. We monitor eligible collateral pledged under Blanket status using quarterly regulatory financial reports or periodic collateral “Certification” documents submitted by all significant borrowers. Currently, approximately 85 percent of members and borrowing nonmembers have been assigned Blanket collateral status. Over 90 percent of single family mortgage loan collateral and commercial real estate collateral is under blanket status and almost all home equity loan collateral is under Blanket status.
Under Listing collateral status, a member pledges and provides us detailed information on specifically identified individual loans and securities that meet certain minimum qualifications. Physical Delivery is the most restrictive collateral status, which we assign to members experiencing significant financial difficulties, insurance companies pledging loans, and newly chartered institutions. We require borrowers assigned to Physical Delivery to deliver into our possession securities and/or original notes, mortgages or deeds of trust. The instruments we accept are highly restrictive and subject to a conservative valuation process. We require Physical status for insurance companies to help ensure our position as a first-priority secured creditor, to the extent permitted under state insurance regulation, because they do not have the backing of the FDIC or other deposit insurance funds controlled by a regulator. We require Physical status for newly chartered institutions until they have developed a solid financial history that trends strongly towards being profitable.
Some members may pledge bond securities, which we hold are under physical delivery collateral status. We regularly estimate market values of collateral under Listing and Physical status using a third-party pricing service.
Borrowing Capacity/Lendable Value. We determine borrowing capacity against pledged collateral by applying CMRs. CMRs are intended to capture market, credit, liquidity, and prepayment risks that may affect the realizable value of each pledged asset in the event we must liquidate collateral. They are percentage adjustments (i.e., discounts) applied to the estimated market value of pledged collateral, and therefore their application results in borrowing capacity that is less than the amount of pledged collateral. The discounts are determined by dividing one by the CMR; for example, a CMR of 150 percent translates into a discount of 66.7 percent, which means that 66.7 percent of the market value is eligible for borrowing. Members and collateral with a higher risk profile, more risky credit quality, and/or less favorable performance are generally assigned higher CMRs.
The table below indicates the range of lendable values remaining after the application of CMRs for each major collateral type pledged at December 31, 2011. The ranges of lendable values are expressed as percentages of collateral market value and exclude subprime and nontraditional mortgage loan collateral. Loans pledged under a Blanket status generally are haircut more aggressively than loans on which we have detailed loan structure and underwriting information.
Collateralization of Former Members. On December 31, 2011, we had $4,756 million of Advances outstanding to former members that had been acquired by financial institutions who are not members of our FHLBank. Of this amount, $4,102 million was supported by subordination or other intercreditor security agreements with other FHLBanks, with collateral totaling $5,136 million based on our required collateral levels. The remainder was collateralized by $31 million of marketable securities and $1,604 million in loan collateral held in our custody. Subordination agreements mitigate our risk in the event of default of the counterparty FHLBank by giving our claim to the value of collateral priority over the interests of the subordinating FHLBank, thus providing an incentive to ensure pledged collateral values are sufficient to cover all parties.
Perfection. With certain statutory exceptions that are unlikely to be applicable, the FHLBank Act affords any security interest granted to us by a member, or by an affiliate of a member, priority over the claims and rights of any party, including any receiver, conservator, trustee, or similar party having rights of a lien creditor. As additional security for members' indebtedness, we have a statutory lien on their FHLBank capital stock.
We perfect our security interest in collateral by 1) filing financing statements on each member pledging loan collateral, 2) taking possession or control of all pledged securities and cash collateral, and 3) taking physical possession of pledged loan collateral when we deem it appropriate based on a member's financial condition. In addition, at our discretion and consistent with our Credit Policy, we are permitted to call on members to pledge additional collateral at any time during the life of a borrowing. Credit losses could occur should a regulatory agency, for an unknown reason, prevent us from liquidating our collateral position. Credit risk exposure also exists in cases of fraud by a failing institution or its employees.
Subprime and Nontraditional Mortgage Loan Collateral. We have policies and processes to identify subprime loans pledged by members to which we have high credit risk exposure or have extended significant credit. We perform on-site collateral reviews, sometimes engaging third parties, of members we deem to have high credit risk exposure. The reviews include identification of loans that meet our definitions of subprime and nontraditional. Our definitions of subprime loans and nontraditional mortgage loans (NTM) are expansive and conservative. During the review process, we estimate overall subprime and nontraditional mortgage exposure levels by performing random statistical sampling of residential loans in the members' pledged portfolios.
Based on our collateral reviews, we estimate that approximately 20 to 25 percent of pledged residential loan collateral has one or more subprime characteristics and that approximately five to seven percent of pledged collateral meets the definition of “nontraditional.” These percentages have increased slightly over the last several years. We apply significantly higher
adjustments to the standard CMRs on almost all collateral identified as subprime and/or nontraditional mortgages. No security known to have more than one-third subprime collateral is eligible for pledge to support additional credit borrowings.
Internal Credit Ratings of Members. We assign each borrower an internal credit rating, based on a combination of internal credit analysis and consideration of available credit ratings from independent credit rating organizations. The analysis focuses on asset quality, financial performance, earnings quality, liquidity, and capital adequacy. The credit ratings are used in conjunction with other measures of the credit risk posed by members and pledged collateral, as described above, in managing credit risk exposure of Advances. A lower internal credit rating can cause us to 1) decrease the institution's borrowing capacity via higher CMRs, 2) require the institution to provide an increased level of detail on pledged collateral, 3) require it to deliver collateral into our custody, and/or 4) prompt us to more closely and/or frequently monitor the institution using several established processes.
The following tables show the distribution of internal credit ratings we assigned to member and nonmember borrowers, which we use to help manage credit risk exposure. The lower the numerical rating, the higher our assessment of the member's credit quality. A “4” rating is our assessment of the lowest level of satisfactory performance.
Many members continue to be adversely affected by the last recession, the weak economic recovery, and the continued distress in the housing market. As of December 31, 2011, 152 members and borrowing nonmembers (20 percent of the total) had credit ratings of 5 or below, with $4.5 billion of borrowing capacity. There was a modest improvement in our members' overall financial health in 2011, as indicated by the movement of 16 members out of the two lowest credit ratings levels.
Member Failures, Closures, and Receiverships. There were no member failures in our District in 2011. However, there were two member failures during the first two months of 2012. These institutions had no Advances outstanding with us.
Mortgage Purchase Program
Overview. We believe that the residual amount of credit risk exposure to loans in the Mortgage Purchase Program is moderate, an assessment made based on the following factors:
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various credit enhancements for conventional loans, which generally protect us against losses to a 50 percent loss severity on each loan;
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conservative underwriting and loan characteristics consistent with favorable expected credit performance;
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a relatively moderate overall amount of delinquencies and defaults experienced when compared to national averages;
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only $5.4 million of program-to-date charge-offs through December 31, 2011;
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our estimate that $21 million of additional losses have been incurred in the Program as of December 31, as recognized in our allowance for credit losses, which represent only 0.32 percentage points of the unpaid principal balance of conventional mortgages; and
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financial analysis suggesting that future credit losses will not materially harm capital adequacy and will not significantly affect profitability except under the most extreme and unlikely conditions for mortgage defaults.
Portfolio Loan Characteristics. The following table shows Fair Isaac and Company (FICO®) credit scores of homeowners at origination dates for the conventional loan portfolio. There was little change in the FICO® score distribution in 2011 compared with prior periods. We believe the distribution of FICO® scores is one indication of the portfolio's overall favorable credit quality, with 68 percent of the portfolio having scores above an excellent level of 740 and 86 percent having scores above 700 which is threshold generally considered indicative of homeowners' good credit quality.
(1)
Represents the original FICO® score.
High loan-to-value ratios, in which homeowners have little or no equity at stake, are key drivers in many mortgage delinquencies and defaults. The following tables show loan-to-value ratios for conventional loans based on values estimated at the origination dates and current values estimated at the noted periods. The estimated current ratios are based on original loan values, principal paydowns that have occurred since origination, and a third-party estimate of changes in historical home prices for the metropolitan statistical area in which each loan resides. Both measures are weighted by current unpaid principal.
Overall loan-to-value ratios deteriorated only slightly in 2011. At December 31, 2011, 14 percent of loans were estimated to have current loan-to-value ratios above 90 percent, up from three percent at origination, despite significant deterioration in national average housing prices in recent years. There has been a more substantial increase in the percentage of loans with current loan-to-value ratios between 80 and 90 percent, from six percent at origination to 14 percent at the end of 2011. Further significant reductions in home prices could move the ratios on these loans above 100 percent and increase loan defaults.
Based on the available data, we believe we have little exposure to loans in the Program considered to have characteristics of “subprime” or “alternative/nontraditional” loans. Further, we do not knowingly purchase any loan that violates the terms of our Anti-Predatory Lending Policy.
The geographical allocation of conventional loans in the Program is concentrated in Ohio, as shown on the following table based on unpaid principal balance.
Lender Risk Account. Conventional mortgage loans are supported against credit losses by various combinations of primary mortgage insurance, supplemental mortgage insurance and the Lender Risk Account. The Lender Risk Account is a purchase-price holdback that PFIs may receive back from us, starting five years from the loan purchase date, for managing credit risk to pre-defined acceptable levels of exposure on loan pools they sell to us. The Lender Risk Account is funded by the FHLBank as a portion of the purchase proceeds to cover expected credit losses for a specific pool of loans. As a result, some pools of loans may have sufficient credit enhancements to recapture all losses while other pools of loans may not. The amount of loss claims against the Lender Risk Account in 2011 was approximately $5 million. The Account had balances of $69 million and $44 million at December 31, 2011 and 2010, respectively. The Account increased in 2011 as a result of implementing the new credit enhanced program that replaces the supplemental mortgage insurance with an increased use of the Account. See Note 11 of the Notes to Financial Statements for additional details.
Credit Performance. The table below provides an analysis of conventional loans delinquent or in foreclosure, along with the national average serious delinquency rate.
(1)
Includes conventional loans 30 to 89 days delinquent and not in foreclosure.
(2)
Includes conventional loans that are 90 days or more past due or where the decision of foreclosure or a similar alternative such as pursuit of deed-in-lieu has been reported.
(3)
Early stage delinquencies expressed as a percentage of the total conventional loan portfolio.
(4)
Serious delinquencies expressed as a percentage of the total conventional loan portfolio.
(5)
National average number of fixed-rate prime conventional loans that are 90 days or more past due or in the process of foreclosure is based on the most recent national delinquency data available. The December 31, 2011 rate is based on September 30, 2011 data.
The Mortgage Purchase Program has experienced a moderate amount of delinquencies and foreclosures. The rates continued to be well below national averages and we expect this to continue to be the case. Growth in overall delinquency rates slowed in 2011, with early stage delinquency rates actually falling. These data may not indicate a sustainable trend of a subsiding of stresses in the housing market or a respite based on a slowdown in the rate at which financial institutions are initiating foreclosures.
We consider a high risk loan as having a current loan-to-value ratio above 100 percent. At December 31, 2011, high risk loans had experienced relatively moderate serious delinquencies (i.e., delinquencies that are 90 days or more past due or in the process of foreclosure). For example, of the $505 million of conventional principal balances with current loan-to-values above 100 percent, only $35 million (seven percent) were seriously delinquent. We believe these data further support our view that the overall portfolio is comprised of high quality loans.
Credit Losses. The following table shows the effects of credit enhancements on the determination of the allowance for credit losses at the noted periods:
The data presented above are aggregated, which provide useful information on the health of the overall portfolio. Credit risk exposure depends on the actual and potential credit performance of the loans in each pool compared to the pool's equity (on individual loans) and credit enhancements, including primary mortgage insurance (for individual loans), the Lender Risk Account, and supplemental mortgage insurance. Although the overwhelming majority of pools have not experienced credit losses and are not projected to do so except under extremely stressful economic conditions including further home price declines, some pools are experiencing credit losses that began in 2010.
Although we establish credit enhancements in each mortgage pool at the time of the pool's origination that are sufficient to absorb loan losses of approximately 50 percent, the magnitude of the declines in home prices, increase in unemployment rates, and increase in delinquencies in some areas since 2006 has resulted in losses in some of the mortgage pools that have exhausted credit enhancements. Some of our mortgage pools have a concentration of loans originated in states and localities (e.g., California, Arizona, Florida, and Nevada) that have had the most severe declines in home prices. We purchased most of these loan pools from a former member that stopped selling us mortgage loans in 2007. When a mortgage pool's credit enhancements are exhausted, the FHLBank realizes any additional credit losses in that pool.
In addition to the analysis performed to determine the allowance for credit losses as discussed in Note 11 of the Notes to Financial Statements, we perform analysis using recognized third-party credit and prepayment models, which are updated periodically, to estimate potential ranges of lifetime credit risk exposure for the loans in the Program. We believe that future credit losses will be moderately higher. However, even under adverse scenarios for home prices or unemployment rates (and assuming the two SMI providers continue to pay claims), we do not expect further credit losses to significantly decrease our overall profitability or annual dividends payable to members, or to materially affect our capital adequacy. For example, for an additional 20 percent decline in all home prices over the next two years, we estimate that our lifetime credit losses could increase by approximately $60 million, which would decrease annual ROE by 0.30 percentage points over the next five years (most of the losses are estimated to occur in the next five years).
Credit Risk Exposure to Insurance Providers.
Primary Mortgage Insurance
Some of our conventional loans carry primary mortgage insurance (PMI) as a credit enhancement feature. Based on the guidelines of the Mortgage Purchase Program, we have assessed that we do not have any credit risk exposure to the primary mortgage insurance providers.
Supplemental Mortgage Insurance
Another credit enhancement feature is Supplemental Mortgage Insurance (SMI) purchased from Genworth and MGIC. Beginning February 1, 2011, we no longer use SMI as a credit enhancement for all new business; instead, we augment credit enhancements with a greater amount of the purchase proceeds added to the Lender Risk Account. However, we have outstanding SMI coverage through Genworth and MGIC. Although we discontinued committing new business with MGIC in 2008, 50 percent of our outstanding loans with SMI were underwritten by MGIC at December 31, 2011.
We subject both SMI providers to a standard credit underwriting analysis. Both providers have experienced weakened financial conditions in the last several years. The lowest credit rating from NRSROs is B+ for MGIC and BB- for Genworth, with both on negative outlook. Our exposure to these providers is that they may be unable to fulfill their contractual coverage on loss claims. In a scenario in which home prices do not change and both providers fail to fulfill any of their insurance coverage on defaulting loans (with an assumption that we would obtain only a limited recovery rate), we estimate exposure at December 31, 2011 to the providers over the life of the loans to be approximately $21 million. In a more adverse scenario in which home prices decline an additional 20 percent over the next two years and both providers
fail to pay claims (with the same limited recovery rate assumption), we estimate exposure to be approximately $32 million.
At this time, from our analysis based in part on consultation with a third-party rating agency that specializes in mortgage insurance companies, we do not expect either of the providers to fail to fulfill their insurance contracts. Over time, as existing business in the Mortgage Purchase Program pays off and is replaced with new business which does not rely on SMI, the amount of exposure will diminish.
Investments
Liquidity Investments. The following table presents the carrying value of liquidity investments outstanding in relation to the counterparties' lowest long-term credit ratings provided by Standard & Poor's, Moody's, and/or Fitch Advisory Services.
(1)
Consists of debt securities issued by International Bank for Reconstruction and Development.
(2)
Consists of securities that are issued and effectively guaranteed by Fannie Mae and/or Freddie Mac, which have the backing of the U.S. government, although they are not obligations of the U.S. government.
(3)
Represents corporate debentures issued or guaranteed by the Federal Deposit Insurance Corporation (FDIC) under the Temporary Liquidity Guarantee Program (TLGP).
(4)
Securities purchased under agreements to resell are considered collateralized financing arrangements and effectively represent short-term loans with highly rated counterparties.
We believe these investments were purchased from counterparties that have a strong ability to repay principal and interest. At December 31, 2011, 40 percent of our liquidity investments were purchased from counterparties that provide explicit guarantees from the U.S. government (Treasuries and TLGP securities), that are effectively guaranteed (government-sponsored enterprises), or that are secured with collateral (securities purchased under agreements to resell). Despite Standard & Poor's downgrade of certain of these securities, we believe they continue to represent minimal credit risk exposure to us.
We believe we face minimal exposure in our unsecured liquidity investments to counterparties that could have significant direct or indirect exposure to European sovereign debt, especially to those countries experiencing financial distress. We are aggressive in limiting exposure to such counterparties, either by placing maturity limits, dollar limits, or outright suspensions of any activity. Also, in 2011, as shown in the table above, we lowered exposure to private unsecured counterparties and substituted investments to government-guaranteed and secured counterparties. At December 31, 2011 our exposure to foreign unsecured counterparties totaled $5,325 million, all to counterparties with holding companies domiciled in countries receiving triple-A sovereign ratings. The following table presents our exposure to foreign unsecured counterparties by country.
Mortgage-Backed Securities.
GSE Mortgage-Backed Securities
We have never held any asset-backed securities other than mortgage-backed securities. Historically, almost all of our mortgage-backed securities have been residential GSE securities issued by Fannie Mae and Freddie Mac, which provide credit safeguards by guaranteeing either timely or ultimate payments of principal and interest, and agency securities issued by Ginnie Mae, which the federal government guarantees. We believe that the conservatorships of Fannie Mae and Freddie Mac lower the chance that they would not be able to fulfill their credit guarantees. In addition, based on the data available to us and on our purchase practices, we believe that most of the mortgage loans backing our GSE mortgage-backed securities are of high quality with strong credit performance.
As indicated in Note 7 of the Notes to Financial Statements, at December 31, 2011, our GSE mortgage-backed securities had a total book value of $9,684 million and an estimated net unrealized market value gain totaling $399 million, which resulted in a market value of 104 percent of book value. The market value gain reflects the lower overall level of mortgage rates at year end, compared to when the securities were originated, and elevated market prices on GSE mortgage-backed securities. The elevated market prices are commonly attributed to the combination of the high demand for mortgage-related securities, the view of market participants that GSE mortgage-backed securities have little if any credit risk, and a relative lack of supply of new mortgage securities.
Mortgage-Backed Securities Issued by Other Government Agencies
Beginning in the fourth quarter of 2010, we invested in mortgage-backed securities issued and guaranteed by the National Credit Union Administration. These securities have floating rate coupons tied to one-month LIBOR with interest rate caps ranging from seven to eight percent. At December 31, 2011, their book value totaled $1,501 million, with an estimated net market value loss of $1 million. The strength of the issuer's guarantee and backing by the full faith and credit of the U.S. government is sufficient to protect us against credit losses on these securities.
Private Label Mortgage-Backed Securities
The following table presents information on the one private-label mortgage-backed security we had outstanding at December 31, 2011. We sold four of these types of securities in the third quarter of 2011.
(1)
Amounts used to calculate percentages are based on dollars in thousands. Accordingly, recalculations based upon the disclosed amounts (millions) may not produce the same results.
Unlike GSE and agency mortgage-backed securities, our holdings of private-label mortgage-backed securities expose us to credit risk because the issuers do not guarantee principal and interest payments. We believe our private-label security is composed of high quality mortgages and have had, and will continue to have, a minimal amount of credit risk. It carries increased credit subordination, is collateralized primarily by prime, fixed-rate, first lien mortgages originated in 2003, has a current estimated average loan-to-value ratio of 44 percent, and has an average serious delinquency rate of only 1.67 percent at December 31, 2011. We have never considered any of our private-label mortgage-backed securities to be other-than-temporarily impaired on any date.
Derivatives
Credit Risk Exposure. The table below presents the gross credit risk exposure (i.e., the market value) and net exposure of derivatives outstanding at December 31, 2011. On this date, and throughout 2011 we had a minimal amount of residual credit risk exposure.
(1)
Each category includes the related plus (+) and minus (-) ratings (i.e., “A” includes “A+” and “A-” ratings).
(2)
Represents Mandatory Delivery Contracts.
The following table presents counterparties that provided 10 percent or more of the total notional amount of interest rate swap derivatives outstanding. Although we cannot predict if we will realize credit risk losses from any of our derivatives counterparties, we continue to have no reason to believe any of them will be unable to continue making timely interest payments or, more generally, to continue to satisfy the terms and conditions of their derivative contracts with us. For the periods noted, no counterparty of our interest rate swaps had any Credit Services outstanding.
Lehman Brothers Derivatives. On September 15, 2008, Lehman Brothers Holdings, Inc. ("Lehman Brothers") filed a petition for bankruptcy protection under Chapter 11 of the U.S. Bankruptcy Code. We had 87 derivative transactions (interest rate swaps) outstanding with a subsidiary of Lehman Brothers, Lehman Brothers Special Financing, Inc. ("LBSF"), with a total notional principal amount of $5.7 billion. Under the provisions of our master agreement with LBSF, all of these swaps automatically terminated immediately prior to the bankruptcy filing by Lehman Brothers. The close-out provisions of the Agreement required us to pay LBSF a net fee of approximately $189 million, which represented the swaps' total estimated market value at the close of business on Friday, September 12, 2008. We paid LBSF approximately $14 million to settle all of
the transactions, comprised of the $189 million market value fee minus the value of collateral we had delivered previously and other interest and expenses. On Tuesday, September 16, 2008, we replaced these swaps with new swaps transacted with other counterparties. The new swaps had the same terms and conditions as the terminated LBSF swaps. The counterparties to the new swaps paid us a net fee of approximately $232 million to enter into these transactions based on the estimated market values at the time we replaced the swaps.
The $43 million difference between the settlement amount we paid Lehman and the market value fee we received on the replacement swaps represented an economic gain to us based on changes in the interest rate environment between the termination date and the replacement date. Although the difference was a gain to us in this instance, because it represented exposure from terminating and replacing derivatives, it could have been a loss if the interest rate environment had been different. We are amortizing the gain into earnings according to the swaps' final maturities, most of which will occur by the end of 2012.
In early March 2010, representatives of the Lehman bankruptcy estate advised us that they believed that we had been unjustly enriched and that the bankruptcy estate was entitled to the $43 million difference between the settlement amount we paid Lehman and the market value fee we received on the replacement swaps. In early May 2010, we received a Derivatives Alternative Dispute Resolution notice from the Lehman bankruptcy estate with a settlement demand of $65.8 million, plus interest accruing primarily at LIBOR plus 14.5 percent since the bankruptcy filing, based on their view of how the settlement amount should have been calculated. In accordance with the Alternative Dispute Resolution Order of the Bankruptcy Court administering the Lehman estate, senior management participated in a non-binding mediation in New York on August 25, 2010, and our legal counsel continued discussions with the court-appointed mediator for several weeks thereafter. The mediation concluded on October 15, 2010 without a settlement of the claims asserted by the Lehman bankruptcy estate. We believe that we correctly calculated, and fully satisfied, our obligation to Lehman in September 2008, and we intend to vigorously dispute any claim for additional amounts.
Liquidity Risk
Liquidity Overview
Our principal long-term source of funding and liquidity is through cost effective access to the capital markets for participation in the issuance of FHLBank System debt securities (Consolidated Obligations) and for execution of derivative transactions. We also raise liquidity via our liquidity investment portfolio and the ability to sell certain investments without significant accounting consequences. As shown on the Statements of Cash Flows, in 2011, our share of participations in debt issuances totaled $413.5 billion for Discount Notes and $18.0 billion for Consolidated Bonds. The System's favorable debt ratings, the implicit U.S. government backing of our debt, and our effective funding management were, and continue to be, instrumental in ensuring satisfactory access to the capital markets.
Our liquidity position remained strong in 2011 and our overall ability to fund our operations through debt issuance at acceptable interest costs remained sufficient. Although we can make no assurances, we expect this to continue to be the case, and we believe the possibility of a liquidity or funding crisis in the FHLBank System that would impair our FHLBank's ability to participate in issuances of new debt, service outstanding debt, maintain adequate capitalization, or pay competitive dividends is remote.
Beginning in the second half of 2010 and continuing in 2011, we held additional asset liquidity by investing in short-term U.S. Treasury securities and GSE debt obligations and extending maturities of short-term debt. Although the government continues to face serious fiscal challenges and Standard & Poor's downgraded the FHLBank System's debt to AA+ in August 2011, in all of 2011 the System experienced uninterrupted access on acceptable terms to the capital markets for its debt issuance and funding needs. Investors continue to favor the System's debt issuances; spreads on the System's longer-term Consolidated Obligations to U.S. Treasury rates and LIBOR did not change materially, even at the height of the government's financing issues and Standard & Poor's in the summer. After experiencing modest and temporary increases in late July and early August, the System's short-term debt costs returned by mid-August to the historically normal range.
We must meet both operational and contingency liquidity requirements. We satisfied the operational liquidity requirement both as a function of meeting the contingency liquidity requirement and because we were able to adequately access the capital markets to issue Obligations. In addition, Finance Agency guidance requires us to target at least 15 consecutive days of positive liquidity based on specific assumptions. In practice, we tend to hold over 20 days of positive liquidity. The amount of liquidity per the Finance Agency guidance and our internal operational liquidity measures tended to be in the range of $4 billion to $6 billion during 2011.
Contingency Liquidity Requirement
Contingency liquidity risk is the potential inability to meet liquidity needs because our access to the capital markets to issue Consolidated Obligations is restricted or suspended for a period of time due to a market disruption, operational failure, or real or perceived credit quality problems. We continued to hold an ample amount of liquidity reserves to protect against contingency liquidity risk.
(1)
Includes, among others, cash, overnight Federal funds, overnight deposits, self-liquidating term Federal funds, 95 percent of the market value of available-for-sale negotiable securities, and 75 percent of the market value of certain held-to-maturity obligations, including obligations of the United States, U.S. government agency obligations and mortgage-backed securities.
(2)
Includes maturing net liabilities in the next seven business days, assets traded not yet settled, Advance commitments outstanding, Advances maturing in the next seven business days, and a three percent hypothetical increase in Advances.
Deposit Reserve Requirement
To support our member deposits, we also must meet a statutory deposit reserve requirement. The sum of our investments in obligations of the United States, deposits in eligible banks or trust companies, and Advances with a final maturity not exceeding five years must equal or exceed the current amount of member deposits. The following table presents the components of this liquidity requirement.
Contractual Obligations
The following table summarizes our contractual obligations at December 31, 2011. The allocations according to the expiration terms and payment due dates of these obligations were not materially different from those at the end of 2010. Changes reflected normal business variations. We believe that, as in the past, we will continue to have sufficient liquidity, including from access to the debt markets to issue Consolidated Obligations, to satisfy these obligations timely.
(1)
Does not include Discount Notes and contractual interest payments related to Consolidated Bonds. Total is based on contractual maturities; the actual timing of payments could be affected by factors affecting redemptions.
Off-Balance Sheet Arrangements
The following table summarizes our off-balance sheet items at December 31, 2011. The allocations according to the expiration terms and payment due dates of these items were not materially different from those at the end of 2010, and changes reflected normal business variations.
(1)
Represents notional amount of off-balance sheet obligations.
Operational Risk
Operational risk is defined as the risk of an unexpected loss resulting from human error, fraud, unenforceability of legal contracts, or deficiencies in internal controls or information systems. We mitigate operational risk through adherence to internal policies, department procedures and controls, use of tested information systems, disaster recovery provisions for those systems, acquisition of insurance coverage to help protect us from financial exposure relating to errors or fraud by our personnel, and comprehensive policies and procedures related to Human Resources. In addition, the Internal Audit Department, which reports directly to the Audit Committee of the Board of Directors, regularly monitors and tests compliance with our policies, procedures, applicable regulatory requirements and best practices.
There were no material developments regarding our operational risk exposure in 2011.
Internal Department Procedures and Controls
Each of our departments maintains and regularly reviews and enhances, as needed, a system of internal procedures and controls, including those that address proper segregation of duties. Each system is designed to prevent any one individual from processing the entirety of a transaction that affects member accounts, correspondent FHLBank accounts or third-party servicers providing support to us. We review daily and periodic transaction activity reports in a timely manner to detect erroneous or fraudulent activity. Procedures and controls also are assessed on an enterprise-wide basis, independently from the business unit departments. We also are in compliance with Sarbanes-Oxley Sections 302 and 404, which focus on the control environment over financial reporting.
Information Systems
We have a committee of the Board of Directors that has oversight responsibility for the timely and effective application and support of appropriate automated facilities in concert with our business objectives. A related management committee reports to the Board Committee, approves short- and long-range information technology initiatives and annual disaster recovery test plans, and reviews data security standards and safeguards. Additionally, separate groups validate the strength of our security and confirm that established policies and procedures are being followed.
We employ a systems development life cycle and test methodology for all significant software changes, new applications, system upgrades and disaster recovery tests. This testing and validation is designed to ensure continuity of business processing. The methodology includes documented test plans, cases and evaluations.
Disaster Recovery Provisions
We have a Business Resumption Contingency Plan that provides us with the ability to maintain operations in various scenarios of business disruption. A committee of staff reviews and updates this plan periodically to ensure that it serves our changing operational needs and that of our members. We have an off-site facility in a suburb of Cincinnati, Ohio, which is tested at least annually. We also have a back-up agreement in place with the FHLBank of Indianapolis in the event that both of our Cincinnati-based facilities are inoperable.
Insurance Coverage
We have insurance coverage for employee fraud, forgery and wrongdoing, as well as Directors' and Officers' liability coverage that provides protection for claims alleging breach of duty, misappropriation of funds, neglect, acts of omission, employment practices, and fiduciary liability.
Human Resources Policies and Procedures
The risks associated with our Human Resources function are categorized as either Employment Practices Risk or Human Capital Risk. Employment Practices Risk is the potential failure to properly administer our policies regarding employment practices and compensation and benefit programs for eligible staff and retirees, and the potential failure to observe and properly comply with federal, state and municipal laws and regulations. Human Capital Risk is the potential inability to attract and retain appropriate levels of qualified human resources to maintain efficient operations.
Comprehensive policies and procedures are in place to limit Employment Practices Risk. These are supported by an established internal control system that is routinely monitored and audited. With respect to Human Capital Risk, we strive to maintain a competitive salary and benefit structure, which is regularly reviewed and updated as appropriate to attract and retain qualified staff. In addition, we have a management succession plan that is reviewed and approved by our Board of Directors.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
Introduction
The preparation of financial statements in accordance with GAAP requires management to make a number of significant judgments, estimates, and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities (if applicable), and the reported amounts of income and expenses during the reported periods. Although management believes its judgments, estimates, and assumptions are reasonable, actual results may differ and other parties could arrive at different conclusions.
We have identified the following critical accounting policies that require management to make subjective or complex judgments about inherently uncertain matters. Our financial condition and results of operations could be materially affected under different conditions or different assumptions related to these accounting policies.
Accounting for Derivatives and Hedging Activity
In accordance with Finance Agency Regulations, we execute all derivatives to reduce market risk exposure, not for speculation or solely for earnings enhancement. As in past years, in 2011 all outstanding derivatives hedged specific assets, liabilities, or Mandatory Delivery Contracts. We record derivative instruments at their fair values on the Statements of Condition, and we record changes in these fair values in current period earnings. We generally plan our use of derivatives to maximize the probability that they are highly effective in offsetting changes in the market values of the designated balance sheet instruments.
Fair Value Hedges
As indicated in the "Use of Derivatives in Market Risk Management" section of "Quantitative and Qualitative Disclosures About Risk Management," we designate the majority of our derivatives as fair value hedges. Fair value hedge accounting permits the changes in fair values of the hedged risk in the hedged instruments to be recorded in the current period, thus offsetting, partially or fully, the change in fair value of the derivatives. For derivatives accounted for as fair value hedges, the hedged risk is designated to be changes in LIBOR benchmark interest rates. The result is that there has been a relatively small amount of unrealized earnings volatility from hedging market risk with derivatives.
In order to determine if a derivative qualifies for fair value hedge accounting, we must assess how effective the derivative has been, and is expected to be, in hedging changes in the fair values of the risk being hedged. To do this, each month we perform effectiveness testing using a consistently applied standard statistical methodology, regression analysis, that measures the degree of correlation and relationship between the fair values of the derivative and hedged instrument. The results of the statistical measures must pass pre-defined critical values to enable us to conclude that the fair values of the derivative transaction have a close correlation and strong relationship with the fair values of the hedged instrument. If any of the measure is outside of its respective tolerance, the hedge no longer qualifies for hedge accounting. This then means we must record the fair value change of the derivative in current earnings without any offset in the fair value change of the related hedged instrument. Due to the intentional matching of terms between the derivative and the hedged instrument, we expect that failing an effectiveness test will be infrequent. This has been the case historically.
Each month, we compute fair values on all derivatives and related hedged instruments across a range of interest rate scenarios. As of year-end 2011, for derivatives receiving long-haul fair value hedge accounting, the total net difference between the fair values of the derivatives and related hedged instruments under an assumption of stressed interest rate environments was in a range of negative $10 million to positive $5 million. We believe this range is modest compared to the amount of notional
principal amount. As noted previously, each derivative/hedged instrument transaction had very closely related, or exactly matched, characteristics such as notional amount, final maturity, options, interest payment frequencies, reset dates, etc. Fair value differences that have actually occurred have historically resulted in a relatively small amount of earnings volatility. These differences are primarily because 1) our interest rate swaps have an adjustable-rate LIBOR leg (which is referenced to 1- or 3-month LIBOR), whereas the hedged instruments do not, and 2) option values of the swaps versus those of hedged instruments may have different changes in values.
An important element of effectiveness testing is the duration of the derivative and the hedged instrument. The effective duration is affected primarily by the final maturity and any option characteristics. In general, the shorter the effective duration the more likely it is that effectiveness testing will fail. This is because, given a relatively short duration, the LIBOR leg of the swap is a relatively important component (i.e., very small dollar changes may result in relatively large statistical movements) of the monthly change in the derivative's fair value, and there is no offsetting LIBOR leg on the hedged instrument.
If a derivative/hedged instrument transaction fails effectiveness testing, it does not mean that the hedge relationship is no longer successful in achieving its intended economic purpose. For example, an Obligation hedged with an interest rate swap creates adjustable-rate LIBOR funding, which is used to match fund adjustable-rate LIBOR and other short-term Advances. The hedge achieves the desired result (matching the net funding with the asset) because, economically, the Advance is part of the overall hedging strategy and the reason for engaging in the derivative transaction.
Fair Value Option--Economic Hedge
In 2011, we began to account for certain Bond-related derivatives using an accounting election called "fair value option," which is included in the economic hedge category. We currently have a $5.0 billion policy limit on the notional principal amount of such election. An economic hedge under the fair value option does not require passing effectiveness testing to permit the derivatives' fair market value to be offset with the market value of the hedged instrument, as is required under a fair value hedge. However, it records the fair market value of the hedged instrument at its full fair value instead of only the value of hedging the benchmark interest rate (LIBOR). The effect of electing full fair value is that the hedged instruments' market value includes the impact of changes in spreads between LIBOR and the interest rate index related to the hedged instrument. Therefore, full fair value results in a different kind of unrealized earnings volatility (which could be higher or lower) compared to accounting under fair value hedge treatment. The magnitude and direction depends on changes in interest rates, changes in LIBOR versus Consolidated Obligation debt costs, and the dollar amount of hedges that may fail effectiveness testing under the fail value hedging treatment.
Accounting for Premiums and Discounts on Mortgage Loans and Mortgage-Backed Securities
The accounting for amortization/accretion of premiums/discounts can result in substantial earnings volatility, most of which relates to our Mortgage Purchase Program, mortgage-backed securities, and Consolidated Obligations. Normally, earnings volatility associated with amortization/accretion of premiums/discounts for Obligations is less pronounced than that for mortgage assets.
When we purchase or invest in mortgages, we normally pay an amount that differs from the principal balance. A premium price is paid if the purchase price exceeds the principal amount. A discount price is paid if the purchase price is less than the principal amount. Premiums/discounts are required to be deferred and amortized/accreted to net interest income in a manner such that the yield recognized each month on the underlying asset is constant over the asset's historical life and estimated future life. This is called the constant effective (level) yield method.
We typically pay more than the principal balance when the interest rate on a purchased mortgage is greater than the prevailing market rate for similar mortgages. The net purchase premium is amortized as a reduction in the mortgage's book yield. Similarly, if we pay less than the principal balance, the net discount is accreted in the same manner as the premium, resulting in an increase in the mortgage's book yield. We have historically purchased most of the loans in the Mortgage Purchase Program at premiums. Overall, mortgage-backed securities have been purchased at net premiums, generally at prices close to par. At the end of 2011, the Mortgage Purchase Program had a net premium balance of $120 million and mortgage-backed securities had a net premium balance of $41 million, resulting in a total mortgage net premium balance of $161 million.
When mortgage principal cash flows are volatile, there can be substantial fluctuation in the accounting recognition of premiums and discounts. We update the constant effective yield method monthly using actual historical and projected principal cash flows. Projected principal cash flows requires us to estimate prepayment speeds, which are driven primarily by changes in interest rates. When interest rates decline, actual and projected prepayment speeds are likely to increase. This accelerates the amortization/accretion, resulting in a reduction in the mortgages' book yields on premium balances and an increase in book
yields on discount balances. The opposite effect tends to occur when interest rates rise. The immediate adjustment and the schedules for future amortization/accretion are based on applying the new constant effective yield as if it had been in effect since the purchase of the assets. See Note 1 of the Notes to Financial Statements for additional information.
Our mortgages under the Mortgage Purchase Program are stratified for amortization purposes into multiple portfolios according to common characteristics such as coupon interest rate, state of origination, final original maturity (mostly 15, 20, and 30 years), loan age, and type of mortgage (i.e., conventional and FHA). We compute amortization/accretion for each mortgage-backed security separately. Projected prepayment speeds are derived using a market-tested third-party prepayment model. We estimate prepayment speeds using a single interest rate scenario of implied forward interest rates for LIBOR and residential mortgages computed from the daily average market interest rate environment from the previous month. We use implied forward interest rates because they underlie many market practices, both from a theoretical and operational perspective. We regularly test the reasonableness and accuracy of the prepayment model by comparing its projections to actual prepayment results experienced over time and to dealer prepayment indications.
It is difficult to calculate how much amortization/accretion is likely to change over time. Prepayment projections are inherently subject to uncertainty because it is difficult to accurately predict either future market conditions or the prepayment response to these conditions even if they were able to be known. Exact trends depend on the relationship between market interest rates and coupon rates on outstanding mortgage assets, the historical evolution of mortgage interest rates, the age of the mortgage loans, demographic and population trends, and other market factors. Changes in amortization/accretion also depend on 1) the accuracy of prepayment projections compared to actual realized prepayments and 2) term structure models used to simulate possible future evolution of various interest rates. The term structure models depend heavily on theories and assumptions related to future interest rates and interest rate volatility. We strive to maintain a consistency in our use of prepayment and term structure models, although we do from time to time enhance these models based on developments in theories, technologies, best practices, and market conditions.
We regularly perform analyses that test the sensitivity of premium/discount recognition for mortgage assets to changes in prepayment speeds. The following table shows, as of year-end 2011, the estimated adjustments to the immediate recognition of premium amortization/discount accretion for various interest rate shocks. Although some of the changes shown below would result in a substantial change in ROE in the quarter in which the rate change occurred, it currently would not materially threaten the competitiveness of profitability.
Provision for Credit Losses
We evaluate Advances and the Mortgage Purchase Program to assure an adequate reserve is maintained to absorb probable losses inherent in these portfolios.
Advances
We evaluate probable credit losses inherent in Advances due to borrower default or delayed receipt of interest and principal, taking into consideration the amount recoverable from the collateral pledged. This analysis is performed for each member separately on at least a quarterly basis. We believe we have adequate policies and procedures in place to effectively manage credit risk exposure on Advances. These include monitoring the creditworthiness and financial condition of the institutions to which we lend funds, reviewing the quality and value of collateral pledged by members to secure Advances, estimating borrowing capacity based on collateral value and type for each member, and evaluating historical loss experience. At December 31, 2011, we had rights to collateral (either loans or securities), on a member-by-member basis, with an estimated fair value that exceeds the amount of outstanding Advances. At the end of 2011, the aggregate estimated value of this collateral was $156.8 billion. Although some of this overcollateralization may reflect a desire to maintain excess borrowing capacity, all of a member's pledged collateral would be available as necessary to cover any of that member's credit obligations to the FHLBank.
Based on the nature and quality of the collateral held as security for Advances, including overcollateralization, our credit analyses of members and collateral, and members' prior repayment history (i.e., we have never recorded a loss from an Advance), we believe that no allowance for losses was necessary at December 31, 2011. See Notes 1 and 9 of the Notes to Financial Statements for additional information.
Mortgage Loans Acquired Under the Mortgage Purchase Program
We analyze loans in the Mortgage Purchase Program on at least a quarterly basis by 1) estimating the incurred credit losses inherent in the portfolio and comparing these to credit enhancements, including the recoverability of insurance, and 2) establishing reserves based on the results. We apply a consistent methodology to determine our estimates.
We acquire both FHA and conventional fixed-rate mortgage loans under the Mortgage Purchase Program. Because FHA mortgage loans are U.S. government insured, we have determined that they do not require a loan loss allowance. We are protected against credit losses on conventional mortgage loans from several sources, in order of priority:
▪
having the related real estate as collateral, which effectively includes the borrower's equity,
▪
by credit enhancements including 1) primary mortgage insurance, if applicable, 2) the member's Lender Risk Account, and 3) Supplemental Mortgage Insurance, if applicable, applied on a loan-by-loan basis.
We assume any credit exposure if losses exceed the related real estate value and credit enhancements.
The key estimates and assumptions that affect our allowance for credit losses generally include: the characteristics of specific conventional loans outstanding under the Program; evaluations of the overall delinquent loan portfolio through the use of migration analysis; loss severity estimates; historical claims and default experience; expected proceeds from credit enhancements; comparisons to industry reported data; and current economic trends and conditions.
These estimates require significant judgments, especially considering the current unprecedented deterioration in the national housing market, the inability to readily determine the fair value of all underlying properties, the application of pool level credit enhancements, and the uncertainty in other macroeconomic factors that make estimating defaults and severity imprecise.
The review of credit enhancements (in addition to any primary mortgage insurance) includes the Lender Risk Account and any Supplemental Mortgage Insurance policy, as well as outstanding claims against those enhancements. The conventional loans are associated with specific Master Commitment Contracts and their related Lender Risk Accounts and are considered in such groups when we evaluate credit quality.
Supplemental Mortgage Insurance coverage, if applicable, is applied on a loan-by-loan basis. Two key factors contribute to the possibility of exceeding the coverage: first, the severity of the loss and, second, the total losses within a particular Master Commitment Contract. Since the first half of 2005, SMI policies for Master Commitment Contracts issued in amounts greater than $35 million have had a stop-loss feature that limits the total dollar amount of coverage provided by the insurer on each Master Commitment Contract. Beginning in May 2008, policies for all Master Commitment Contracts include a stop-loss feature. The stop-loss is equal to the total initial principal balance of loans under the Master Commitment Contract multiplied by the stop-loss percentage and represents the maximum aggregate amount payable by the Supplemental Mortgage Insurance provider under the policy for that pool. The stop-loss is established at a level that permits the affected loan pools to attain an investment-grade double-A implied credit rating at the time a Master Commitment Contract is closed. To date, the stop-loss feature has not negatively affected the estimate of credit losses; and we expect this to continue to be the case.
Based on our analysis, as of December 31, 2011, we determined that an allowance for credit losses of $21 million was required for our conventional mortgage loans in the Mortgage Purchase Program. Further substantial reductions in home prices or other economic variables that affect mortgage defaults could increase credit losses experienced in the portfolio.
Other-Than-Temporary Impairment Analysis for Investment Securities
Due to the decline in value of residential U.S. real estate and difficult conditions in the credit and mortgage markets, we closely monitor the performance of our investment securities to evaluate our exposure to the risk of loss of principal or interest on these investments and to determine on a quarterly basis whether this risk of loss represents an other-than-temporary impairment.
An investment security is deemed impaired if the fair value of the security is less than its amortized cost. To determine whether an impairment is other-than-temporary, we assess whether the amortized cost basis of the security will be recovered by considering numerous factors, as described in Notes 1 and 8 of the Notes to Financial Statements. We must recognize impairment losses if we intend to sell the security or if available evidence indicates it is more likely than not we will be required to sell the security before the recovery of its amortized cost basis. We also must recognize impairment losses when any credit losses are expected for the security. This includes consideration of market conditions and projections of future results which requires significant judgments, estimates and assumptions, especially considering the unprecedented deterioration in the national housing market and the uncertainty in other macroeconomic factors that make estimating future results imprecise.
If we were to determine that an other-than-temporary impairment existed, the security would initially be written down to current market value, with the loss recognized in non-interest income if we intend to sell the security or it is more likely than not we will be required to sell the security before recovery of the amortized cost basis. If we do not intend to sell the security and it is not more likely than not we will be required to sell the security before recovery, the security would be written down to current market value with a separate display of losses related to credit deterioration and losses related to all other factors on the income statement. Any non-credit loss related amounts would then be reclassified and recorded in other comprehensive income, resulting in only net credit-related losses recorded on the income statement. As of December 31, 2011 we did not consider any of our investment securities to be other-than-temporarily impaired.
Fair Values
Fair values play an important role in the valuation of certain assets, liabilities and derivative transactions, which may be presented in the Statements of Condition or related Notes to the Financial Statements at fair value. We carry investments classified as available-for-sale and trading, and all derivatives, on the Statements of Condition at fair value. Additionally, any financial instruments where the fair value option election has been made are carried at fair value on the Statements of Condition.
Fair value is defined as the price - the “exit 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. Because our investments currently do not have available quoted market prices, we determine fair values based on 1) our valuation models or 2) dealer indications, which may be based on the dealers' own valuation models and/or prices of similar instruments.
Valuation models and their underlying assumptions are based on the best estimates of management with respect to 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, and the income and expense related thereto. The use of different assumptions or changes in the models and assumptions, as well as changes in market conditions, could result in materially different net income and retained earnings.
We have control processes designed to ensure that fair value measurements are appropriate and reliable, that they are based on observable inputs wherever possible and that our valuation approaches and assumptions are reasonable and consistently applied. Where applicable, valuations are also compared to alternative external market data (e.g., quoted market prices, broker or dealer indications, pricing services and comparative analyses to similar instruments). For further discussion regarding how we measure financial assets and financial liabilities at fair value, see Note 20 of the Notes to Financial Statements.
We categorize each of our financial instruments carried at fair value into one of three levels in accordance with the fair value hierarchy. The 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 (Levels 1 and 2), while unobservable inputs reflect our assumptions of market variables (Level 3). Management utilizes valuation techniques that maximize the use of observable inputs and minimize the use of unobservable inputs. Because items classified as Level 3 are valued using significant unobservable inputs, the process for determining the fair value of these items is generally more subjective and involves a high degree of management judgment and use of assumptions.
The following table summarizes our assets and liabilities measured at fair value on a recurring basis by level of valuation hierarchy.
(1) Based on total fair value of derivative assets and liabilities after effect of counterparty netting and cash collateral netting.
(2) Represents Consolidated Obligation Bonds recorded under the fair value option.
RECENTLY ISSUED ACCOUNTING STANDARDS AND INTERPRETATIONS
See Note 2 of the Notes to Financial Statements for a discussion of recently issued accounting standards and interpretations.
OTHER FINANCIAL INFORMATION
Income Statements
Summary income statements for each quarter within the two years ended December 31, 2011 are provided in the tables below.
Investment Securities
Data on investments for the years ended December 31, 2011, 2010 and 2009 are provided in the tables below.
*
Consists of debt securities issued by International Bank for Reconstruction and Development.
As of December 31, 2011, investments had the following maturity and yield characteristics.
*
Mortgage-backed securities allocated based on contractual principal maturities assuming no prepayments.
**
Consists of debt securities issued by International Bank for Reconstruction and Development.
As of December 31, 2011, the FHLBank held securities of the following issuers, excluding certificates of deposit, with a book value greater than 10 percent of FHLBank capital. The table includes government-sponsored enterprises, securities of the U.S. government, and government agencies and corporations. All other issuers are combined in the table below.
Loan Portfolio Analysis
The FHLBank's outstanding loans, loans 90 days or more past due and accruing interest, and allowance for credit loss information for the five years ended December 31 are shown below. The FHLBank's interest and related shortfall on non-accrual loans and loans modified in troubled debt restructurings was not material during the year ended December 31, 2011.
(1)
See Note 1 of the Notes to Financial Statements for an explanation of the FHLBank's non-accrual policy.
Other Borrowings
Borrowings with original maturities of one year or less are classified as short-term. The following is a summary of short-term borrowings exceeding 30 percent of total capital for the years ended December 31:
(1)
Represents an implied rate without consideration of concessions.
(2)
Amounts used to calculate weighted average rates for the year are based on dollars in thousands. Accordingly, recalculations based upon amounts in millions may not produce the same results.
(3)
Represents the effective coupon rate.
Term Deposits
At December 31, 2011, term deposits in denominations of $100,000 or more totaled $90,850,000. The table below presents the maturities for term deposits in denominations of $100,000 or more:
Ratios
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk.
Information required under this Item is set forth in the “Quantitative and Qualitative Disclosures About Risk Management” caption at Part II, Item 7, of this filing.
Item 8.
Item 8. Financial Statements and Supplementary Data.
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Shareholders
of the Federal Home Loan Bank of Cincinnati:
In our opinion, the accompanying statements of condition and the related statements of income, capital, and cash flows present fairly, in all material respects, the financial position of the Federal Home Loan Bank of Cincinnati (the "FHLBank") at December 31, 2011 and 2010, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2011 in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, the FHLBank maintained, in all material respects, effective internal control over financial reporting as of December 31, 2011, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The FHLBank's management is responsible for these financial statements, for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management's Report on Internal Control over Financial Reporting. Our responsibility is to express opinions on these financial statements and on the FHLBank's internal control over financial reporting based on our integrated audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.
A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
Cincinnati, Ohio
March 16, 2012
FEDERAL HOME LOAN BANK OF CINCINNATI
STATEMENTS OF CONDITION
(In thousands, except par value)
(a)
Fair values: $13,035,503 and $13,019,799 at December 31, 2011 and 2010, respectively.
The accompanying notes are an integral part of these financial statements.
FEDERAL HOME LOAN BANK OF CINCINNATI
STATEMENTS OF INCOME
(In thousands)
The accompanying notes are an integral part of these financial statements.
FEDERAL HOME LOAN BANK OF CINCINNATI
STATEMENTS OF CAPITAL
(In thousands)
The accompanying notes are an integral part of these financial statements.
FEDERAL HOME LOAN BANK OF CINCINNATI
STATEMENTS OF CASH FLOWS
(In thousands)
The accompanying notes are an integral part of these financial statements.
(continued from previous page)
FEDERAL HOME LOAN BANK OF CINCINNATI
STATEMENTS OF CASH FLOWS
(In thousands)
The accompanying notes are an integral part of these financial statements.
FEDERAL HOME LOAN BANK OF CINCINNATI
NOTES TO FINANCIAL STATEMENTS
Background Information
The Federal Home Loan Bank of Cincinnati (the FHLBank), a federally chartered corporation, is one of 12 District Federal Home Loan Banks (FHLBanks). The FHLBanks serve the public by enhancing the availability of credit for residential mortgages and targeted community development. The FHLBank provides a readily available, competitively-priced source of funds to its member institutions. The FHLBank is a cooperative whose member institutions own nearly all of the capital stock of the FHLBank and may receive dividends on their investment to the extent declared by the FHLBank's Board of Directors. Former members own the remaining capital stock to support business transactions still carried on the FHLBank's Statements of Condition. Regulated financial depositories and insurance companies engaged in residential housing finance may apply for membership. State and local housing authorities that meet certain statutory criteria may also borrow from the FHLBank; while eligible to borrow, housing authorities are not members of the FHLBank and, as such, are not allowed to hold capital stock.
All members must purchase stock in the FHLBank. Members must own capital stock in the FHLBank based on the amount of their total assets. Each member also may be required to purchase activity-based capital stock as it engages in certain business activities with the FHLBank. As a result of these requirements, the FHLBank conducts business with stockholders in the normal course of business. For financial statement purposes, the FHLBank defines related parties as those members with more than 10 percent of the voting interests of the FHLBank's outstanding capital stock. See Note 23 for more information relating to transactions with stockholders.
The Federal Housing Finance Agency (Finance Agency) was established and became the independent Federal regulator of the FHLBanks, Federal Home Loan Mortgage Corporation (Freddie Mac) and Federal National Mortgage Association (Fannie Mae), effective July 30, 2008 with the passage of the “Housing and Economic Recovery Act of 2008” (HERA). Pursuant to HERA, all regulations, orders, determinations, and resolutions that were issued, made, prescribed, or allowed to become effective by the former Federal Housing Finance Board will remain in effect until modified, terminated, set aside, or superseded by the Finance Agency Director, any court of competent jurisdiction, or operation of law. The Finance Agency's stated mission with respect to the FHLBanks is to provide effective supervision, regulation and housing mission oversight of the FHLBanks to promote their safety and soundness, support housing finance and affordable housing, and support a stable and liquid mortgage market.
Each FHLBank operates as a separate entity with its own management, employees, and board of directors. The FHLBank does not have any special purpose entities or any other type of off-balance sheet conduits.
The Office of Finance is a joint office of the FHLBanks established by the Finance Agency to facilitate the issuance and servicing of the debt instruments of the FHLBanks, known as Consolidated Obligations, and to prepare combined quarterly and annual financial reports of all 12 FHLBanks. As provided by the Federal Home Loan Bank Act of 1932, as amended (the FHLBank Act), or by Finance Agency Regulation, the FHLBanks' Consolidated Obligations are backed only by the financial resources of the FHLBanks and are the primary source of funds for the FHLBanks. Deposits, other borrowings, and capital stock issued to members provide other funds. The FHLBank primarily uses its funds to provide Advances to members and to purchase loans from members through its Mortgage Purchase Program. The FHLBank also provides member institutions with correspondent services, such as wire transfer, security safekeeping, and settlement services.
Note 1 - Summary of Significant Accounting Policies
Basis of Presentation. The FHLBank's accounting and financial reporting policies conform to accounting principles generally accepted in the United States of America (GAAP).
Cash Flows. In the Statements of Cash Flows, the FHLBank considers non-interest bearing cash and due from banks as cash and cash equivalents. Federal funds sold are not treated as cash equivalents for purposes of the Statements of Cash Flows, but are instead treated as short-term investments and are reflected in the investing activities section of the Statements of Cash Flows.
Reclassifications. Certain amounts in the 2010 and 2009 financial statements and footnotes have been reclassified to conform to the 2011 presentation.
Subsequent Events. The FHLBank has evaluated subsequent events for potential recognition or disclosure through the issuance of these financial statements and believes there have been no material subsequent events requiring additional disclosure or recognition in these financial statements.
Use of Estimates. The preparation of financial statements in accordance with GAAP requires management to make subjective assumptions and estimates. These assumptions and estimates affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities, and the reported amounts of income and expenses. Actual results could differ from these estimates.
Fair Values. Some of the FHLBank's financial instruments lack an available trading market with prices characterized as those 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. Therefore, the FHLBank uses pricing services and/or internal models employing significant estimates and present value calculations when disclosing fair values. See Note 20 for more information.
Interest Bearing Deposits, Securities Purchased Under Agreements to Resell (Resale Agreements), and Federal Funds Sold. These investments provide short-term liquidity and are carried at cost. The FHLBank treats securities purchased under agreements to resell as collateralized financings. The FHLBank invests in certificates of deposits (CDs) not meeting the definition of a security that are recorded, at amortized cost, as interest-bearing deposits. The FHLBank also invests in certain CDs that meet the definition of a security and are recorded as held-to-maturity and available-for-sale securities.
Investment Securities. The FHLBank classifies investments as trading, available-for-sale and held-to-maturity at the date of acquisition. Purchases and sales of securities are recorded on a trade date basis.
Securities classified as trading are acquired for liquidity purposes and asset/liability management and carried at fair value. The FHLBank records changes in the fair value of these investments through other income as a net gain or loss on trading securities. However, the FHLBank does not participate in speculative trading practices and holds these investments indefinitely as management periodically evaluates its liquidity needs.
Securities that are not classified as held-to-maturity or trading are classified as available-for-sale and are carried at fair value. The change in fair value of available-for-sale securities is recorded in other comprehensive income as a net unrealized gain or loss on available-for-sale securities.
Securities that the FHLBank has both the ability and intent to hold to maturity are classified as held-to-maturity and are carried at amortized cost, adjusted for periodic principal repayments, amortization of premiums and accretion of discounts.
Certain changes in circumstances may cause the FHLBank to change its intent to hold a security to maturity without calling into question its intent to hold other debt securities to maturity in the future. Thus, the sale or transfer of a held-to-maturity security due to certain changes in circumstances, such as evidence of significant deterioration in the issuer's creditworthiness or changes in regulatory requirements, is not considered to be inconsistent with its original classification. Other events that are isolated, nonrecurring, and unusual for the FHLBank that could not have been reasonably anticipated may cause the FHLBank to sell or transfer a held-to-maturity security without necessarily calling into question its intent to hold other debt securities to maturity.
In addition, sales of debt securities that meet either of the following two conditions may be considered as maturities for purposes of the classification of securities: (1) the sale occurs near enough to the security's maturity date (or call date if exercise of the call is probable) that interest rate risk is substantially eliminated as a pricing factor and changes in market interest rates would not have a significant effect on the security's fair value, or (2) the sale of the security occurs after the FHLBank has already collected a substantial portion (at least 85 percent) of the principal outstanding at acquisition due either to prepayments on the security or to scheduled payments on the security payable in equal installments (both principal and interest) over its term.
The FHLBank amortizes purchased premiums and accretes purchased discounts on mortgage-backed securities and other investment categories with a term of greater than one year using the retrospective level-yield method (retrospective method). The retrospective method requires that the FHLBank estimate prepayments over the estimated life of the securities and make a retrospective adjustment of the effective yield each time that the FHLBank changes the estimated life as if the new estimate had been known since the original acquisition date of the securities. The FHLBank uses nationally recognized third-party prepayment models to project estimated cash flows. Due to their short term nature, the FHLBank amortizes premiums and accretes discounts on other investment categories with a term of one year or less using a straight-line methodology based on the
contractual maturity of the securities. Analyses of the straight-line compared to the level-yield methodology have been performed by the FHLBank and it has determined that the impact of the difference on the financial statements for each period reported, taken individually and as a whole, is not material.
The FHLBank computes gains and losses on sales of investment securities using the specific identification method and includes these gains and losses in other income.
Investment Securities Other-than-Temporary-Impairment. The FHLBank evaluates its individual available-for-sale and held-to-maturity securities in an unrealized loss position for other-than-temporary impairment on a quarterly basis. A security is considered impaired when its fair value is less than its amortized cost. The FHLBank considers an other-than-temporary impairment to have occurred under any of the following circumstances:
▪
If the FHLBank has an intent to sell the impaired debt security;
▪
If, based on available evidence, the FHLBank believes it is more likely than not that it will be required to sell the impaired debt security before the recovery of its amortized cost basis; or
▪
If the FHLBank does not expect to recover the entire amortized cost basis of the debt security.
If either of the first two conditions above is met, the FHLBank recognizes an other-than-temporary impairment charge in earnings equal to the entire difference between the security's amortized cost basis and its fair value as of the Statement of Condition date.
For securities in an unrealized loss position that meet neither of the first two conditions, the FHLBank performs an analysis to determine if it will recover the entire amortized cost basis of each of these securities; this analysis includes a cash flow test for private-label mortgage-backed securities. The present value of the cash flows expected to be collected is compared to the amortized cost basis of the debt security to determine whether a credit loss exists. If there is a credit loss (the difference between the present value of the cash flows expected to be collected and the amortized cost basis of the debt security), the carrying value of the debt security is adjusted to its fair value. However, rather than recognizing the entire difference between the amortized cost basis and fair value in earnings, only the amount of the impairment representing the credit loss (i.e., the credit component) is recognized in earnings, while the amount related to all other factors (i.e., the non-credit component) is recognized in accumulated other comprehensive income, which is a component of equity. The credit loss on a debt security is limited to the amount of that security's unrealized loss. The total other-than-temporary impairment is presented in the statement of income with an offset for the amount of the total other-than-temporary impairment that is recognized in accumulated other comprehensive income. Subsequent non-other-than-temporary impairment-related changes in the fair value of available-for-sale securities are included in accumulated other comprehensive income. The other-than-temporary impairment recognized in accumulated other comprehensive income for debt securities classified as held-to-maturity is accreted over the remaining life of the debt security as an increase in the carrying value of the security (with no effect on earnings unless the security is subsequently sold or there is additional other-than-temporary impairment related to credit loss recognized).
For subsequent accounting of other-than-temporarily impaired securities, if the present value of principal cash flows expected to be collected is less than the amortized cost basis, the FHLBank would record an additional other-than-temporary impairment. The amount of total other-than-temporary impairment for an available-for-sale security that was previously impaired is determined as the difference between its amortized cost less the amount of other-than-temporary impairment recognized in accumulated other comprehensive income prior to the determination of other-than-temporary impairment and its fair value.
Advances. The FHLBank reports Advances (loans to members, former members or housing associates) net of premiums, discounts (including discounts on Advances related to the Affordable Housing Program (AHP), as discussed below), unearned commitment fees and hedging adjustments. The FHLBank amortizes the premiums and accretes the discounts on Advances to interest income using a level-yield methodology. The FHLBank records interest on Advances to income as earned.
In cases in which the FHLBank funds a new Advance concurrent with or within a short period of time before or after the prepayment of an existing Advance, the FHLBank evaluates whether the new Advance meets the accounting criteria to qualify as a modification of an existing Advance or whether it constitutes a new Advance. The FHLBank compares the present value of cash flows on the new Advance to the present value of cash flows remaining on the existing Advance. If there is at least a 10 percent difference in the cash flows or if the FHLBank concludes the differences between the Advances are more than minor based on qualitative factors, the Advance is accounted for as a new Advance. In all other instances, the new Advance is accounted for as a modification.
The FHLBank charges a borrower a prepayment fee when the borrower prepays certain Advances before the original maturity. The FHLBank records prepayment fees, net of basis adjustments related to hedging activities included in the book value of the Advances, as “Prepayment fees on Advances, net” in the interest income section of the Statements of Income.
If a new Advance qualifies as a modification of the existing Advance, the net prepayment fee on the prepaid Advance is deferred, recorded in the basis of the modified Advance, and amortized/accreted using a level-yield methodology over the life of the modified Advance to Advance interest income.
For prepaid Advances that are hedged and meet the hedge accounting requirements, the FHLBank terminates the hedging relationship upon prepayment and records the associated fair value gains and losses, adjusted for the prepayment fees, in interest income. If the FHLBank funds a new Advance to a member concurrent with or within a short period of time after the prepayment of a previous Advance to that member, the FHLBank evaluates whether the new Advance qualifies as a modification of the original hedged Advance. If the new Advance qualifies as a modification of the original hedged Advance, the fair value gains or losses of the Advance and the prepayment fees are included in the carrying amount of the modified Advance, and gains or losses and prepayment fees are amortized in interest income over the life of the modified Advance using a level-yield methodology. If the modified Advance is also hedged and the hedge meets the hedging criteria, the modified Advance is marked to fair value after the modification, and subsequent fair value changes are recorded in other income.
If a new Advance does not qualify as a modification of an existing Advance, it is treated as an Advance termination with subsequent funding of a new Advance and the existing fees net of related hedging adjustments are recorded in interest income as “Prepayment fees on Advances, net.”
The FHLBank defers commitment fees for Advances and amortizes them to interest income using a level-yield methodology. Refundable fees are deferred until the commitment expires or until the Advance is made. The FHLBank records commitment fees for Standby Letters of Credit as a deferred credit when it receives the fees and accretes them using a straight-line methodology over the term of the Standby Letter of Credit. Based upon past experience, the FHLBank's management believes that the likelihood of Standby Letters of Credit being drawn upon is remote.
Mortgage Loans Held for Portfolio. The FHLBank classifies mortgage loans as held for portfolio and, accordingly, reports them at their principal amount outstanding net of unamortized premiums and discounts and mark-to-market basis adjustments on loans initially classified as mortgage loan commitments. The FHLBank has the intent and ability to hold these mortgage loans to maturity.
The FHLBank defers and amortizes premiums and discounts paid to and received by the FHLBank's participating members (Participating Financial Institutions, or PFIs) and mark-to-market basis adjustments, as interest income using the retrospective method. The FHLBank aggregates the mortgage loans by similar characteristics (type, maturity, note rate and acquisition date) in determining prepayment estimates for the retrospective method.
The FHLBank may receive non-origination fees, called pair-off fees. Pair-off fees represent a make-whole provision and are assessed when a member fails to deliver the quantity of loans committed to in a Mandatory Delivery Contract. Pair-off fees are recorded in other income. A Mandatory Delivery Contract is a legal commitment the FHLBank makes to purchase, and a PFI makes to deliver, a specified dollar amount of mortgage loans, with a forward settlement date, at a specified range of mortgage note rates and prices.
Allowance for Credit Losses. An allowance for credit losses is separately established for each identified portfolio segment, if it is probable that a loss triggering event has occurred in the FHLBank's portfolio as of the Statements of Condition date and the amount of loss can be reasonably estimated. To the extent necessary, an allowance for credit losses for off-balance sheet credit exposures is recorded as a liability. See Note 11 for details on each allowance methodology.
A portfolio segment is defined as the level at which an entity develops and documents a systematic method for determining its allowance for credit losses. The FHLBank has developed and documented a systematic methodology for determining an allowance for credit losses, where applicable, for (1) Advances, letters of credit and other extensions of credit to members, collectively referred to as “credit products”; (2) government-guaranteed or insured mortgage loans held for portfolio; and (3) conventional loans held for portfolio.
Classes of financing receivables generally are a disaggregation of a portfolio segment to the extent needed to understand the exposure to credit risk arising from these financing receivables. The FHLBank determined that no further disaggregation of the portfolio segments identified above is needed as the credit risk arising from these financing receivables is assessed and measured by the FHLBank at the portfolio segment level.
A loan is considered impaired when, based on current information and events, it is probable that the FHLBank will be unable to collect all amounts due according to the contractual terms of the loan agreement.
Loans that are on non-accrual status and that are considered collateral-dependent are measured for impairment based on the fair value of the underlying property (net of estimated selling costs) and the amount of applicable credit enhancements less the estimated costs associated with maintaining and disposing of the property. Loans are considered collateral-dependent if repayment is expected to be provided solely by the sale of the underlying property, that is, there is no other available and reliable source of repayment. Collateral-dependent loans are impaired if the fair value of the underlying collateral is insufficient to recover the unpaid principal balance on the loan. Interest income on impaired loans is recognized in the same manner as non-accrual loans noted below.
The FHLBank places a conventional mortgage loan on non-accrual status if it is determined that either (1) the collection of interest or principal is doubtful (e.g., when a related allowance for credit losses is recorded on a loan considered to be a troubled debt restructuring as a result of the individual evaluation for impairment), or (2) interest or principal is past due for 90 days or more, except when the loan is well-secured and in the process of collection (e.g., through credit enhancements and with monthly settlements on a schedule/scheduled basis). Loans with settlements on a schedule/scheduled basis means the FHLBank receives monthly principal and interest payments from the servicer regardless of whether the mortgagee is making payments to the servicer. Loans with monthly settlement on an actual/actual basis are considered well-secured; however, servicers of actual/actual loan types contractually do not advance principal and interest regardless of borrower creditworthiness. As a result, these loans are placed on non-accrual status once they become 90 days delinquent.
For those mortgage loans placed on non-accrual status, accrued but uncollected interest is reversed against interest income. The FHLBank records cash payments received on non-accrual loans first as interest income and then as a reduction of principal as specified in the contractual agreement, unless the collection of the remaining principal amount due is considered doubtful. If the collection of the remaining principal amount due is considered doubtful, cash payments received are applied first solely to principal until the remaining principal amount due is expected to be collected and then as a recovery of any charge-off, if applicable, followed by recording interest income. A loan on non-accrual status may be restored to accrual when (1) none of its contractual principal and interest is due and unpaid, and the FHLBank expects repayment of the remaining contractual interest and principal, or (2) it otherwise becomes well secured and in the process of collection.
The FHLBank evaluates whether to record a charge-off on a conventional mortgage loan upon the occurrence of a confirming event. Confirming events include, but are not limited to, the occurrence of foreclosure or notification of a claim against any of the credit enhancements. A charge-off is recorded if the recorded investment in the loan will not be recovered.
Premises, Software and Equipment, Net. The FHLBank records premises, software and equipment at cost less accumulated depreciation and amortization. The FHLBank's accumulated depreciation and amortization related to these items was $16,875,000 and $14,473,000 at December 31, 2011 and 2010. The FHLBank computes depreciation on a straight-line methodology over the estimated useful lives of assets ranging from three to ten years. The FHLBank amortizes leasehold improvements on a straight-line basis over the shorter of the estimated useful life of the improvement or the remaining term of the lease. The FHLBank capitalizes improvements and major renewals but expenses ordinary maintenance and repairs when incurred. Depreciation and amortization expense for premises, software and equipment was $2,543,000, $2,724,000, and $2,598,000 for the years ended December 31, 2011, 2010, and 2009.
The FHLBank includes gains and losses on disposal of premises, software and equipment in other income. The net realized loss on disposal of premises, software and equipment was $37,000, $42,000, and $23,000 in 2011, 2010, and 2009.
The cost of computer software developed or obtained for internal use is capitalized and amortized over future periods. As of December 31, 2011 and 2010, the FHLBank had $7,614,000 and $8,605,000 in unamortized computer software costs. Amortization of computer software costs charged to expense was $1,836,000, $1,954,000, and $1,497,000 for the years ended December 31, 2011, 2010, and 2009.
Derivatives. All derivatives are recognized on the Statements of Condition at their fair values and are reported as either derivative assets or derivative liabilities, net of cash collateral and accrued interest from counterparties. Cash flows associated with derivatives are reflected as cash flows from operating activities in the Statement of Cash Flows unless the derivative meets the criteria to be a financing derivative.
Each derivative is designated as one of the following:
1.
a qualifying hedge of the fair value of a recognized asset or liability or an unrecognized firm commitment (a "fair value" hedge); or
2.
a non-qualifying hedge (“economic hedge”) for asset/liability management purposes.
If hedging relationships meet certain criteria including, but not limited to, formal documentation of the hedging relationship and an expectation to be highly effective, they are eligible for fair value 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 FHLBank to evaluate the effectiveness of the hedging relationships at inception and on an ongoing basis and to calculate the changes in fair value of the derivatives and related hedged items independently. This is known as the “long-haul” method of 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 FHLBank discontinued use of the shortcut method effective July 1, 2009 for all new hedging relationships.
Derivatives are typically executed at the same time as the hedged Advances or Consolidated Obligations and the FHLBank designates the hedged item in a qualifying hedge relationship as of the trade date. In many hedging relationships, the FHLBank may designate the hedging relationship upon its commitment to disburse an Advance or trade a Consolidated Obligation in which settlement occurs within the shortest period of time possible for the type of instrument based on market settlement conventions. The FHLBank records the changes in fair value of the derivative and the hedged item beginning on the trade date.
Changes in the fair value of a derivative 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, are recorded in other income as “Net gain (loss) on derivatives and hedging activities.”
An economic hedge is defined as a derivative hedging specific or non-specific underlying assets, liabilities, or firm commitments that does not qualify or was not designated for hedge accounting, but is an acceptable hedging strategy under the FHLBank's risk management program. These economic hedging strategies also comply with Finance Agency regulatory requirements prohibiting speculative hedge transactions. An economic hedge by definition introduces the potential for earnings variability caused by the changes in fair value of the derivatives that are recorded in the FHLBank's income but that are not offset by corresponding changes in the value of the economically hedged assets, liabilities, or firm commitments. As a result, the FHLBank recognizes only the change in fair value of these derivatives in other income as “Net gain (loss) on derivatives and hedging activities” with no offsetting fair value adjustments for the assets, liabilities, or firm commitments.
The difference between accruals of interest receivables and payables on derivatives that are designated as fair value hedge relationships is recognized as adjustments to the interest income or expense of the designated hedged item. The differentials between accruals of interest receivables and payables on economic hedges are recognized in other income as “Net gain (loss) on derivatives and hedging activities.”
The FHLBank may issue debt, make Advances, or purchase financial instruments in which a derivative instrument is “embedded.” Upon execution of these transactions, the FHLBank assesses whether the economic characteristics of the embedded derivative are clearly and closely related to the economic characteristics of the remaining component of the Advance, debt, or purchased financial instrument (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 the FHLBank determines that (1) the embedded derivative has 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 a stand-alone derivative instrument pursuant to an economic hedge. However, if the entire contract (the host contract and the embedded derivative) is to be measured at fair value, with changes in fair value reported in current-period earnings (such as an investment security classified as “trading” as well as hybrid financial instruments that are eligible for the fair value option), or if the FHLBank cannot reliably identify and measure the embedded derivative for purposes of separating that derivative from its host contract, the entire contract is carried on the Statements of Condition at fair value and no portion of the contract is designated as a hedging instrument.
The FHLBank discontinues hedge accounting prospectively when: (1) it 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; or (3) management determines that designating the derivative as a hedging instrument is no longer appropriate.
When hedge accounting is discontinued because the FHLBank determines that the derivative no longer qualifies as an effective fair value hedge of an existing hedged item, the FHLBank continues to carry the derivative on the Statements of Condition at its fair value, ceases to adjust the hedged asset or liability for changes in fair value, and amortizes the cumulative basis adjustment on the hedged item into earnings over the remaining life of the hedged item using a level-yield methodology.
Consolidated Obligations. Consolidated Obligations are recorded at amortized cost unless the FHLBank has elected the fair value option, in which case, the Consolidated Obligations are carried at fair value.
Dealers receive concessions in connection with the issuance of certain Consolidated Obligations. The Office of Finance prorates the amount of the concession to the FHLBank based upon the percentage of the debt issued that is assumed by the FHLBank. Concessions paid on Consolidated Obligations designated under the fair value option are expensed as incurred in other non-interest expense. Concessions paid on Consolidated Obligation Bonds not designated under the fair value option are deferred and amortized, using a level-yield methodology, over the terms to maturity or the expected lives of the Consolidated Obligation Bonds. Unamortized concessions are included in “Other assets” and the amortization of such concessions is included in Consolidated Obligation Bond interest expense.
The FHLBank charges to expense as incurred the concessions applicable to Consolidated Obligation Discount Notes because of the short maturities of these Notes. Analyses of expensing concessions as incurred compared to a level-yield methodology have been performed by the FHLBank and it has determined that the impact of the difference on the financial statements for each period reported, taken individually and as a whole, is not material.
The FHLBank accretes the discounts and amortizes the premiums on Consolidated Obligation Bonds to interest expense using a level-yield methodology over the terms to maturity or estimated lives of the corresponding Consolidated Obligation Bonds. Due to their short-term nature, it expenses the discounts on Consolidated Obligation Discount Notes using a straight-line methodology over the term of the Notes. Analyses of a straight-line compared to a level-yield methodology have been performed by the FHLBank and the FHLBank has determined that the impact of the difference on the financial statements for each period reported, taken individually and as a whole, is not material.
Mandatorily Redeemable Capital Stock. The FHLBank reclassifies stock subject to redemption from equity to liability upon expiration of the “grace period” after a member provides written notice of redemption, gives notice of intent to withdraw from membership, or attains nonmember status by merger or acquisition, charter termination, or involuntary termination from membership, because the member shares then meet the definition of a mandatorily redeemable financial instrument. Shares meeting this definition are reclassified to a liability at fair value. Dividends declared on shares classified as a liability are accrued at the expected dividend rate and reflected as interest expense in the Statements of Income. The repurchase or redemption of mandatorily redeemable capital stock is reflected as a cash outflow in the financing activities section of the Statements of Cash Flows.
If a member cancels its written notice of redemption or notice of withdrawal, the FHLBank reclassifies the mandatorily redeemable capital stock from a liability to equity. After the reclassification, dividends on the capital stock are no longer classified as interest expense.
Employee Benefit Plans. The FHLBank records the periodic benefit cost associated with its employee retirement plans and its contributions associated with its defined contribution plans as compensation and benefits in the Statements of Income.
Restricted Retained Earnings. In 2011, the 12 FHLBanks entered into a Joint Capital Enhancement Agreement, as amended (Capital Agreement). Under the Capital Agreement, beginning in the third quarter of 2011, the FHLBank contributes 20 percent of its quarterly net income to a separate restricted retained earnings account until the account balance equals at least one percent of the FHLBank's average balance of outstanding Consolidated Obligations for the previous quarter. These restricted retained earnings are not available to pay dividends and are presented separately on the Statements of Condition.
Finance Agency Expenses. The FHLBank funds its proportionate share of the costs of operating the Finance Agency. The portion of the Finance Agency's expenses and working capital fund paid by each FHLBank has been allocated based on the FHLBank's pro rata share of total annual assessments (which are based on the ratio between each FHLBank's minimum required regulatory capital and the aggregate minimum required regulatory capital of every FHLBank).
Office of Finance Expenses. The FHLBank is assessed for its proportionate share of the costs of operating the Office of Finance. As approved by the Office of Finance Board of Directors, effective January 1, 2011, each FHLBank's proportionate share of Office of Finance operating and capital expenditures is calculated using a formula that is based upon the following components: (1) two-thirds based upon each FHLBank's share of total Consolidated Obligations outstanding and (2) one-third
based upon an equal pro-rata allocation. Prior to January 1, 2011, the FHLBank was assessed for Office of Finance operating and capital expenditures based equally on each FHLBank's percentage of capital stock, percentage of Consolidated Obligations issued and percentage of Consolidated Obligations outstanding.
Voluntary Housing Programs. The FHLBank classifies amounts awarded under its voluntary housing programs as other expenses.
Affordable Housing Program (AHP). The FHLBank Act requires each FHLBank to establish and fund an AHP. The FHLBank charges the required funding for AHP to earnings and establishes a liability. The AHP funds provide subsidies to members to assist in the purchase, construction, or rehabilitation of housing for very low-, low-, and moderate-income households. The FHLBank issues AHP Advances at interest rates below the customary interest rate for non-subsidized Advances. When the FHLBank makes an AHP Advance, the present value of the variation in the cash flow caused by the difference in the interest rate between the AHP Advance rate and the FHLBank's related cost of funds for comparable maturity funding is charged against the AHP liability and recorded as a discount on the AHP Advance. As an alternative, the FHLBank also has the authority to make the AHP subsidy available to members as a grant. The discount on AHP Advances is accreted to interest income on Advances using a level-yield methodology over the life of the Advance.
Resolution Funding Corporation (REFCORP). Although the FHLBanks are exempt from ordinary Federal, state, and local taxation except for local real estate tax, they were required to make quarterly payments to REFCORP through the second quarter of 2011. These payments represented a portion of the interest on bonds that were issued by REFCORP. REFCORP is a corporation established by Congress in 1989 to provide funding for the resolution and disposition of insolvent savings institutions. Officers, employees, and agents of the Office of Finance are authorized to act for and on behalf of REFCORP to carry out the functions of REFCORP.
Note 2 - Recently Issued Accounting Standards and Interpretations
Disclosures about Offsetting Assets and Liabilities. On December 16, 2011, the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) issued common disclosure requirements intended to help investors and other financial statement users better assess the effect or potential effect of offsetting arrangements on a company's financial position, whether a company's financial statements are prepared on the basis of GAAP or International Financial Reporting Standards (IFRS). This guidance will require the FHLBank to disclose both gross and net information about financial instruments, including derivative instruments, which are either offset on the statement of condition or subject to an enforceable master netting arrangement or similar agreement. This guidance is effective for interim and annual periods beginning on January 1, 2013 and will be applied retrospectively for all comparative periods presented. The adoption of this guidance will result in increased interim and annual financial statement disclosures, but will not affect the FHLBank's financial condition, results of operations, or cash flows.
Disclosures about an Employer's Participation in a Multiemployer Plan. On September 21, 2011, FASB issued guidance to enhance disclosures about an employer's participation in a multiemployer pension plan. This guidance was effective for annual periods ending after December 15, 2011 (December 31, 2011 for the FHLBank) and was applied retrospectively for all periods presented. The adoption of this guidance resulted in increased annual financial statement disclosures, but did not affect the FHLBank's financial condition, results of operations, or cash flows. See Note 18 for additional disclosures required under this guidance.
Presentation of Comprehensive Income. On June 16, 2011, FASB issued guidance to increase the prominence of other comprehensive income in financial statements. This guidance requires an entity that reports items of other comprehensive income to present comprehensive income in either a single statement or in two consecutive statements. This guidance eliminates the option to present other comprehensive income in a statement of capital. This guidance is effective for interim and annual periods beginning after December 15, 2011 (January 1, 2012 for the FHLBank) and should be applied retrospectively for all periods presented. The FHLBank plans to elect the two-statement approach beginning on January 1, 2012. The adoption of this guidance is limited to the presentation of the interim and annual financial statements.
On December 23, 2011, the FASB issued guidance to defer the effective date of the new requirement to present reclassifications of items out of accumulated other comprehensive income in the income statement. This guidance is effective for interim and annual periods beginning after December 15, 2011 (January 1, 2012 for the FHLBank). The FHLBank will still be required to adopt the remaining guidance contained in the new accounting standard for the presentation of comprehensive income.
Fair Value Measurement and Disclosure Convergence. On May 12, 2011, the FASB and the IASB issued substantially converged guidance on fair value measurement and disclosure requirements. This guidance clarifies how fair value accounting should be applied where its use is already required or permitted by other guidance within GAAP or International Financial Reporting Standards. These amendments do not require additional fair value measurements. This guidance generally represents clarifications to the application of existing fair value measurement and disclosure requirements, as well as some instances where a particular principle or requirement for measuring fair value or disclosing information about fair value measurements has changed. This guidance is effective for interim and annual periods beginning on or after December 15, 2011 (January 1, 2012 for the FHLBank) and will be applied prospectively. The adoption of this guidance may result in increased financial statement disclosures, but will not have a material effect on the FHLBank's financial condition, results of operations, or cash flows.
Reconsideration of Effective Control for Repurchase Agreements. On April 29, 2011, the FASB issued guidance to improve the accounting for repurchase agreements and other agreements that both entitle and obligate a transferor to repurchase or redeem financial assets before their maturity. The new guidance removes from the assessment of effective control: (1) the criterion requiring the transferor to have the ability to repurchase or redeem financial assets before their maturity on substantially the agreed terms, even in the event of the transferee's default, and (2) the collateral maintenance implementation guidance related to that criterion. This guidance is effective for interim and annual reporting periods beginning on or after December 15, 2011 (January 1, 2012 for the FHLBank). This guidance will be applied prospectively to transactions or modifications of existing transactions that occurred on or after the effective date. The adoption of this guidance will not have a material effect on the FHLBank's financial condition, results of operations, or cash flows.
A Creditor’s Determination of Whether a Restructuring Is a Troubled Debt Restructuring. On April 5, 2011, the FASB issued guidance to clarify which debt modifications constitute troubled debt restructurings. This guidance is intended to help creditors determine whether a modification of the terms of a receivable meets the criteria to be considered a troubled debt restructuring, both for purposes of recording an impairment loss and for presenting previously deferred disclosures related to troubled debt restructurings. The required disclosures were effective for interim and annual reporting periods beginning on or after June 15, 2011 (July 1, 2011 for the FHLBank) and applied retrospectively to troubled debt restructurings occurring on or after the beginning of the annual period of adoption. The adoption of this amended guidance resulted in increased financial statement disclosures, but did not materially affect the FHLBank's financial condition, results of operations, or cash flows. See Note 11 for additional disclosures required under this guidance.
Note 3 - Cash and Due from Banks
Compensating Balances. The FHLBank maintains collected cash balances with commercial banks in return for certain services. These agreements contain no legal restrictions on the withdrawal of funds. The average collected cash balances for the years ended December 31, 2011 and 2010 were approximately $50,000 and $57,000.
In addition, the FHLBank maintained average required balances with various Federal Reserve Banks of approximately $1,000,000 for the years ended December 31, 2011 and 2010. These represent average balances legally required to be maintained over each 14-day cycle and contain no legal restrictions on the withdrawal of the funds. The FHLBank may use earnings credits on these balances to pay for services received from the Federal Reserve Banks.
Pass-through Deposit Reserves. The FHLBank acts as a pass-through correspondent for member institutions required to deposit reserves with the Federal Reserve Banks. The amount shown as “Cash and due from banks” includes pass-through reserves deposited with Federal Reserve Banks of approximately $16,244,000 and $14,756,000 as of December 31, 2011 and 2010.
Note 4 - Securities Purchased Under Agreements to Resell
The FHLBank periodically holds securities purchased under agreements to resell those securities. These amounts represent short-term loans and are classified as assets in the Statements of Condition. The securities purchased under agreements to resell are held in safekeeping in the name of the FHLBank by third-party custodians approved by the FHLBank. Should the market value of the underlying securities decrease below the market value required as collateral, the counterparty must place an equivalent amount of additional securities in safekeeping in the name of the FHLBank or remit an equivalent amount of cash; otherwise, the dollar value of the resale agreement will be decreased accordingly.
Note 5 - Trading Securities
Table 5.1 - Trading Securities by Major Security Types (in thousands)
*
Consists of debt securities issued and effectively guaranteed by Federal Home Loan Mortgage Corporation (Freddie Mac) or Federal National Mortgage Association (Fannie Mae) which have the backing of the U.S. government, although they are not obligations of the U.S. government.
**
Consists of Government National Mortgage Association (Ginnie Mae) mortgage-backed securities.
Table 5.2 - Net (Losses) Gains on Trading Securities (in thousands)
Note 6 - Available-for-Sale Securities
Table 6.1 - Available-for-Sale Securities by Major Security Types (in thousands)
*
Consists of debt securities issued by International Bank for Reconstruction and Development.
All securities outstanding with gross unrealized losses at December 31, 2011 have been in a continuous unrealized loss position for less than 12 months.
Table 6.2 - Available-for-Sale Securities by Contractual Maturity (in thousands)
Table 6.3 - Interest Rate Payment Terms of Available-for-Sale Securities (in thousands)
Realized Gains and Losses. The FHLBank did not sell any securities out of its available-for-sale portfolio for the year ended December 31, 2011. The FHLBank received (in thousands) $854,910 in proceeds and realized (in thousands) $90 in gross losses and no gross gains from the sale of available-for-sale securities during the year ended December 31, 2010. The FHLBank did not sell any securities out of its available-for-sale portfolio for the year ended December 31, 2009.
Note 7 - Held-to-Maturity Securities
Table 7.1 - Held-to-Maturity Securities by Major Security Types (in thousands)
(1)
Carrying value equals amortized cost.
*
Consists of debt securities issued and effectively guaranteed by Freddie Mac and/or Fannie Mae, which have the backing of the U.S. government, although they are not obligations of the U.S. government.
**
Represents corporate debentures issued or guaranteed by the Federal Deposit Insurance Corporation (FDIC) under the Temporary Liquidity Guarantee Program (TLGP).
***
Consists of mortgage-backed securities issued or guaranteed by the National Credit Union Administration (NCUA) and the U.S. government.
****
Consists of mortgage-backed securities issued and effectively guaranteed by Freddie Mac and/or Fannie Mae, which have the backing of the U.S. government, although they are not obligations of the U.S. government.
Table 7.2 - Net Purchased Premiums Included in the Amortized Cost of Mortgage-backed Securities Classified as Held-to-Maturity (in thousands)
Table 7.3 summarizes the held-to-maturity securities with unrealized losses, which are aggregated by major security type and length of time that individual securities have been in a continuous unrealized loss position.
Table 7.3 - Held-to-Maturity Securities in a Continuous Unrealized Loss Position (in thousands)
*
Represents corporate debentures issued or guaranteed by the FDIC under the TLGP.
**
Consists of mortgage-backed securities issued or guaranteed by the NCUA and the U.S. government.
***
Consists of mortgage-backed securities issued and effectively guaranteed by Freddie Mac and/or Fannie Mae, which have the backing of the U.S. government, although they are not obligations of the U.S. government.
****
Consists of debt securities issued and effectively guaranteed by Freddie Mac and/or Fannie Mae, which have the backing of the U.S. government, although they are not obligations of the U.S. government.
Table 7.4 - Held-to-Maturity Securities by Contractual Maturity (in thousands)
(1)
Carrying value equals amortized cost.
(2)
Mortgage-backed securities are not presented by contractual maturity because their expected maturities will likely differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment fees.
Table 7.5 - Interest Rate Payment Terms of Held-to-Maturity Securities (in thousands)
Realized Gains and Losses. The FHLBank sold securities out of its held-to-maturity portfolio during the years ended December 31, 2011, 2010 and 2009 each of which had less than 15 percent of the acquired principal outstanding at the time of the sale. These sales are considered maturities for the purposes of security classification.
Table 7.6 - Proceeds and Gross Gains from Sale of Held-to-Maturity Securities (in thousands)
Note 8 - Other-Than-Temporary Impairment Analysis
The FHLBank evaluates its individual available-for-sale and held-to-maturity investment securities holdings in an unrealized loss position for other-than-temporary impairment on a quarterly basis. As part of its securities' evaluation for other-than-temporary impairment, the FHLBank considers its intent to sell each debt security and whether it is more likely than not that the FHLBank will be required to sell the security before its anticipated recovery. If either of these conditions is met, the FHLBank recognizes an other-than-temporary impairment in earnings equal to the entire difference between the security's amortized cost basis and its fair value at the balance sheet date. For securities in unrealized loss positions that meet neither of these conditions, the FHLBank performs analyses to determine if any of these securities are other-than-temporarily impaired. At December 31, 2011, the FHLBank's private-label residential mortgage-back security was in an unrealized gain position. As a result, the FHLBank did not consider this investment to be other-than-temporarily impaired at December 31, 2011.
For its other U.S. obligations, government-sponsored enterprise investments (mortgage-backed securities and non-mortgage-backed securities), and TLGP investments, the FHLBank determined that the strength of the issuers' guarantees through direct obligations or support from the U.S. government is sufficient to protect the FHLBank from losses based on current expectations. As a result, the FHLBank determined that, as of December 31, 2011, all of the gross unrealized losses on these investments were temporary as the declines in market value of these securities were not attributable to credit quality. Furthermore, the FHLBank does not intend to sell the investments, and it is not more likely than not that the FHLBank will be required to sell the investments before recovery of their amortized cost bases. As a result, the FHLBank did not consider any of these investments to be other-than-temporarily impaired at December 31, 2011.
The FHLBank also reviewed its available-for-sale securities and the remainder of its held-to-maturity securities that have experienced unrealized losses at December 31, 2011 and determined that the unrealized losses were temporary, based on the creditworthiness of the issuers and the related collateral characteristics, and that the FHLBank will recover its entire amortized cost basis. Additionally, because the FHLBank does not intend to sell these securities, nor is it more likely than not that the FHLBank will be required to sell the securities before recovery, it did not consider the investments to be other-than-temporarily impaired at December 31, 2011.
The FHLBank did not consider any of its investments to be other-than-temporarily impaired at December 31, 2010.
Note 9 - Advances
The FHLBank offers a wide range of fixed- and variable-rate Advance products with different maturities, interest rates, payment characteristics and optionality. Fixed-rate Advances generally have maturities ranging from one day to 30 years. Variable-rate advances generally have maturities ranging from less than 30 days to 10 years, where the interest rates reset periodically at a fixed spread to the London Interbank Offered Rate (LIBOR) or other specified index. At December 31, 2011 and 2010, the FHLBank had Advances outstanding, including AHP Advances (see Note 15), at interest rates ranging from 0.00 percent to 9.20 percent. Advances with interest rates of 0.00 percent are AHP-subsidized Advances.
Table 9.1 - Advance Redemption Terms (dollars in thousands)
The FHLBank offers Advances to members that may be prepaid on specified dates (call dates) without incurring prepayment or termination fees (callable Advances). In exchange for receiving the right to call the Advance on a predetermined call schedule, the member pays a higher fixed rate for the Advance relative to an equivalent maturity, non-callable, fixed-rate Advance. If the call option is exercised, replacement funding may be available. Other Advances may only be prepaid subject to a fee to the
FHLBank (prepayment fee) that makes the FHLBank financially indifferent to the prepayment of the Advance. At December 31, 2011 and 2010, the FHLBank had callable Advances (in thousands) of $9,798,715 and $10,525,489.
Table 9.2 - Advances by Year of Contractual Maturity or Next Call Date for Callable Advances (in thousands)
The FHLBank also offers putable Advances. With a putable Advance, the FHLBank effectively purchases a put option from the member that allows the FHLBank to terminate the Advance at predetermined dates. The FHLBank normally would exercise its option when interest rates increase relative to contractual rates. At December 31, 2011 and 2010, the FHLBank had putable Advances, excluding those where the related put options have expired, totaling (in thousands) $6,204,450 and $6,658,150.
Through December 2005, the FHLBank offered convertible Advances. Convertible Advances allow the FHLBank to convert an Advance from one interest-payment term structure to another. At December 31, 2011 and 2010, the FHLBank had convertible Advances, excluding those where the related conversion options have expired, totaling (in thousands) $1,178,500 and $1,356,000.
Table 9.3 - Advances by Year of Contractual Maturity or Next Put/Convert Date for Putable/Convertible Advances (in thousands)
Table 9.4 - Advances by Interest Rate Payment Terms (in thousands)
(1)
Payment terms based on current interest rate terms, which would reflect any option exercises or rate conversions subsequent to the related Advance issuance.
At December 31, 2011 and 2010, 54 percent and 58 percent, respectively, of the FHLBank's fixed-rate Advances were swapped to a variable rate.
Credit Risk Exposure and Security Terms. The FHLBank's potential credit risk from Advances is concentrated in commercial banks and savings institutions. At December 31, 2011 and 2010, the FHLBank had $14.8 billion and $15.1 billion of Advances outstanding that were greater than or equal to $1.0 billion per borrower. These Advances were made to 4 and 5 borrowers (members and nonmembers), which represented 53.3 percent and 51.1 percent of total Advances outstanding at December 31, 2011 and 2010.
The FHLBank lends to financial institutions within its district according to Federal statutes, including the FHLBank Act, which requires the FHLBank to hold, or have access to, collateral to secure its Advances. The management of the FHLBank has policies and procedures in place that it believes enable it to appropriately manage credit risk, including requirements for physical possession or control of pledged collateral, restrictions on borrowing, specific review of each Advance request, verifications of collateral, and continuous monitoring of borrowings and the member's financial condition. Based on the collateral pledged as security for Advances, management's credit analyses of members' financial condition, and credit extension and collateral policies, the FHLBank expects to collect all amounts due according to the contractual terms of the Advances. For additional information related to the FHLBank's credit risk on Advances, see Note 11.
Table 9.5 - Borrowers Holding Five Percent or more of Total Advances, Including Any Known Affiliates that are Members of the FHLBank (dollars in millions)
(1)
Former member.
Note 10 - Mortgage Loans Held for Portfolio
Total mortgage loans held for portfolio represent residential mortgage loans under the Mortgage Purchase Program that the FHLBank's members originate, credit enhance, and then sell to the FHLBank. The FHLBank does not service any of these loans. The FHLBank plans to retain its existing portfolio of mortgage loans.
Table 10.1 - Mortgage Loans Held for Portfolio (in thousands)
(1)
Medium-term is defined as a term of 15 years or less.
(2)
Represents the unamortized balance of the mortgage purchase commitments' market values at the time of settlement. The market value of the commitment is included in the basis of the mortgage loan and amortized accordingly.
Table 10.2 - Mortgage Loans Held for Portfolio by Collateral/Guarantee Type (in thousands)
For information related to the FHLBank's credit risk on mortgage loans and allowance for credit losses, see Note 11.
Table 10.3 - Members, Including Any Known Affiliates that are Members of the FHLBank, and Former Members Selling Five Percent or more of Total Unpaid Principal (dollars in millions)
(1)
Former member.
Note 11 - Allowance for Credit Losses
The FHLBank has established an allowance methodology for each of the FHLBank's portfolio segments: credit products; government-guaranteed or insured mortgage loans held for portfolio; and conventional mortgage loans held for portfolio.
Credit products
The FHLBank manages its credit exposure to credit products through an integrated approach that provides for a credit limit to be established for each borrower, includes an ongoing review of each borrower's financial condition and is coupled with detailed collateral and lending policies to limit risk of loss while balancing borrowers' needs for a reliable source of funding. In addition, the FHLBank lends to its members in accordance with federal statutes, including the Federal Home Loan Bank Act (FHLBank Act), and Finance Agency Regulations, which require the FHLBank to obtain sufficient collateral to fully secure credit products. The estimated value of the collateral required to secure each member's credit products is calculated by applying collateral discounts, or haircuts, to the value of the collateral. The FHLBank accepts certain investment securities, residential mortgage loans, deposits, and other real estate related assets as collateral. In addition, community financial institutions (CFIs) are eligible to utilize expanded statutory collateral provisions for small business and agriculture loans. The FHLBank's capital stock owned is also pledged as collateral. Collateral arrangements and a member’s borrowing capacity vary based on the financial condition and performance of the institution, the types of collateral pledged and the overall quality of those assets. The FHLBank can call for additional or substitute collateral to protect its security interest. Management of the FHLBank believes that these policies effectively manage the FHLBank's credit risk from credit products.
Members experiencing financial difficulties are subject to FHLBank-performed “stress tests” of the impact of poorly performing assets on the member’s capital and loss reserve positions. Depending on the results of these tests and the level of overcollateralization, a member may be allowed to maintain pledged loan assets in its custody, may be required to deliver those loans into the custody of the FHLBank or its agent, and/or may be required to provide details on these loans to facilitate an estimate of their fair value. The FHLBank perfects its security interest in all pledged collateral. The FHLBank Act affords any security interest granted to the FHLBank by a member priority over the claims or rights of any other party except for claims or rights of a third party that would be entitled to priority under otherwise applicable law and that are held by a bona fide purchaser for value or by a secured party holding a prior perfected security interest.
Using a risk-based approach, the FHLBank considers the payment status, collateral types and concentration levels, and borrower's financial condition to be indicators of credit quality on its credit products. At December 31, 2011 and 2010, the FHLBank had rights to collateral on a member-by-member basis with an estimated value in excess of its outstanding extensions of credit.
The FHLBank continues to evaluate and make changes to its collateral guidelines, as necessary, based on current market conditions. At December 31, 2011 and 2010, the FHLBank did not have any Advances that were past due, in non-accrual status, or impaired. In addition, there were no troubled debt restructurings related to credit products of the FHLBank during 2011 and 2010.
The FHLBank has not experienced any credit losses on Advances since it was founded in 1932. Based upon the collateral held as security, its credit extension and collateral policies, management's credit analysis and the repayment history on credit products, the FHLBank has not incurred any credit losses on credit products as of December 31, 2011 and 2010. Accordingly, the FHLBank has not recorded any allowance for credit losses on Advances.
At December 31, 2011 and 2010, no liability to reflect an allowance for credit losses for off-balance sheet credit exposures was recorded. See Note 21 for additional information on the FHLBank's off-balance sheet credit exposure.
Mortgage Loans - Government-guaranteed or Insured
The FHLBank invests in government-guaranteed or insured fixed-rate mortgage loans secured by one-to-four family residential properties. Government-guaranteed mortgage loans are mortgage loans guaranteed or insured by the Federal Housing Administration (FHA). Any losses from such loans are expected to be recovered from the FHA. Any losses from such loans that are not recovered from the FHA would be due to a claim rejection by the FHA and, as such, would be recoverable from the selling participating financial institutions (PFIs). Therefore, the FHLBank only has credit risk for these loans if the servicer fails to pay for losses not covered by insurance or guarantees. As a result, the FHLBank did not establish an allowance for credit losses on government-guaranteed or insured mortgage loans. Furthermore, due to the government guarantee or insurance, none of these mortgage loans have been placed on non-accrual status.
Mortgage Loans - Conventional Mortgage Purchase Program
The allowance for conventional loans is determined by analyses that include consideration of various data observations such as past performance, current performance, loan portfolio characteristics, collateral-related characteristics, industry data, and prevailing economic conditions. The measurement of the allowance for credit losses consists of: (1) collectively evaluating homogeneous pools of residential mortgage loans; (2) reviewing specifically identified loans for impairment; and (3) estimating a margin of imprecision.
Collectively Evaluated Mortgage Loans. The credit risk analysis of conventional loans evaluated collectively for impairment considers historical delinquency migration, applies estimated loss severities, and incorporates the credit enhancements of the Mortgage Purchase Program in order to determine the FHLBank's best estimate of probable incurred losses. The credit risk analysis of all conventional mortgage loans is performed at the individual Master Commitment Contract level to properly determine the credit enhancements available to recover losses on loans under each individual Master Commitment Contract. The Master Commitment Contract is an agreement with a member in which the member agrees to make every attempt to sell a specific dollar amount of loans to the FHLBank over a one-year period. Migration analysis is a methodology for determining, through the FHLBank's experience over a historical period, the rate of default on pools of similar loans. The FHLBank applies migration analysis to loans based on payment status categories such as current, 30, 60, and 90 days past due. The FHLBank then estimates how many loans in these categories may migrate to a loss realization event and applies a current loss severity to estimate losses. The estimated losses are then reduced for the benefit of projected credit enhancements available in order to estimate the losses incurred at the Statement of Condition date.
Individually Evaluated Mortgage Loans. Conventional mortgage loans that are considered troubled debt restructurings are specifically identified for purposes of calculating the allowance for credit losses. The FHLBank measures impairment of these specifically identified loans by either estimating the present value of expected cash flows, or estimating the loan's observable market price. Specifically identified loans evaluated for impairment are removed from the collectively evaluated mortgage loan population.
Estimating a Margin of Imprecision. The FHLBank also assesses a factor for the margin of imprecision to the estimation of loan losses for the homogeneous population. This amount represents a subjective management judgment, based on facts and circumstances that exist as of the reporting date, that is unallocated to any specific measurable economic or credit event and is intended to cover other inherent losses that may not otherwise be captured in the methodology described above.
Rollforward of Allowance for Credit Losses on Mortgage Loans. The following tables present a rollforward of the allowance for credit losses on conventional mortgage loans as well as the recorded investment in mortgage loans by impairment
methodology. The recorded investment in a loan is the unpaid principal balance of the loan adjusted for accrued interest, unamortized premiums or discounts, and direct write-downs. The recorded investment is not net of any allowance.
Table 11.1 - Rollforward of Allowance for Credit Losses on Conventional Mortgage Loans (in thousands)
Table 11.2 - Allowance for Credit Losses and Recorded Investment on Conventional Mortgage Loans by Impairment Methodology (in thousands)
Credit Enhancements. The FHLBank's allowance for credit losses considers the credit enhancements associated with conventional mortgage loans. These credit enhancements apply after a homeowner's equity is exhausted. The amount of credit enhancements needed to protect the FHLBank against credit losses is determined through use of a third-party default model. The totality of the credit enhancements have historically protected the FHLBank against credit risk exposure on each conventional loan down to approximately a 50 percent “loan-to-value” level at the time of origination, subject, in certain cases, to an aggregate stop-loss feature in the Supplemental Mortgage Insurance policy. This means that the loan's value (observed from a sale price or appraisal) can fall to approximately half of its value at the time the loan was originated before the FHLBank would be exposed to a potential credit loss. Any incurred losses that are expected to be recovered from the credit enhancements are not reserved as part of the FHLBank's allowance for credit losses.
The conventional mortgage loans under the Mortgage Purchase Program are supported by some combination of credit enhancements (primary mortgage insurance (PMI), supplemental mortgage insurance (SMI) and the Lender Risk Account (LRA), including pooled LRA for those members participating in an aggregated Mortgage Purchase Program pool), in addition to the associated property as collateral. Beginning in February 2011, the FHLBank discontinued the use of SMI for all new loan purchases and replaced it with expanded use of the LRA. The LRA is funded by the FHLBank as a portion of the purchase proceeds to cover expected losses. Excess funds over required balances are distributed to the member in accordance with a step-down schedule that is established at the time of a Master Commitment Contract, subject to performance of the related loan pool. The LRA established for a pool of loans is limited to only covering losses of that specific pool of loans.
Table 11.3 - Changes in the LRA (in thousands)
Credit Quality Indicators. Key credit quality indicators for mortgage loans include the migration of past due loans, non-accrual loans, and loans in process of foreclosure. The table below summarizes the FHLBank's key credit quality indicators for mortgage loans.
Table 11.4 - Recorded Investment in Delinquent Mortgage Loans (dollars in thousands)
(1)
Includes loans where the decision of foreclosure or a similar alternative such as pursuit of deed-in-lieu has been reported. Loans in process of foreclosure are included in past due or current loans dependent on their delinquency status.
(2)
Loans that are 90 days or more past due or in the process of foreclosure (including past due or current loans in the process of foreclosure) expressed as a percentage of the total loan portfolio class recorded investment amount.
(3)
Each conventional loan past due 90 days or more is on a schedule/scheduled monthly settlement basis and contains one or more credit enhancements. Loans that are well secured and in the process of collection as a result of remaining credit enhancements and schedule/scheduled settlement are not placed on non-accrual status.
The FHLBank did not have any real estate owned at December 31, 2011 or 2010.
Troubled Debt Restructurings. A troubled debt restructuring is considered to have occurred when a concession is granted to a borrower for economic or legal reasons related to the borrower's financial difficulties and that concession would not have been considered otherwise. As a result of adopting the new accounting guidance on a creditor's determination of whether a restructuring is a troubled debt restructuring discussed in Note 2, the FHLBank reassessed all restructurings that occurred on or after January 1, 2011 for identification as troubled debt restructurings. Upon identifying certain restructurings as troubled debt
restructurings, the FHLBank identified them as impaired and applied the impairment measurement guidance for those receivables prospectively.
The FHLBank's troubled debt restructurings primarily involve loans where an agreement permits the recapitalization of past due amounts up to the original loan amount. Under this type of modification, no other terms of the original loan are modified, including the borrower's original interest rate and contractual maturity. The FHLBank had 13 modified loans considered troubled debt restructurings at December 31, 2011.
A loan considered a troubled debt restructuring is individually evaluated for impairment when determining its related allowance for credit losses. Credit loss is measured by factoring in expected cash shortfalls (i.e., loss severity rate) incurred as of the reporting date.
Table 11.5 - Recorded Investment in Troubled Debt Restructurings (in thousands)
Due to the minimal change in terms of modified loans (i.e., no principal forgiven), the FHLBank's pre-modification recorded investment was not materially different than the post-modification recorded investment in troubled debt restructurings during the year ended December 31, 2011.
Certain conventional Mortgage Purchase Program loans modified within the previous twelve months and considered troubled debt restructurings experienced a payment default during the year ended December 31, 2011 as noted in the table below.
Table 11.6 - Recorded Investment of Financing Receivables Modified within the Previous 12 Months and Considered Troubled Debt Restructurings that Subsequently Defaulted (in thousands)
Modified loans that subsequently default recognize a higher probability of loss when calculating the allowance for credit losses.
Individually Evaluated Impaired Loans. At December 31, 2011, only certain conventional Mortgage Purchase Program loans individually evaluated for impairment required an allowance for credit losses. Table 11.7 presents the recorded investment, unpaid principal balance, and related allowance associated with these loans. The FHLBank did not evaluate any loans individually at December 31, 2010.
Table 11.7 - Individually Evaluated Impaired Loan Statistics by Product Class Level (in thousands)
Table 11.8 - Average Recorded Investment of Individually Evaluated Impaired Loans and Related Interest Income Recognized (in thousands)
Note 12 - Derivatives and Hedging Activities
Nature of Business Activity
The FHLBank is exposed to interest rate risk primarily from the effect of interest rate changes on its interest-earning assets and on the funding sources that finance these assets. The goal of the FHLBank's interest-rate risk management strategies is not to eliminate interest-rate risk, but to manage it within appropriate limits. To mitigate the risk of loss, the FHLBank has established policies and procedures, which include guidelines on the amount of exposure to interest rate changes it is willing to accept. In addition, the FHLBank monitors the risk to its interest income, net interest margin and average maturity of interest-earning assets and funding sources.
Consistent with Finance Agency Regulations, the FHLBank enters into derivatives to manage the interest rate risk exposures inherent in otherwise unhedged assets and funding positions, to achieve the FHLBank's risk management objectives and to act as an intermediary between its members and counterparties. The use of derivatives is an integral part of the FHLBank's financial management strategy. However, Finance Agency Regulations and the FHLBank's financial management policy prohibit trading in or the speculative use of derivative instruments and limit credit risk arising from them.
The most common ways in which the FHLBank uses derivatives are to:
▪
reduce the interest rate sensitivity and repricing gaps of assets and liabilities;
▪
manage embedded options in assets and liabilities;
▪
reduce funding costs by combining a derivative with a Consolidated Obligation, as the cost of a combined funding structure can be lower than the cost of a comparable Consolidated Obligation Bond;
▪
preserve a favorable interest rate spread between the yield of an asset (e.g., an Advance) and the cost of the related liability (e.g., the Consolidated Obligation Bond used to fund the Advance); without the use of derivatives, this interest rate spread could be reduced or eliminated when a change in the interest rate on the Advance does not match a change in the interest rate on the Bond; and
▪
protect the value of existing asset or liability positions.
Types of Derivatives
The FHLBank may enter into interest rate swaps (including callable and putable swaps), swaptions, interest rate cap and floor agreements, calls, puts, futures, and forward contracts to manage its exposure to changes in interest rates.
An interest rate swap is an agreement between two entities to exchange cash flows in the future. The agreement sets the dates on which the cash flows will be paid and the manner in which the cash flows will be calculated. One of the simplest forms of an interest rate swap involves the promise by one party to pay cash flows equivalent to the interest on a notional principal amount at a predetermined fixed rate for a given period of time. In return for this promise, this party receives cash flows equivalent to the interest on the same notional principal amount at a variable-rate index for the same period of time. The variable-rate received by the FHLBank in its derivatives is the London Interbank Offered Rate (LIBOR).
Application of Interest Rate Swaps
The FHLBank generally uses derivatives as fair value hedges of underlying financial instruments. However, because the FHLBank uses interest rate swaps when they are considered to be the most cost-effective alternative to achieve the FHLBank's financial and risk management objectives, it may enter into interest rate swaps that do not necessarily qualify for hedge accounting (economic hedges). The FHLBank re-evaluates its hedging strategies from time to time and may change the hedging techniques it uses or adopt new strategies.
The FHLBank transacts most of its derivatives with large banks and major broker-dealers. Some of these banks and broker-dealers or their affiliates buy, sell, and distribute Consolidated Obligations. The FHLBank is not a derivatives dealer and thus does not trade derivatives for short-term profit.
Types of Hedged Items
The FHLBank documents at inception all relationships between derivatives designated as hedging instruments and the hedged items, its risk management objectives and strategies for undertaking various hedge transactions, and its method of assessing effectiveness. This process includes linking all derivatives that are designated as fair value hedges to assets and liabilities on the Statements of Condition. The FHLBank also formally assesses (both at the hedge's inception and at least quarterly) whether the derivatives that are used in hedging transactions have been effective in offsetting changes in the fair value of the hedged items and whether those derivatives may be expected to remain effective in future periods. The FHLBank currently uses regression analyses to assess the effectiveness of its hedges.
Consolidated Obligations - The FHLBank enters into derivatives to hedge the interest rate risk associated with its specific debt issuances. The FHLBank manages the risk arising from changing market prices and volatility of a Consolidated Obligation by matching the cash inflow on a derivative with the cash outflow on the Consolidated Obligation.
For instance, in a typical transaction, fixed-rate Consolidated Obligations are issued for one or more FHLBanks, and the FHLBank simultaneously enters into a matching interest rate swap in which the counterparty pays fixed cash flows to the FHLBank designed to mirror in timing and amount the cash outflows the FHLBank pays on the Consolidated Obligation. The FHLBank pays a variable cash flow that closely matches the interest payments it receives on short-term or variable-rate Advances, typically 3-month LIBOR. These transactions are treated as fair value hedges.
This strategy of issuing Bonds while simultaneously entering into derivatives enables the FHLBank to offer a wider range of attractively priced Advances to its members and may allow the FHLBank to reduce its funding costs. The continued attractiveness of such debt depends on yield relationships between the Bond and the derivative markets. If conditions in these markets change, the FHLBank may alter the types or terms of the Bonds that it issues. By acting in both the capital and the swap markets, the FHLBank may raise funds at lower costs than through the issuance of simple fixed- or variable-rate Consolidated Obligations in the capital markets alone.
Advances - The FHLBank offers a wide array of Advance structures to meet members' funding needs. These Advances may have maturities up to 30 years with variable or fixed rates and may include early termination features or options. The FHLBank may use derivatives to adjust the repricing and/or options characteristics of Advances in order to more closely match the characteristics of the FHLBank's funding liabilities. In general, whenever a member executes a fixed-rate Advance or a variable-rate Advance with embedded options, the FHLBank will simultaneously execute a derivative with terms that offset the terms and embedded options, if any, in the Advance. For example, the FHLBank may hedge a fixed-rate Advance with an interest rate swap where the FHLBank pays a fixed-rate coupon and receives a floating-rate coupon, effectively converting the fixed-rate Advance to a floating-rate Advance. These types of hedges are typically treated as fair value hedges.
When issuing a putable Advance, the FHLBank effectively purchases a put option from the member that allows the FHLBank to put or extinguish the fixed-rate Advance, which the FHLBank normally would exercise when interest rates increase. The FHLBank may hedge these Advances by entering into a cancelable derivative.
Mortgage Loans - The FHLBank invests in fixed-rate mortgage loans. The prepayment options embedded in these mortgage loans can result in extensions or contractions in the expected repayment of these investments, depending on changes in estimated prepayment speeds. The FHLBank may manage the interest rate and prepayment risks associated with mortgages through a combination of debt issuance and derivatives. The FHLBank issues both callable and noncallable debt and prepayment linked Consolidated Obligations to achieve cash flow patterns and liability durations similar to those expected on the mortgage loans. The FHLBank is also permitted to use derivatives to match the expected prepayment characteristics of the mortgages, although to date it has not done so.
Firm Commitments - Certain mortgage purchase commitments are considered derivatives. The FHLBank normally hedges these commitments by selling to-be-announced (TBA) mortgage-backed securities for forward settlement. A TBA represents a forward contract for the sale of mortgage-backed securities at a future agreed upon date for an established price. The mortgage purchase commitment and the TBA used in the firm commitment hedging strategy (economic hedge) are recorded as a derivative asset or derivative liability at fair value, with changes in fair value recognized in the current period earnings. When the mortgage purchase commitment derivative settles, the current market value of the commitment is included in the basis of the mortgage loan and amortized accordingly.
Investments - The interest rate and prepayment risks associated with the FHLBank's investment securities are managed through a combination of debt issuance and, possibly, derivatives. The FHLBank may manage the prepayment and interest rate risks by funding investment securities with Consolidated Obligations that have call features or by hedging the prepayment risk with caps or floors, callable swaps or swaptions.
Financial Statement Effect and Additional Financial Information
The notional amount of derivatives serves as a factor in determining periodic interest payments or cash flows received and paid. The notional amount represents neither the actual amounts exchanged nor the overall exposure of the FHLBank to credit and market risk. The risks of derivatives only can be measured meaningfully on a portfolio basis that takes into account the derivatives, the items being hedged and any offsets between the two.
Table 12.1 summarizes the fair value of derivative instruments. For purposes of this disclosure, the derivative values include the fair value of derivatives and the related accrued interest.
Table 12.1 - Fair Value of Derivative Instruments (in thousands)
(1)
Amounts represent the effects of legally enforceable master netting agreements that allow the FHLBank to settle positive and negative positions and of cash collateral held or placed with the same counterparties.
Table 12.2 presents the components of net (losses) gains on derivatives and hedging activities as presented in the Statements of Income.
Table 12.2 - Net (Losses) Gains on Derivatives and Hedging Activities (in thousands)
Table 12.3 presents by type of hedged item, the gains (losses) on derivatives and the related hedged items in fair value hedging relationships and the impact of those derivatives on the FHLBank's net interest income.
Table 12.3 - Effect of Fair Value Hedge Related Derivative Instruments (in thousands)
(1)
The net interest on derivatives in fair value hedge relationships is included in the interest income/expense line item of the respective hedged item.
Managing Credit Risk on Derivatives
The FHLBank is subject to credit risk due to nonperformance by counterparties to its derivative agreements. The degree of counterparty risk depends on the extent to which master netting arrangements are included in the contracts to mitigate the risk. The FHLBank manages counterparty credit risk through credit analysis, collateral requirements and adherence to the requirements set forth in FHLBank policies and Finance Agency Regulations. The FHLBank requires collateral agreements on all derivatives that establish collateral delivery thresholds. Based on credit analyses and collateral requirements at December 31, 2011 and 2010, the management of the FHLBank did not anticipate any credit losses on its derivative
agreements. See Note 20 for discussion regarding the FHLBank's fair value methodology for derivative assets/liabilities, including the evaluation of the potential for the fair value of these instruments to be affected by counterparty credit risk and Note 21 for a discussion of a dispute with a past counterparty.
Table 12.4 presents credit risk exposure on derivative instruments, excluding circumstances where a counterparty's pledged collateral to the FHLBank exceeds the FHLBank's net position.
Table 12.4 - Credit Risk Exposure (in thousands)
(1)
Includes net accrued interest receivables of (in thousands) $1,060 and $1,722 at December 31, 2011 and 2010.
Certain of the FHLBank's interest rate swap contracts contain provisions that require the FHLBank to post additional collateral with its counterparties if there is deterioration in the FHLBank's credit ratings. The aggregate fair value of all interest rate swaps with credit-risk-related contingent features that were in a liability position at December 31, 2011 was (in thousands) $610,324, for which the FHLBank had posted collateral of (in thousands) $508,262 in the normal course of business, resulting in a net balance of (in thousands) $102,062. The collateral posted reflects the August 8, 2011, Standard & Poor's Rating Services downgrade of the long-term credit ratings of the 10 FHLBanks with AAA ratings from AAA to AA+ (the FHLBanks of Chicago and Seattle were already rated AA+). The ratings of the FHLBanks were constrained by the long-term credit rating of the United States of America. On August 5, 2011, Standard & Poor's lowered its long-term credit rating on the United States of America from AAA to AA+ with a negative outlook. The outlook for the 12 FHLBanks is negative. Standard & Poor's actions did not affect the short-term A-1+ ratings of the FHLBanks. On August 2, 2011, Moody's confirmed the long-term Aaa rating on the senior unsecured debt issues of the FHLBank System and the 12 FHLBanks. In conjunction with the revision of the U.S. government outlook to negative, Moody's rating outlook for the FHLBank System and the 12 FHLBanks was also revised to negative.
If one of the FHLBank's credit ratings had been lowered to the next lower rating that would have triggered additional collateral to be delivered, the FHLBank would have been required to deliver up to an additional (in thousands) $35,000 of collateral (at fair value) to its derivatives counterparties at December 31, 2011.
Note 13 - Deposits
The FHLBank offers demand and overnight deposits to members and qualifying nonmembers. In addition, the FHLBank offers short-term interest bearing deposit programs to members. A member that services mortgage loans may deposit in the FHLBank funds collected in connection with the mortgage loans, pending disbursement of such funds to the owners of the mortgage loans; the FHLBank classifies these items as other interest bearing deposits.
Certain financial institutions have agreed to maintain compensating balances in consideration for correspondent and other non-credit services. These balances are included in interest bearing deposits on the accompanying financial statements. The compensating balances required to be held by the FHLBank averaged (in thousands) $3,120,090 and $1,480,312 during 2011 and 2010.
Deposits classified as demand, overnight, and other pay interest based on a daily interest rate. Term deposits pay interest based on a fixed rate determined at the issuance of the deposit. The average interest rates paid on interest bearing deposits during 2011, 2010, and 2009 were 0.05 percent, 0.09 percent, and 0.10 percent.
Non-interest bearing deposits represent funds for which the FHLBank acts as a pass-through correspondent for member institutions required to deposit reserves with the Federal Reserve Banks.
Table 13.1- Deposits (in thousands)
The aggregate amount of time deposits with a denomination of $100 thousand or more was (in thousands) $90,850 and $210,625 as of December 31, 2011 and 2010.
Note 14 - Consolidated Obligations
Consolidated Obligations consist of Consolidated Bonds and Discount Notes. The FHLBanks issue Consolidated Obligations through the Office of Finance as their agent. In connection with each debt issuance, each FHLBank specifies the amount of debt it wants issued on its behalf. The Office of Finance tracks the amount of debt issued on behalf of each FHLBank. In addition, the FHLBank separately tracks and records as a liability its specific portion of Consolidated Obligations for which it is the primary obligor.
The Finance Agency and the U.S. Secretary of the Treasury have oversight over the issuance of FHLBank debt through the Office of Finance. Consolidated Bonds are issued primarily to raise intermediate- and long-term funds for the FHLBanks and are not subject to any statutory or regulatory limits on maturity. Consolidated Discount Notes are issued primarily to raise short-term funds and have original maturities up to one year. These notes sell at less than their face amount and are redeemed at par value when they mature.
Although the FHLBank is primarily liable for its portion of Consolidated Obligations (i.e., those issued on its behalf), the FHLBank is also jointly and severally liable with the other eleven FHLBanks for the payment of principal and interest on all Consolidated Obligations of each of the other FHLBanks. The Finance Agency, at its discretion, may require any FHLBank to make principal or interest payments due on any Consolidated Obligation whether or not the Consolidated Obligation represents a primary liability of such FHLBank. Although it has never occurred, to the extent that an FHLBank makes any payment on a Consolidated Obligation on behalf of another FHLBank that is primarily liable for the Consolidated Obligation, Finance Agency Regulations provide that the paying FHLBank is entitled to reimbursement from the non-complying FHLBank for those payments and other associated costs (including interest to be determined by the Finance Agency). If, however, the Finance Agency determines that the non-complying FHLBank is unable to satisfy its repayment obligations, the Finance Agency may allocate the outstanding liabilities of the non-complying FHLBank among the remaining FHLBanks on a pro rata basis in proportion to each FHLBank's participation in all Consolidated Obligations outstanding or in any other manner it may determine to ensure that the FHLBanks operate in a safe and sound manner.
The par values of the 12 FHLBanks' outstanding Consolidated Obligations were approximately $691.9 billion and $796.4 billion at December 31, 2011 and 2010. Regulations require the FHLBank to maintain unpledged qualifying assets equal to its participation in the Consolidated Obligations outstanding. Qualifying assets are defined as cash; secured Advances; assets with an assessment or rating at least equivalent to the current assessment or rating of the Consolidated Obligations; obligations of or fully guaranteed by the United States; obligations, participations, or other instruments of or issued by Fannie Mae or Ginnie Mae; mortgages, obligations, or other securities which are or have ever been sold by Freddie Mac under the FHLBank Act; and such securities as fiduciary and trust funds may invest in under the laws of the state in which the FHLBank is located. Any assets subject to a lien or pledge for the benefit of holders of any issue of Consolidated Obligations are treated as if they were free from lien or pledge for purposes of compliance with these regulations.
The following is a summary of the FHLBank's participation in Consolidated Bonds outstanding at December 31 by year of contractual maturity.
Table 14.1 - Consolidated Bonds Outstanding by Contractual Maturity (dollars in thousands)
Table 14.2 - Consolidated Discount Notes Outstanding (dollars in thousands)
(1)
Represents an implied rate without consideration of concessions.
Consolidated Obligations are issued with either fixed-rate coupon payment terms or variable-rate coupon payment terms that use a variety of indices for interest rate resets, including LIBOR. To meet the expected specific needs of certain investors in Consolidated Obligations, both fixed-rate Bonds and variable-rate Bonds may contain features that result in complex coupon payment terms and call options. When such Consolidated Obligations are issued, the FHLBank may enter into derivatives containing offsetting features that effectively convert the terms of the Bond to those of a simple variable-rate Bond or of a fixed-rate Bond. At December 31, 2011 and 2010, 33 percent and 30 percent of the FHLBank's fixed-rate Consolidated Bonds were swapped to a variable rate.
Table 14.3 - Consolidated Bonds Outstanding by Features (in thousands)
Table 14.4 - Consolidated Bonds Outstanding by Contractual Maturity or Next Call Date (in thousands)
These Consolidated Obligations, beyond having fixed-rate or simple variable-rate coupon payment terms, may also have the following broad principal repayment terms:
Indexed principal redemption Consolidated Bonds (index amortizing notes) repay principal according to predetermined amortization schedules that are linked to the level of a certain index. At December 31, 2011 and 2010, the index amortizing notes had fixed-rate coupon payment terms. Usually, as market interest rates rise (fall), the maturity of the index amortizing notes extends (contracts); and
Optional principal redemption Consolidated Bonds (callable bonds) that the FHLBank may redeem in whole or in part at its discretion on predetermined call dates according to the terms of the Consolidated Bond offerings.
Table 14.5 - Consolidated Bonds by Interest-rate Payment Type (in thousands)
Concessions on Consolidated Obligations. Unamortized concessions included in other assets were (in thousands) $11,707 and $14,261 at December 31, 2011 and 2010. The amortization of such concessions is included in Consolidated Obligation interest expense and totaled (in thousands) $15,686, $24,659 and $33,364 in 2011, 2010, and 2009.
Note 15 - Affordable Housing Program (AHP)
The FHLBank Act requires each FHLBank to establish an AHP. Each FHLBank provides subsidies in the form of direct grants and below-market interest rate Advances to members who use the funds to assist in the purchase, construction, or rehabilitation of housing for very low-, low-, and moderate-income households. Annually, the FHLBanks must set aside for the AHP the greater of $100 million or 10 percent of net earnings. For purposes of the AHP calculation, net earnings is defined as net income before assessments, plus interest expense related to mandatorily redeemable capital stock, less the assessment for REFCORP. The AHP and REFCORP assessments are calculated simultaneously because of their interdependence. The FHLBank accrues AHP expense monthly based on its net earnings. The FHLBank reduces the AHP liability as members use subsidies. Calculation of the REFCORP assessment is discussed in Note 16.
As discussed in Note 16, the FHLBank fully satisfied its REFCORP obligation in 2011. Because the REFCORP assessment reduced the amount of net earnings used to calculate the AHP assessment, it had the effect of reducing the total amount of funds allocated to the AHP. The amounts allocated to the new restricted retained earnings account, however, will not be treated as an assessment and will not reduce each FHLBank's net income. As a result, each FHLBank's AHP contributions as a percentage of pre-assessment earnings will increase because the REFCORP obligation has been fully satisfied.
If the FHLBank experienced a net loss during a quarter, but still had net earnings for the year, the FHLBank's obligation to the AHP would be calculated based on the FHLBank's year-to-date net earnings. If the FHLBank had net earnings in subsequent quarters, it would be required to contribute additional amounts to meet its calculated annual obligation. If the FHLBank
experienced a net loss for a full year, the FHLBank would have no obligation to the AHP for the year, because each FHLBank's required annual AHP contribution is limited to its annual net earnings. If the aggregate 10 percent calculation described above was less than $100 million for all 12 FHLBanks, each FHLBank would be required to contribute a pro rata amount sufficient to assure that the aggregate contributions of the FHLBanks equaled $100 million. The pro ration would be made on the basis of an FHLBank's income in relation to the income of all FHLBanks for the previous year.
There was no shortfall, as described above, in 2011, 2010 or 2009. If an FHLBank finds that its required AHP obligations are contributing to its financial instability, it may apply to the Finance Agency for a temporary suspension of its contributions. The FHLBank has never made such an application. The FHLBank had outstanding principal in AHP-related Advances (in thousands) of $149,243 and $159,975 at December 31, 2011 and 2010.
Table 15.1 - Analysis of the FHLBank's AHP Liability (in thousands)
Note 16 - Resolution Funding Corporation (REFCORP)
On August 5, 2011, the Finance Agency certified that the FHLBanks had fully satisfied their REFCORP obligation with their payment made on July 15, 2011, which was accrued as applicable in each FHLBank's June 30, 2011 financial statements. The FHLBanks entered into a Joint Capital Enhancement Agreement, as amended, which requires each FHLBank to allocate 20 percent of its net income to a separate restricted retained earnings account, beginning in the third quarter of 2011. See Note 17 for additional information on the FHLBank's Joint Capital Enhancement Agreement and REFCORP Certification.
Prior to the satisfaction of the FHLBanks' REFCORP obligation, each FHLBank was required to make payments to REFCORP (20 percent of annual GAAP net income before REFCORP assessments and after payment of AHP assessments) until the total amount of payments actually made was equivalent to a $300 million annual annuity whose final maturity date was April 15, 2030. The Finance Agency shortened or lengthened the period during which the FHLBanks made payments to REFCORP based on actual payments made relative to the referenced annuity. The Finance Agency, in consultation with the U.S. Secretary of the Treasury, selected the appropriate discounting factors used in calculating the annuity. See Note 15 for additional information on the FHLBank's AHP calculation.
Table 16.1 - Analysis of the FHLBank's REFCORP Liability (in thousands)
Note 17 - Capital
The FHLBank is subject to three capital requirements under its Capital Plan and the Finance Agency rules and regulations:
1.
Risk-based capital. The FHLBank must maintain at all times permanent capital, defined as Class B stock and retained earnings, in an amount at least equal to the sum of its credit risk, market risk, and operations risk capital requirements, all of which are calculated in accordance with the rules and regulations of the Finance Agency. The Finance Agency may require the FHLBank to maintain a greater amount of permanent capital than is required by the risk-based capital requirements. Mandatorily redeemable capital stock is considered capital for determining the FHLBank's compliance with its regulatory requirements.
2.
Total regulatory capital. The FHLBank is required to maintain at all times a total regulatory capital-to-assets ratio of at least four percent. Total regulatory capital is the sum of permanent capital, Class A stock, any general loss allowance, if consistent with GAAP and not established for specific assets, and other amounts from sources determined by the Finance Agency as available to absorb losses.
3.
Leverage capital. The FHLBank is required to maintain at all times a leverage capital-to-assets ratio of at least five percent. Leverage capital is defined as the sum of permanent capital weighted 1.5 times and all other capital without a weighting factor.
At December 31, 2011 and 2010, the FHLBank was in compliance with each of these capital requirements.
Table 17.1 - Capital Requirements (dollars in thousands)
The FHLBank currently offers only Class B stock, which is issued and redeemed at a par value of $100 per share. Class B stock may be issued to meet membership and activity stock purchase requirements, to pay dividends, and to pay interest on mandatorily redeemable capital stock. Membership stock is required to become a member of and maintain membership in the FHLBank. The membership stock requirement is based upon a percentage of the member's total assets, currently determined within a declining range from 0.15 percent to 0.03 percent of each member's total assets, with a current minimum of $1 thousand and a current maximum of $25 million for each member. In addition to membership stock, a member may be required to hold activity stock to capitalize its Mission Asset Activity with the FHLBank.
Mission Asset Activity includes Advances, certain funds and rate Advance commitments, and Mortgage Purchase Program activity that occurred after implementation of the Capital Plan on December 30, 2002. Members must maintain an activity stock balance at least equal to the minimum activity allocation percentage, which currently is zero percent for the Mortgage Purchase Program and two percent for all other Mission Asset Activity. If a member owns more than the maximum activity allocation percentage, which currently is four percent of all Mission Asset Activity, the additional stock is that member's excess stock. The FHLBank's unrestricted excess stock is defined as total Class B stock minus membership stock, activity stock calculated at the maximum allocation percentage, shares reserved for exclusive use after a stock dividend, and shares subject to redemption and withdrawal notices. The FHLBank's excess stock may normally be used by members to support a portion of their activity stock requirement as long as those members maintain at least their minimum activity stock allocation percentage.
A member may request redemption of all or part of its Class B stock or may withdraw from membership by giving five years' advance written notice. When the FHLBank repurchases capital stock, it must first repurchase shares for which a redemption or withdrawal notice's five-year redemption period or withdrawal period has expired. Since its Capital Plan was implemented, the FHLBank has repurchased, at its discretion, all member shares subject to outstanding redemption notices prior to the expiration of the five-year redemption period.
The Gramm-Leach-Bliley Act of 1999 (GLB Act) made membership in the FHLBanks voluntary for all members. Any member that has withdrawn from membership may not be readmitted to membership in any FHLBank until five years from the divestiture date for all capital stock that was held as a condition of membership, unless the institution has cancelled its notice of withdrawal prior to the divestiture date. This restriction does not apply if the member is transferring its membership from one FHLBank to another on an uninterrupted basis.
The FHLBank's retained earnings are owned proportionately by the current holders of Class B stock. The holders' interest in the retained earnings is realized at the time the FHLBank periodically declares dividends or at such time as the FHLBank is liquidated. The FHLBank's Board of Directors may declare and pay dividends in either cash or capital stock, assuming the FHLBank is in compliance with Finance Agency rules.
Restricted Retained Earnings. The Joint Capital Enhancement Agreement (Capital Agreement) is intended to enhance the capital position of each FHLBank. The intent of the Capital Agreement is to allocate that portion of each FHLBank's earnings historically paid to satisfy its REFCORP obligation to a separate retained earnings account at that FHLBank.
Each FHLBank had been required to contribute 20 percent of its earnings toward payment of the interest on REFCORP bonds until satisfaction of the REFCORP obligation, as certified by the Finance Agency on August 5, 2011. The Capital Agreement provides that, upon full satisfaction of the REFCORP obligation, each FHLBank will contribute 20 percent of its net income each quarter to a restricted retained earnings account until the balance of that account equals at least one percent of that FHLBank's average balance of outstanding Consolidated Obligations for the previous quarter. These restricted retained earnings are not available to pay dividends.
The FHLBank amended its Capital Plan to implement the provisions of the Capital Agreement. The Finance Agency approved the Capital Plan amendments on August 5, 2011. In accordance with the Capital Agreement, starting in the third quarter of 2011, each FHLBank contributes 20 percent of its net income to a separate restricted retained earnings account. At December 31, 2011, the FHLBank had (in thousands) $11,683 in restricted retained earnings.
Mandatorily Redeemable Capital Stock. The FHLBank is a cooperative whose members and former members own all of the FHLBank's capital stock. Member shares cannot be purchased or sold except between the FHLBank and its members at its $100 per share par value. The FHLBank reclassifies stock subject to redemption from equity to liability upon expiration of the “grace period” after a member submits a written redemption request or withdrawal notice, or when the member attains nonmember status by merger or acquisition, charter termination, or involuntary termination of membership. A member may cancel or revoke its written redemption request or its withdrawal notice prior to the end of the five-year redemption period. Under the FHLBank's Capital Plan, there is a five calendar day “grace period” for revocation of a redemption request and a 30 calendar day “grace period” for revocation of a withdrawal notice during which the member may cancel the redemption request or withdrawal notice without a penalty or fee. The cancellation fee after the “grace period” is currently two percent of the requested amount in the first year and increases one percent a year until it reaches a maximum of six percent in the fifth year. The cancellation fee can be waived by the FHLBank's Board of Directors for a bona fide business purpose.
Stock subject to a redemption or withdrawal notice that is within the “grace period” continues to be considered equity because there is no penalty or fee to retract these notices. Expiration of the “grace period” triggers the reclassification from equity to a liability (mandatorily redeemable capital stock) at fair value because after the “grace period” the penalty to retract these notices is considered substantive. If a member cancels its written notice of redemption or notice of withdrawal, the FHLBank will reclassify mandatorily redeemable capital stock from a liability to equity. Dividends related to capital stock classified as a liability are accrued at the expected dividend rate and reported as interest expense in the Statements of Income. The repayment of these mandatorily redeemable financial instruments is reflected as a cash outflow in the financing activities section of the Statements of Cash Flows. For the years ended December 31, 2011, 2010, and 2009 dividends on mandatorily redeemable capital stock in the amount (in thousands) of $13,955, $17,664, and $9,348 were recorded as interest expense.
Table 17.2 - Mandatorily Redeemable Capital Stock Roll Forward (in thousands)
The number of stockholders holding the mandatorily redeemable capital stock was 13, 16, and 23 at December 31, 2011, 2010, and 2009.
As of December 31, 2011, there were no members or former members that had requested redemptions of capital stock whose stock had not been reclassified as mandatorily redeemable capital stock because the “grace periods” had not yet expired on these requests.
Table 17.3 shows the amount of mandatorily redeemable capital stock by contractual year of redemption. The year of redemption in the table is the end of the five-year redemption period. Consistent with the Capital Plan currently in effect, the FHLBank is not required to redeem membership stock until five years after either (i) the membership is terminated or (ii) the FHLBank receives notice of withdrawal. The FHLBank is not required to redeem activity-based stock until the later of the expiration of the notice of redemption or until the activity to which the capital stock relates no longer remains outstanding. If activity-based stock becomes excess stock as a result of an activity no longer remaining outstanding, the FHLBank may repurchase such shares, in its sole discretion, subject to the statutory and regulatory restrictions on capital stock redemption discussed below.
The GLB Act states that an FHLBank may repurchase, in its sole discretion, any member's stock investments that exceed the required minimum amount.
Table 17.3 - Mandatorily Redeemable Capital Stock by Contractual Year of Redemption (in thousands)
(1)
Represents mandatorily redeemable capital stock that is past the end of the contractual redemption period because there is activity outstanding to which the mandatorily redeemable capital stock relates.
Excess Capital Stock. Finance Agency rules limit the ability of an FHLBank to create member excess stock under certain circumstances. The FHLBank may not pay dividends in the form of capital stock or issue new excess stock to members if its excess stock exceeds one percent of its total assets or if the issuance of excess stock would cause the FHLBank's excess stock to exceed one percent of its total assets. At December 31, 2011, the FHLBank had excess capital stock outstanding totaling more than one percent of its total assets. At December 31, 2011, the FHLBank was in compliance with the Finance Agency's excess stock rules.
Statutory and Regulatory Restrictions on Capital Stock Redemption. In accordance with the GLB Act, FHLBank stock is putable by the member. However, there are significant statutory and regulatory restrictions on the FHLBank's obligation or right to redeem outstanding stock, including the following:
▪
The FHLBank may not redeem any capital stock if, following the redemption, the FHLBank would fail to satisfy any of its minimum capital requirements. By law, no FHLBank stock may be redeemed if the FHLBank becomes undercapitalized.
▪
The FHLBank may not redeem any capital stock without approval of the Finance Agency if either its Board of Directors or the Finance Agency determines that the FHLBank has incurred or is likely to incur losses resulting or expected to result in a charge against capital while such charges are continuing or expected to continue.
Additionally, the FHLBank may not redeem or repurchase shares of stock from any member if (1) the principal or interest on any Consolidated Obligation has not been paid in full when due; (2) the FHLBank has failed to certify in writing to the Finance Agency that it will remain in compliance with its liquidity requirements and will remain capable of making full and timely payment of all of its current obligations; (3) the FHLBank has notified the Finance Agency that it cannot provide the foregoing certification, projects it will fail to comply with statutory or regulatory liquidity requirements, or will be unable to timely and fully meet all of its current obligations; or (4) the FHLBank has failed to comply with statutory or regulatory liquidity requirements or to timely and fully meet all of its current obligations, or has entered into or negotiated to enter into an agreement with one or more other FHLBanks to obtain financial assistance to meet its current obligations.
If the FHLBank is liquidated, after payment in full to the FHLBank's creditors, the FHLBank's stockholders will be entitled to receive the par value of their capital stock. In addition, each stockholder will be entitled to any retained earnings in an amount proportional to the stockholder's share of the total shares of capital stock. In the event of a merger or consolidation of the FHLBank, the Board of Directors shall determine the rights and preferences of the FHLBank's stockholders, subject to any terms and conditions imposed by the Finance Agency.
In addition to possessing the authority to prohibit stock redemptions, the FHLBank's Board of Directors has the right to call for the FHLBank's members, as a condition of membership, to make additional capital stock purchases as needed to satisfy statutory and regulatory capital requirements under the GLB Act.
The FHLBank's Board of Directors has a statutory obligation to review and adjust member capital stock requirements in order to comply with the FHLBank's minimum capital requirements, and each member must comply promptly with any such requirement. However a member could reduce its outstanding business with the FHLBank as an alternative to purchasing stock.
Note 18 - Pension and Postretirement Benefit Plans
Qualified Defined Benefit Multi-employer Plan. The FHLBank participates in the Pentegra Defined Benefit Plan for Financial Institutions (Pentegra Defined Benefit Plan), a tax-qualified defined benefit pension plan. The Pentegra Defined Benefit Plan is treated as a multi-employer plan for accounting purposes, but operates as a multiple-employer plan under the Employee Retirement Income Security Act of 1974 (ERISA) and the Internal Revenue Code. As a result, certain multi-employer plan disclosures, including the certified zone status, are not applicable to the Pentegra Defined Benefit Plan. Under the Pentegra Defined Benefit Plan, contributions made by one participating employer may be used to provide benefits to employees of other participating employers because assets contributed by an employer are not segregated in a separate account or restricted to provide benefits only to employees of that employer. Also, in the event a participating employer is unable to meet its contribution requirements, the required contributions for the other participating employers could increase proportionately. The Pentegra Defined Benefit Plan covers substantially all officers and employees of the FHLBank who meet certain eligibility requirements.
The Pentegra Defined Benefit Plan operates on a plan year from July 1 through June 30. The Pentegra Defined Benefit Plan files one Form 5500 on behalf of all employers who participate in the plan. The Employer Identification Number is 13-5645888 and the three-digit plan number is 333. There are no collective bargaining agreements in place at the FHLBank.
The Pentegra Defined Benefit Plan's annual valuation process includes calculating the plan's funded status and separately calculating the funded status of each participating employer. The funded status is defined as the market value of assets divided by the funding target (100 percent of the present value of all benefit liabilities accrued at that date). As permitted by ERISA, the Pentegra Defined Benefit Plan accepts contributions for the prior plan year up to eight and a half months after the end of the prior plan year. As a result, the market value of assets at the valuation date (July 1) will increase by any subsequent contributions designated for the immediately preceding plan year ended June 30.
The most recent Form 5500 available for the Pentegra Defined Benefit Plan is for the year ended June 30, 2010. The FHLBank contributed more than five percent (5.6 percent) of the total contributions to the Pentegra Defined Benefit Plan for the plan year ended June 30, 2010. The FHLBank did not contribute more than five percent of the total contributions to the Pentegra Defined Benefit Plan for the plan year ended June 30, 2009.
Table 18.1 - Pentegra Defined Benefit Plan Net Pension Cost and Funded Status (dollars in thousands)
(a) The Pentegra Defined Benefit Plan's funded status as of July 1, 2011 is preliminary and may increase because the plan's participants were permitted to make contributions for the plan year ended June 30, 2011 through March 15, 2012. Contributions made on or before March 15, 2012, and designated for the plan year ended June 30, 2011, will be included in the final valuation as of July 1, 2011. The final funded status as of July 1, 2011 will not be available until the Form 5500 for the plan year July 1, 2011 through June 30, 2012 is filed (this Form 5500 is due to be filed no later than April 2013).
(b)
The Pentegra Defined Benefit Plan's funded status as of July 1, 2010 is preliminary and may increase because the plan's participants were permitted to make contributions for the plan year ended June 30, 2010 through March 15, 2011. Contributions made on or before March 15, 2011, and designated for the plan year ended June 30, 2010, will be included in the final valuation as of July 1, 2010. The final funded status as of July 1, 2010 will not be available until the Form 5500 for the plan year July 1, 2010 through June 30, 2011 is filed (this Form 5500 is due to be filed no later than April 2012).
Qualified Defined Contribution Plan. The FHLBank also participates in the Pentegra Defined Contribution Plan for Financial Institutions, a tax-qualified, defined contribution pension plan. The FHLBank contributes a percentage of the participants' compensation by making a matching contribution equal to a percentage of voluntary employee contributions, subject to certain limitations. The FHLBank contributed $802,000, $797,000, and $743,000 in the years ended December 31, 2011, 2010, and 2009.
Nonqualified Supplemental Defined Contribution Retirement Plan. The FHLBank maintained an unfunded supplemental defined contribution plan that restored contributions to those employees who had their qualified defined contribution benefits limited by IRS regulations. The FHLBank terminated the nonqualified supplemental defined contribution plan in December 2009.
Table 18.2 presents the FHLBank’s contributions to the nonqualified supplemental defined contribution plan during the years ended December 31, which used the same matching rules as the qualified defined contribution plan discussed above, as well as the market related earnings.
Table 18.2 - Nonqualified Supplemental Defined Contribution Matching Contributions and Market Related Earnings (in thousands)
Nonqualified Supplemental Defined Benefit Retirement Plan. The FHLBank maintains a nonqualified, unfunded defined benefit plan. The plan ensures that participants receive the full amount of benefits to which they would have been entitled under the qualified defined benefit plan in the absence of limits on benefit levels imposed by the IRS. There are no funded plan assets. The FHLBank has established a grantor trust to meet future benefit obligations and current payments to beneficiaries.
Postretirement Benefits Plan. The FHLBank also sponsors a postretirement benefits plan that includes health care and life insurance benefits for eligible retirees. Future retirees are eligible for the postretirement benefits plan if they were hired prior to August 1, 1990, are age 55 or older, and their age plus years of continuous service at retirement are greater than or equal to 80. Spouses are covered subject to required contributions. There are no funded plan assets that have been designated to provide postretirement benefits.
Table 18.3 presents the obligations and funding status of the FHLBank's nonqualified supplemental defined benefit retirement plan and postretirement benefits plan.
Table 18.3 - Benefit Obligation, Fair Value of Plan Assets and Funded Status (in thousands)
(1)
Represents projected benefit obligation and accumulated postretirement benefit obligation for the nonqualified supplemental defined benefit retirement plan and postretirement benefits plan, respectively.
Amounts recognized in “Other liabilities” on the Statements of Condition for the FHLBank's nonqualified supplemental defined benefit plan and postretirement benefits plan as of December 31, 2011 and 2010 were (in thousands) $30,395 and $26,323.
Table 18.4 - Amounts Recognized in Accumulated Other Comprehensive Income (in thousands)
Table 18.5 - Net Periodic Benefit Cost and Other Amounts Recognized in Accumulated Other Comprehensive Income (in thousands)
Table 18.6 presents the estimated net actuarial loss and prior service benefit that will be amortized from accumulated other comprehensive income into net periodic benefit cost over the next fiscal year.
Table 18.6 - Amortization for Next Fiscal Year (in thousands)
Table 18.7 presents the key assumptions and other information used for the actuarial calculations to determine benefit obligations and net periodic benefit cost for the nonqualified supplemental defined benefit retirement plan.
Table 18.7 - Defined Benefit Retirement Plan Key Assumptions (dollars in thousands)
Table 18.8 presents the key assumptions and other information used for the actuarial calculations for the postretirement benefits plan.
Table 18.8 - Postretirement Benefits Plan Key Assumptions
The effect of a percentage point increase in the assumed health care trend rates would be an increase in net periodic postretirement benefit expense of $53,000 and in accumulated postretirement benefit obligation (APBO) of $788,000. The effect of a percentage point decrease in the assumed health care trend rates would be a decrease in net periodic postretirement benefit expense of $42,000 and in APBO of $628,000.
The discount rates for the disclosures as of December 31, 2011 were determined by using a discounted cash flow approach, which incorporates the timing of each expected future benefit payment. Estimated future benefit payments are based on each plan's census data, benefit formulae and provisions, and valuation assumptions reflecting the probability of decrement and survival. The present value of the future benefit payments is determined by using weighted average duration based interest rate yields from a variety of highly rated relevant corporate bond indices as of December 31, 2011, and solving for the single discount rate that produces the same present value.
The nonqualified supplemental defined benefit plan and postretirement benefits plan are not funded; therefore, no contributions will be made in 2012 other than for the payment of benefits. Table 18.9 presents the estimated future benefits payments reflecting expected future services for the years ended after December 31, 2011.
Table 18.9 - Estimated Future Benefit Payments (in thousands)
Note 19 - Segment Information
The FHLBank has identified two primary operating segments based on its method of internal reporting: Traditional Member Finance and the Mortgage Purchase Program. These segments reflect the FHLBank's two primary Mission Asset Activities and the manner in which they are managed from the perspective of development, resource allocation, product delivery, pricing, credit risk and operational administration. The segments identify the principal ways the FHLBank provides services to member stockholders. The FHLBank, as an interest rate spread manager, considers a segment's net interest income, net interest rate spread and, ultimately, net income as the key factors in allocating resources. Resource allocation decisions are made by considering these profitability measures in the context of the historical, current and expected risk profile of each segment and the entire balance sheet, as well as current incremental profitability measures relative to the incremental market risk profile.
Overall financial performance and risk management are dynamically managed primarily at the level of, and within the context of, the entire balance sheet rather than at the level of individual business segments or product lines. Also, the FHLBank hedges specific asset purchases and specific subportfolios in the context of the entire mortgage asset portfolio and the entire balance sheet. Under this holistic approach, the market risk/return profile of each business segment does not correspond, in general, to the performance that each segment would generate if it were completely managed on a separate basis, and it is not possible to accurately determine what the performance would be if the two business segments were managed on a stand-alone basis. Further, because financial and risk management is a dynamic process, the performance of a segment over a single identified period may not reflect the long-term expected or actual future trends for the segment.
The Traditional Member Finance segment includes products such as Advances and investments and the borrowing costs related to those assets. The FHLBank assigns its investments to this segment primarily because they historically have been used to provide liquidity for Advances and to support the level and volatility of earnings from Advances. Income from the Mortgage Purchase Program is derived primarily from the difference, or spread, between the yield on mortgage loans and the borrowing cost of Consolidated Obligations outstanding allocated to this segment at the time debt is issued. Both segments also earn income from investment of interest-free capital. Capital is allocated proportionate to each segment's average assets based on the total balance sheet's average capital-to-assets ratio. Expenses are allocated based on cost accounting techniques that include direct usage, time allocations and square footage of space used. AHP and REFCORP assessments are calculated using the current assessment rates based on the income before assessments for each segment. All interest rate swaps, including their market value adjustments, are allocated to the Traditional Member Finance segment because the FHLBank has not executed interest rate swaps in its management of the Mortgage Purchase Program's market risk. All derivatives classified as mandatory delivery commitments and forward rate agreements are allocated to the Mortgage Purchase Program segment.
The following tables set forth the FHLBank's financial performance by operating segment for the years ended December 31.
Table 19.1 - Financial Performance by Operating Segment (in thousands)
Note 20 - Fair Value Disclosures
The fair value amounts recorded on the Statements of Condition and presented in the related note disclosures have been determined by the FHLBank using available market information and the FHLBank's best judgment of appropriate valuation methods. These estimates are based on pertinent information available to the FHLBank as of December 31, 2011 and 2010. The fair values reflect the FHLBank's judgment of how a market participant would estimate the fair values.
The Fair Value Summary Table included in this note does not represent an estimate of the overall market value of the FHLBank as a going concern, which would take into account future business opportunities and the net profitability of assets versus liabilities.
Table 20.1 - Fair Value Summary (in thousands)
(1)
Includes (in thousands) $4,900,296 and $0 of Consolidated Bonds recorded under the fair value option at December 31, 2011 and 2010, respectively.
Fair Value Hierarchy. The FHLBank records trading securities, available-for-sale securities, derivative assets, derivative liabilities and certain Consolidated Obligation Bonds at fair value on a recurring basis. The fair value hierarchy is used to prioritize the inputs of valuation techniques used to measure fair value for assets and liabilities carried at fair value on the Statements of Condition. The inputs are evaluated and an overall level for the measurement is determined. This overall level is an indication of how market observable the fair value measurement is.
Outlined below is the application of the fair value hierarchy to the FHLBank's financial assets and financial liabilities that are carried at fair value on a recurring basis.
Level 1 - defined as those instruments for which inputs to the valuation methodology are quoted prices for identical assets or liabilities in active markets.
Level 2 - defined as those instruments for which inputs to the valuation methodology include quoted prices for similar instruments in active markets or, if a valuation methodology is used inputs are selected that are observable, either directly or indirectly, for substantially the full term of the financial instrument. The FHLBank's trading securities, available-for-sale securities, Consolidated Obligations Bonds and derivative instruments are considered Level 2 instruments based on the inputs utilized to derive fair value.
Level 3 - defined as those instruments for which inputs to the valuation methodology are unobservable and significant to the fair value measurement.
The FHLBank utilizes valuation techniques that maximize the use of observable inputs and minimize the use of unobservable inputs.
For instruments carried at fair value, the FHLBank reviews the fair value hierarchy classifications on a quarterly basis. Changes in the observability of the valuation attributes may result in a reclassification of certain financial assets or liabilities. Such reclassifications are reported as transfers in/out at fair value as of the beginning of the quarter in which the changes occur. The FHLBank did not have any transfers during the years ended December 31, 2011 or 2010.
Valuation Techniques and Significant Inputs.
Cash and due from banks: The fair value equals the carrying value.
Interest-bearing deposits: The fair value is determined based on each security's quoted prices, excluding accrued interest, as of the last business day of the period.
Securities purchased under agreements to resell: The fair value approximates the carrying value.
Federal funds sold: The fair value of overnight Federal funds sold approximates the carrying value. The fair value of term Federal funds sold is determined by calculating the present value of the expected future cash flows. The discount rates used in these calculations are the rates for Federal funds with similar terms, as approximated by adding an estimated current spread to the LIBOR swap curve for Federal funds with similar terms. The fair value excludes accrued interest.
Trading securities: The FHLBank's trading portfolio consists of U.S. Treasury obligations, discount notes and bonds issued by Freddie Mac, Fannie Mae (non-mortgage-backed securities), and mortgage-backed securities issued by Ginnie Mae. Quoted market prices in active markets are not available for these securities.
In general, in order to determine the fair value of its non-mortgage backed securities, the FHLBank can use either (a) an income approach based on a market-observable interest rate curve that may be adjusted for a spread, or (b) prices received from third-party pricing vendors. The income approach uses indicative fair values derived from a discounted cash flow methodology. The FHLBank believes that both methodologies result in fair values that are reasonable and similar in all material respects based on the nature of the financial instruments being measured.
For its U.S. Treasury obligations and discount notes and bonds issued by Freddie Mac, and/or Fannie Mae, the FHLBank determines the fair value using the income approach.
Table 20.2 - Significant Inputs for Non-Mortgage-Backed Securities in the Trading Portfolio Carried at Level 2 Within the Fair Value Hierarchy as of December 31, 2011 (in thousands)
To value mortgage-backed security holdings, the FHLBank obtains prices from four designated third-party pricing vendors when available. The pricing vendors use proprietary models to price mortgage-backed securities. The inputs to those models are derived from various sources including, but not limited to: benchmark yields, reported trades, dealer estimates, issuer spreads, benchmark securities, bids, offers and other market-related data. Since many mortgage-backed securities do not trade on a daily basis, the pricing vendors use available information such as benchmark curves, benchmarking of like securities, sector groupings and matrix pricing to determine the prices for individual securities. Each pricing vendor has an established challenge process in place for all mortgage-backed security valuations, which facilitates resolution of potentially erroneous prices identified by the FHLBank.
Recently, the FHLBank conducted reviews of the four pricing vendors to confirm and further augment its understanding of the vendors' pricing processes, methodologies and control procedures for agency and private-label mortgage-backed securities.
Prior to December 31, 2011, the FHLBank established a price for each mortgage-backed security using a formula that was based upon the number of prices received. If four prices were received, the average of the middle two prices was used; if three prices were received, the middle price was used; if two prices were received, the average of the two prices was used; and if one price was received, it was used subject to validation. The computed prices were tested for reasonableness using specified tolerance thresholds. Computed prices within these established thresholds were generally accepted unless strong evidence suggested that using the formula-driven price would not be appropriate. Preliminary estimated fair values that were outside the tolerance thresholds, or that management believed might not be appropriate based on all available information (including those limited instances in which only one price was received), were subject to further analysis including, but not limited to, comparison to the prices for similar securities and/or to non-binding dealer estimates and/or use of an internal model that was deemed most appropriate after consideration of all relevant facts and circumstances that a market participant would consider.
Effective December 31, 2011, the FHLBank refined its method for estimating the fair values of mortgage-backed securities. The FHLBank's refined valuation technique first requires the establishment of a “median” price for each security using the same formula-driven price described above. All prices that are within a specified tolerance threshold of the median price are included in the “cluster” of prices that are averaged to compute a “default” price.
Prices that are outside the threshold (“outliers”) are subject to further analysis (including, but not limited to, comparison to prices provided by an additional third-party valuation service, prices for similar securities, non-binding dealer estimates, and/or use of an internal model that is deemed most appropriate) to determine if an outlier is a better estimate of fair value. If an outlier (or some other price identified in the analysis) is determined to be a better estimate of fair value, then the outlier (or the other price as appropriate) is used as the final price rather than the default price. If, on the other hand, the analysis confirms that an outlier is in fact not representative of fair value and the default price is the best estimate, then the default price is used as the final price. In all cases, the final price is used to determine the fair value of the security.
If all prices received for a security are outside the tolerance threshold level of the median price, then there is no default price, and the final price is determined by an evaluation of all outlier prices as described above.
As of December 31, 2011, four vendor prices were received for substantially all of the FHLBank's mortgage-backed security holdings and the final prices for substantially all of those securities were computed by averaging the four prices. The revision to the valuation technique did not have a significant impact on the estimated fair values of the mortgage-backed security holdings as of December 31, 2011. Based on the FHLBank's review of the pricing methods and controls employed by the third-party pricing vendors and the relative lack of dispersion among the vendor prices, the FHLBank believes its final prices result in reasonable estimates of fair value and further that the fair value measurements are classified appropriately in the fair value hierarchy.
Available-for-sale securities: The FHLBank's available-for-sale portfolio consists of certificates of deposit and other debt securities. Quoted market prices in active markets are not available for these securities. Therefore, the fair value is determined based on each security's indicative fair value obtained from a third-party vendor. The FHLBank performs several validation steps in order to verify the accuracy and reasonableness of these fair values. These steps may include, but are not limited to, a detailed review of instruments with significant periodic price changes and a derived fair value from an option-adjusted discounted cash flow methodology using market-observed inputs for the interest rate environment and similar instruments.
Table 20.3 - Significant Inputs for Non-Mortgage-Backed Securities in the Available-for-Sale Portfolio Carried at Level 2 Within the Fair Value Hierarchy as of December 31, 2011 (in thousands)
*
Consists of debt securities issued by International Bank for Reconstruction and Development.
Held-to-maturity securities: The FHLBank's held-to-maturity portfolio consists of discount notes issued by Freddie Mac and/or Fannie Mae, taxable municipal bonds, TLGP notes, and mortgage-backed securities. Quoted market prices are not available for these securities. The fair value for each individual mortgage-backed security is determined by using the third-party vendor approach described above. The fair value for discount notes is determined using the income approach described above. The fair value for taxable municipal bonds and TLGP notes is determined based on each security's indicative market price obtained
from a third-party vendor excluding accrued interest. The FHLBank uses various techniques to validate the fair values received from third-party vendors for accuracy and reasonableness.
Advances: The FHLBank determines the fair values of Advances by calculating the present value of expected future cash flows from the Advances excluding accrued interest. The discount rates used in these calculations are the replacement rates for Advances with similar terms, as approximated either by adding an estimated current spread to the LIBOR swap curve or by using current indicative market yields, as indicated by the FHLBank's pricing methodologies for Advances with similar current terms. Advance pricing is determined based on the FHLBank's rates on Consolidated Obligations. In accordance with Finance Agency Regulations, Advances with a maturity and repricing period greater than six months require a prepayment fee sufficient to make the FHLBank financially indifferent to the borrower's decision to prepay the Advances. Therefore, the fair value of Advances does not assume prepayment risk.
For swapped option-based Advances, the fair value is determined (independently of the related derivative) by the discounted cash flow methodology based on the LIBOR swap curve and forward rates at period end adjusted for the estimated current spread on new swapped Advances to the swap curve. For swapped Advances with a conversion option, the conversion option is valued by taking into account the LIBOR swap curve and forward rates at period end and the market's expectations of future interest rate volatility implied from current market prices of similar options.
Mortgage loans held for portfolio, net: The fair values of mortgage loans are determined based on quoted market prices offered to approved members as indicated by the FHLBank's Mortgage Purchase Program pricing methodologies for mortgage loans with similar current terms excluding accrued interest. The quoted prices offered to members are based on Fannie Mae price indications on to-be-announced mortgage-backed securities and FHA price indications on government-guaranteed loans; the FHLBank then adjusts these indicative prices to account for particular features of the FHLBank's Mortgage Purchase Program that differ from the Fannie Mae and FHA securities. These features include, but may not be limited to:
▪
the Mortgage Purchase Program's credit enhancements; and
▪
marketing adjustments that reflect the FHLBank's cooperative business model and preferences for particular kinds of loans and mortgage note rates.
These quoted prices, however, can change rapidly based upon market conditions and are highly dependent upon the underlying prepayment assumptions.
In order to determine the fair values, the adjusted prices are also reduced for the FHLBank's estimate of expected net credit losses.
Accrued interest receivable and payable: The fair value approximates the carrying value.
Derivative assets/liabilities: The FHLBank's derivative assets/liabilities consist of interest rate swaps, to-be-announced mortgage-backed securities (forward rate agreements), and mortgage delivery commitments. The FHLBank's interest rate swaps are not listed on an exchange. Therefore, the FHLBank determines the fair value of each individual interest rate swap using market value models that use readily observable market inputs as their basis (inputs that are actively quoted and can be validated to external sources). The FHLBank uses a mid-market pricing convention as a practical expedient for fair value measurements within a bid-ask spread. These models reflect the contractual terms of the interest rate swaps, including the period to maturity, as well as the significant inputs noted below. The fair value determination uses the standard valuation technique of discounted cash flow analysis.
The FHLBank performs several validation steps to verify the reasonableness of the fair value output generated by the primary market value model. In addition to an annual model validation, the FHLBank prepares a monthly reconciliation of the model's fair values to estimates of fair values provided by the derivative counterparties and to another third-party model. The FHLBank believes these processes provide a reasonable basis for it to place continued reliance on the derivative fair values generated by the primary model.
The fair value of TBA mortgage-backed securities is based on independent indicative and/or quoted prices generated by market transactions involving comparable instruments. The FHLBank determines the fair value of mortgage delivery commitments using market prices from the TBA/mortgage-backed security market or TBA/Ginnie Mae market and adjustments noted below.
The discounted cash flow analysis utilizes market-observable inputs (inputs that are actively quoted and can be validated to external sources). Significant inputs, by class of derivative, are as follows:
Interest-rate swaps:
▪
LIBOR swap curve; and
▪
Volatility assumption. Market-based expectations of future interest rate volatility implied from current market prices for similar options.
To-be-announced mortgage-backed securities:
▪
Market-based prices by coupon class and expected term until settlement.
Mortgage delivery commitments:
▪
TBA price. Market-based prices of TBAs by coupon class and expected term until settlement, adjusted to reflect the contractual terms of the mortgage delivery commitments, similar to the mortgage loans held for portfolio process. The adjustments to the market prices are market observable, or can be corroborated with observable market data.
The FHLBank is subject to credit risk in derivatives transactions due to potential nonperformance by its derivatives counterparties, all of which are highly rated institutions. To mitigate this risk, the FHLBank has entered into master netting agreements with all of its derivative counterparties. In addition, to limit the FHLBank's net unsecured credit exposure to these counterparties, the FHLBank has entered into bilateral security agreements with all active derivatives dealer counterparties that provide for delivery of collateral at specified levels tied to counterparty credit ratings. The FHLBank has evaluated the potential for the fair value of the instruments to be impacted by counterparty credit risk and has determined that no adjustments were significant or necessary to the overall fair value measurements at December 31, 2011 or 2010.
The fair values of the FHLBank's derivatives include accrued interest receivable/payable and cash collateral remitted to/received from counterparties; the estimated fair values of the accrued interest receivable/payable and cash collateral approximate their carrying values due to their short-term nature. The fair values of derivatives are netted by counterparty pursuant to the provisions of the FHLBank's master netting agreements. If these netted amounts are positive, they are classified as an asset and if negative, they are classified as a liability.
Deposits: The FHLBank determines the fair values of FHLBank deposits with fixed rates by calculating the present value of expected future cash flows from the deposits and reducing this amount for accrued interest payable. The discount rates used in these calculations are the cost of deposits with similar terms.
Consolidated Obligations: The FHLBank determines the fair values of Discount Notes by calculating the present value of expected future cash flows from the Discount Notes excluding accrued interest. The discount rates used in these calculations are current replacement rates for Discount Notes with similar current terms, as approximated by adding an estimated current spread to the LIBOR swap curve. Each month's cash flow is discounted at that month's replacement rate.
The FHLBank determines the fair values of non-callable Consolidated Obligation Bonds (both unswapped and swapped) by calculating the present value of scheduled future cash flows from the bonds excluding accrued interest. Significant inputs used to determine fair value of these Consolidated Obligation Bonds are as follows:
▪
The discount rates used, which are estimated current market yields, as indicated by the Office of Finance, for bonds with similar current terms. There was no spread adjustment to the Office of Finance indications used to value the non-callable Consolidated Obligations carried at fair value on the Statements of Condition.
The FHLBank determines the fair values of callable Consolidated Obligation Bonds (both unswapped and swapped) by calculating the present value of expected future cash flows from the bonds excluding accrued interest. The fair values are determined by the discounted cash flow methodology based on the following significant inputs for these Consolidated Obligations:
▪
LIBOR swap curve;
▪
Volatility assumption. Market-based expectations of future interest rate volatility implied from current market prices for similar options; and
▪
Spread assumption. As of December 31, 2011 the spread adjustment to the LIBOR Swap Curve was -61 to -31 basis points for callable Consolidated Obligations carried at fair value on the Statements of Condition.
Adjustments may be necessary to reflect the 12 FHLBanks' credit quality when valuing Consolidated Obligation Bonds measured at fair value. Due to the joint and several liability for Consolidated Obligations, the FHLBank monitors its own creditworthiness and the creditworthiness of the other FHLBanks to determine whether any credit adjustments are necessary in its fair value measurement of Consolidated Obligation Bonds. The credit ratings of the FHLBanks and any changes to these credit ratings are the basis for the FHLBanks to determine whether the fair values of Consolidated Obligation Bonds have been significantly affected during the reporting period by changes in the instrument-specific credit risk. The FHLBank had no adjustments during the years ended December 31, 2011 or 2010.
Mandatorily redeemable capital stock: The fair value of capital stock subject to mandatory redemption is par value for the dates presented, as indicated by member contemporaneous purchases and sales at par value. FHLBank stock can only be acquired by members at par value and redeemed at par value. FHLBank stock is not traded and no market mechanism exists for the exchange of stock outside the cooperative structure.
Commitments: The fair values of standby bond purchase agreements are based on the present value of the estimated fees taking into account the remaining terms of the agreements.
Subjectivity of estimates. Estimates of the fair values of Advances with options, mortgage instruments, derivatives with embedded options and bonds with options using the methods described above and other methods are highly subjective and require judgments regarding significant matters such as the amount and timing of future cash flows, prepayment speeds, interest rate volatility, distributions of future interest rates used to value options, and discount rates that appropriately reflect market and credit risks. The judgments also include the parameters, methods, and assumptions used in models to value the options. The use of different assumptions could have a material effect on the fair value estimates. Since these estimates are made as of a specific point in time, they are susceptible to material near term changes.
Fair Value on a Recurring Basis.
Table 20.4 presents the fair value of financial assets and liabilities, by level, within the fair value hierarchy which are recorded on a recurring basis at December 31, 2011 and 2010.
Table 20.4 - Hierarchy Level for Financial Assets and Liabilities - Recurring (in thousands)
(1)
Amounts represent the effects of legally enforceable master netting agreements that allow the FHLBank to settle positive and negative positions and of cash collateral held or placed with the same counterparties.
(2)
Includes Consolidated Obligation Bonds recorded under the fair value option.
(1)
Amounts represent the effects of legally enforceable master netting agreements that allow the FHLBank to settle positive and negative positions and of cash collateral held or placed with the same counterparties.
Fair Value Option. The fair value option provides an irrevocable option to elect fair value as an alternative measurement for selected financial assets, financial liabilities, unrecognized firm commitments, and written loan commitments not previously carried at fair value. It requires a company to display the fair value of those assets and liabilities for which it has chosen to use fair value on the face of the Statements of Condition. Fair value is used for both the initial and subsequent measurement of the designated assets, liabilities and commitments, with the changes in fair value recognized in net income. If elected, interest income and interest expense on Advances and Consolidated Bonds carried at fair value are recognized based solely on the contractual amount of interest due or unpaid and any transaction fees or costs are immediately recognized into other non-interest income or other non-interest expense. Additionally, concessions paid on Consolidated Obligations designated under the fair value option are expensed as incurred in other non-interest expense.
During the year ended December 31, 2011, the FHLBank elected the fair value option for certain Consolidated Obligation Bond transactions. The FHLBank elected the fair value option for these transactions so as to mitigate the income statement volatility that can arise when only the corresponding derivatives are marked at fair value in transactions that do not, or may not, meet hedge effectiveness requirements or otherwise qualify for hedge accounting (i.e., economic hedging transactions).
The following table summarizes the activity related to financial liabilities for which the fair value option was elected during the year ended December 31, 2011.
Table 20.5 - Fair Value Option Financial Liabilities (in thousands)
Table 20.6 - Changes in Fair Values for Items Measured at Fair Value Pursuant to the Election of the Fair Value Option (in thousands)
For items recorded under the fair value option, the related contractual interest income and contractual interest expense are recorded as part of net interest income on the Statement of Income. The remaining changes in fair value for instruments in which the fair value option has been elected are recorded as “Net losses on Consolidated Obligation Bonds held under fair value option” in the Statements of Income. The change in fair value does not include changes in instrument-specific credit risk. The FHLBank has determined that no adjustments to the fair values of its instruments recorded under the fair value option for instrument-specific credit risk were necessary as of December 31, 2011.
The following table reflects the difference between the aggregate unpaid principal balance outstanding and the aggregate fair value for Consolidated Bonds for which the fair value option has been elected.
Table 20.7 - Aggregate Unpaid Balance and Aggregate Fair Value at December 31, 2011 (in thousands)
Note 21 - Commitments and Contingencies
As previously described, Consolidated Obligations are backed only by the financial resources of the FHLBanks. The joint and several liability Finance Agency Regulation authorizes the Finance Agency to require any FHLBank to repay all or a portion of the principal and interest on Consolidated Obligations for which another FHLBank is the primary obligor. No FHLBank has ever been asked or required to repay the principal or interest on any Consolidated Obligation on behalf of another FHLBank, and as of December 31, 2011, and through the filing date of this report, the FHLBank does not believe that it is probable that it will be asked to do so.
The FHLBank determined that it was not necessary to recognize a liability for the fair values of its joint and several obligation related to other FHLBanks' Consolidated Obligations at December 31, 2011 or 2010. The joint and several obligations are mandated by Finance Agency Regulations and are not the result of arms-length transactions among the FHLBanks. The FHLBanks have no control over the amount of the guaranty or the determination of how each FHLBank would perform under the joint and several obligation.
Table 21.1 - Off-Balance Sheet Commitments (in thousands)
(1)
Of the total unsettled Consolidated Bonds, $500,000 (in thousands) were hedged with associated interest rate swaps at December 31, 2011.
(2)
Expiration is based on settlement period rather than underlying contractual maturity of Consolidated Obligations.
Standby Letters of Credit. A Standby Letter of Credit is a financing arrangement between the FHLBank and its member. Standby Letters of Credit are executed for members for a fee. If the FHLBank is required to make payment for a beneficiary's draw, the payment amount is converted into a collateralized Advance to the member. The original terms of these Standby Letters of Credit range from less than one month to 18 years, with a final expiration in 2024. Unearned fees and the value of guarantees related to Standby Letters of Credit are recorded in other liabilities and amounted to $1,865 thousand and $2,153 thousand at December 31, 2011 and 2010.
The FHLBank monitors the creditworthiness of its members that have Standby Letters of Credit. In addition, Standby Letters of Credit are fully collateralized at the time of issuance. As a result, the FHLBank has deemed it unnecessary to record any additional liability on these commitments.
Standby Bond Purchase Agreements. The FHLBank has executed standby bond purchase agreements with one state housing authority whereby the FHLBank, for a fee, agrees as a liquidity provider if required, to purchase and hold the authority's bonds until the designated marketing agent can find a suitable investor or the housing authority repurchases the bonds according to a schedule established by the standby agreement. Each standby agreement dictates the specific terms that would require the FHLBank to purchase the bonds. The bond purchase commitments entered into by the FHLBank have original expiration periods up to six years, currently no later than 2015, although some are renewable at the option of the FHLBank. During 2011 and 2010, the FHLBank was not required to purchase any bonds under these agreements.
Commitments to Purchase Mortgage Loans. The FHLBank enters into commitments that unconditionally obligate the FHLBank to purchase mortgage loans. Commitments are generally for periods not to exceed 90 days. The delivery commitments are recorded as derivatives at their fair values.
Pledged Collateral. The FHLBank generally executes derivatives with major banks and broker-dealers and generally enters into bilateral pledge (collateral) agreements. As of December 31, 2011 and 2010, the FHLBank had no securities pledged as collateral to broker-dealers.
Lease Commitments. The FHLBank charged to operating expenses net rental and related costs of approximately $1,832,000, $1,813,000, and $2,035,000 for the years ending December 31, 2011, 2010, and 2009.
Table 21.2 - Future Minimum Rentals for Operating Leases (in thousands)
Lease agreements for FHLBank premises generally provide for increases in the basic rentals resulting from increases in property taxes and maintenance expenses. Such increases are not expected to have a material effect on the FHLBank.
Legal Proceedings. The FHLBank is subject to legal proceedings arising in the normal course of business. In early March 2010, the FHLBank was advised by representatives of the Lehman Brothers Holdings, Inc. bankruptcy estate that they believed that the FHLBank had been unjustly enriched in connection with the close out of its interest rate swap transactions with Lehman at the time of the Lehman bankruptcy in 2008 and that the bankruptcy estate was entitled to the $43 million difference between the settlement amount the FHLBank paid Lehman in connection with the automatic early termination of those transactions and the market value fee the FHLBank received when replacing the swaps with new swaps transacted with other counterparties. In early May 2010, the FHLBank received a Derivatives Alternative Dispute Resolution notice from the Lehman bankruptcy estate with a settlement demand of $65.8 million, plus interest accruing primarily at LIBOR plus 14.5 percent since the bankruptcy filing, based on their view of how the settlement amount should have been calculated. In accordance with the Alternative Dispute Resolution Order of the Bankruptcy Court administering the Lehman estate, senior management of the FHLBank participated in a non-binding mediation in New York on August 25, 2010, and counsel for the FHLBank continued discussions with the court-appointed mediator for several weeks thereafter. The mediation concluded on October 15, 2010 without a settlement of the claims asserted by the Lehman bankruptcy estate. The FHLBank believes that it correctly calculated, and fully satisfied its obligation to Lehman in September 2008, and the FHLBank intends to vigorously dispute any claim for additional amounts.
The FHLBank also is subject to other legal proceedings arising in the normal course of business. After consultation with legal counsel, management does not anticipate that the ultimate liability, if any, arising out of these matters will have a material effect on the FHLBank's financial condition or results of operations.
Note 22 - Transactions with Other FHLBanks
The FHLBank notes all transactions with other FHLBanks on the face of its financial statements. Occasionally, the FHLBank loans short-term funds to and borrows short-term funds from other FHLBanks. These loans and borrowings are transacted at then current market rates when traded. There were no such loans or borrowings outstanding at December 31, 2011, 2010, or 2009. Additionally, the FHLBank occasionally invests in Consolidated Discount Notes issued on behalf of another FHLBank. These investments are purchased in the open market from third parties and are accounted for in the same manner as other similarly classified investments. There were no such investments outstanding at December 31, 2011, 2010, or 2009. The following table details the average daily balance of lending, borrowing and investing between the FHLBank and other FHLBanks for the years ended December 31.
Table 22.1 - Lending, Borrowing, and Investing Between the FHLBank and Other FHLBanks (in thousands)
The FHLBank may, from time to time, assume the outstanding primary liability for Consolidated Obligations of another FHLBank (at then current market rates on the day when the transfer is traded) rather than issuing new debt for which the FHLBank is the primary obligor. The FHLBank then becomes the primary obligor on the transferred debt. There are no formal arrangements governing the transfer of Consolidated Obligations between the FHLBanks, and these transfers are not investments of one FHLBank in another FHLBank. Transferring debt at current market rates enables the FHLBank System to satisfy the debt issuance needs of individual FHLBanks without incurring the additional selling expenses (concession fees) associated with new debt. It also provides the transferring FHLBanks with outlets for extinguishing debt structures no longer required for their balance sheet management strategies.
There were no Consolidated Obligations transferred to the FHLBank during the year ended December 31, 2011. During the year ended December 31, 2010, the par amount of the liability on Consolidated Obligations transferred to the FHLBank totaled (in thousands) $145,000. All such transfers during the year ended December 31, 2010 were from the FHLBank of Chicago. The net premiums associated with these transactions were (in thousands) $16,722 in 2010. There were no Consolidated Obligations transferred to the FHLBank during the year ended December 31, 2009. The FHLBank accounts for these transfers in the same manner as it accounts for new debt issuances (see Note 14). The FHLBank did not transfer any Consolidated Obligations to other FHLBanks in 2011, 2010, or 2009.
Note 23 - Transactions with Stockholders
As a cooperative, the FHLBank's capital stock is owned by its members, by former members that retain the stock as provided in the FHLBank's Capital Plan and by nonmember institutions that have acquired members and must retain the stock to support Advances or other activities with the FHLBank. All Advances are issued to members and all mortgage loans held for portfolio are purchased from members. The FHLBank also maintains demand deposit accounts for members, primarily to facilitate settlement activities that are directly related to Advances and mortgage loan purchases. Additionally, the FHLBank may enter into interest rate swaps with its stockholders. The FHLBank may not invest in any equity securities issued by its stockholders and it has not purchased any mortgage-backed securities securitized by, or other direct long-term investments in, its stockholders.
For financial statement purposes, the FHLBank defines related parties as those members with more than 10 percent of the voting interests of the FHLBank capital stock outstanding. Federal legislation prescribes the voting rights of members in the election of both member and independent directors. For member directorships, the Finance Agency designates the number of member directorships in a given year and an eligible voting member may vote only for candidates seeking election in its respective state. For independent directorships, the FHLBank's Board of Directors nominates candidates to be placed on the ballot in an at-large election. For both member and independent directorship elections, a member is entitled to vote one share of required capital stock, subject to a statutory limitation, for each applicable directorship. Under this limitation, the total number of votes that a member may cast is limited to the average number of shares of the FHLBank's capital stock that were required to be held by all members in that state as of the record date for voting. Nonmember stockholders are not eligible to vote in director elections. Due to the abovementioned statutory limitation, no member owned more than 10 percent of the voting interests of the FHLBank at December 31, 2011 or 2010.
All transactions with stockholders are entered into in the ordinary course of business. Finance Agency Regulations require the FHLBank to offer the same pricing for Advances and other services to all members regardless of asset or transaction size, charter type, or geographic location. However, the FHLBank may, in pricing its Advances, distinguish among members based upon its assessment of the credit and other risks to the FHLBank of lending to any particular member or upon other reasonable criteria that may be applied equally to all members. The FHLBank's policies and procedures require that such standards and criteria be applied consistently and without discrimination to all members applying for Advances.
Transactions with Directors' Financial Institutions. In the ordinary course of its business, the FHLBank may provide products and services to members whose officers or directors serve as directors of the FHLBank (Directors' Financial Institutions). Finance Agency Regulations require that transactions with Directors' Financial Institutions be made on the same terms as those with any other member. The following table reflects balances with Directors' Financial Institutions for the items indicated below.
Table 23.1 - Transactions with Directors' Financial Institutions (dollars in millions)
(1)
Percentage of total principal (Advances), unpaid principal balance (Mortgage Purchase Program), principal balance (mortgage-backed securities), regulatory capital stock, and notional balances (derivatives).
Concentrations. The following table shows regulatory capital stock balances, outstanding Advance principal balances, and unpaid principal balances of mortgage loans held for portfolio at the dates indicated to members and former members holding five percent or more of regulatory capital stock and include any known affiliates that are members of the FHLBank.
Table 23.2 - Capital Stock, Advances, and Mortgage Purchase Program Principal Balances to Members and Former Members (dollars in millions)
(1)
Former member.
(1)
Former member.
Nonmember Affiliates. The FHLBank has relationships with two nonmember affiliates, the Kentucky Housing Corporation and the Ohio Housing Finance Agency. The nature of these relationships is twofold: one as an approved borrower from the FHLBank and one in which the FHLBank invests in the purchase of these nonmembers' bonds. The Kentucky Housing Corporation and the Ohio Housing Finance Agency had no borrowings during the years ended December 31, 2011, 2010, or 2009. The FHLBank did not have principal investments in the bonds of the Kentucky Housing Corporation at December 31, 2011. The FHLBank had principal investments in the bonds of the Kentucky Housing Corporation of $2,955,000 and $10,375,000 as of December 31, 2010 and 2009, respectively. The FHLBank did not have any investments in the bonds of the Ohio Housing Finance Agency as of December 31, 2011, 2010, or 2009. The FHLBank did not have any investments in or borrowings extended to any other nonmember affiliates during the years ended December 31, 2011, 2010, or 2009.
SUPPLEMENTAL FINANCIAL DATA
Supplemental financial data required is set forth in the “Other Financial Information” caption at Part II, Item 7 of this report.
Item 9.
Item 9.
Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.
There were no changes in or disagreements with our accountants on accounting and financial disclosure during the two most recent fiscal years.
Item 9A.
Item 9A.
Controls and Procedures.
DISCLOSURE CONTROLS AND PROCEDURES
As of December 31, 2011, the FHLBank's management, including its principal executive officer and principal financial officer, evaluated the effectiveness of our disclosure controls and procedures as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934 (the “Exchange Act”). Based upon that evaluation, these two officers each concluded that, as of December 31, 2011, the FHLBank maintained effective disclosure controls and procedures designed to ensure that information required to be disclosed in the reports that it files under the Exchange Act is (1) accumulated and communicated to management as appropriate to allow timely decisions regarding disclosure and (2) recorded, processed, summarized and reported within the time periods specified in the rules and forms of the Securities and Exchange Commission.
MANAGEMENT'S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING
The management of the FHLBank is responsible for establishing and maintaining adequate internal control over financial reporting. The FHLBank's internal control over financial reporting is designed by, or under the supervision of, the FHLBank's management, including its principal executive officer and principal financial officer, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external reporting purposes in accordance with accounting principles generally accepted in the United States of America.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
The FHLBank's management assessed the effectiveness of the FHLBank's internal control over financial reporting as of December 31, 2011. In making this assessment, it used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control-Integrated Framework. Based on its assessment, management of the FHLBank determined that, as of December 31, 2011, the FHLBank's internal control over financial reporting was effective based on those criteria.
The FHLBank's registered public accounting firm, PricewaterhouseCoopers LLP, has issued an attestation report expressing an unqualified opinion on internal control over financial reporting as of December 31, 2011. This report is included in “Item 8. Financial Statements and Supplementary Data.”
CHANGES IN INTERNAL CONTROL OVER FINANCIAL REPORTING
There were no changes in the FHLBank's internal control over financial reporting that occurred during the fourth quarter ended December 31, 2011 that materially affected, or are reasonably likely to materially affect, the FHLBank's internal control over financial reporting.
Item 9B.
Item 9B.
Other Information.
Not applicable.
PART III
Item 10.
Item 10. Directors, Executive Officers and Corporate Governance.
NOMINATION AND ELECTION OF DIRECTORS
The Finance Agency has authorized us to have a total of 17 directors: 10 member directors and seven independent directors. Two of our independent directors are designated as public interest directors and all 17 directors are elected by our members. In October 2011, member director Robert Brosky passed away. As permitted by regulation, the Board chose to fill this director vacancy and unanimously elected J. Lynn Greenstein to serve this Ohio member director term, which expires December 31, 2012. The Board's decision to elect Ms. Greenstein was influenced by her leadership positions within the banking and insurance industry and the Ohio Bankers League, which help to bring insight to the Board and contribute to the FHLBank's mission and corporate objectives.
The Finance Agency has issued regulations that govern the election process as well as the annual total number of directorships and number of member directorships for each state in the District.
For both member and independent directorship elections, a member institution may cast one vote per position up for election for each share of stock that the member was required to hold as of December 31 of the calendar year immediately preceding the election year. However, the number of votes that any member may cast for any one directorship cannot exceed the average number of shares of FHLBank stock that were required to be held by all members located in its state. The election process is conducted by mail. Our Board of Directors does not solicit proxies nor is any member institution permitted to solicit proxies in an election.
DIRECTORS
The following table sets forth certain information (ages as of March 1, 2012) regarding each of our current directors.
(1)
Mr. Koch, an independent director beginning in 2008, also served as a member director from 1990-1995 and 1998-2006.
Member Directors
Finance Agency regulations govern the eligibility requirements for our member directors. Each member director, and each nominee to a member directorship, must be a U.S. citizen and an officer or director of a member that: is located in the voting state to be represented by the member directorship, was a member of the FHLBank as of the record date, and meets all minimum capital requirements established by its appropriate Federal banking agency or state regulator.
Each member director is nominated and elected by our members through an annual voting process administered by us. Any member that is entitled to vote in the election may nominate an eligible individual to fill each available member directorship for its voting state, and all eligible nominees must be presented to the membership in the voting state. In accordance with Finance Agency regulations, except when acting in a personal capacity, no director, officer, attorney, employee or agent of the FHLBank may communicate in any manner that he or she directly or indirectly, supports or opposes the nomination or election of a particular individual for a member directorship or take any other action to influence the voting with respect to a particular individual. As a result, the FHLBank is not in a position to know which factors its member institutions considered in nominating candidates for member directorships or in voting to elect member directors.
Mr. Caudill has been involved in banking for over 40 years. He served as President and Chief Executive Officer of Peoples Bank, Morehead and Sandy Hook, Kentucky, from 1981 until July 2006. Since August 2006, Mr. Caudill has served as a director of Kentucky Bancshares, Inc. and its subsidiary, Kentucky Bank, of Paris, Kentucky.
Mr. DeRoberts is a founding director of The Arlington Bank, headquartered in Upper Arlington, Ohio, and has served the bank as its Chairman since 1999. In addition, from June 1978 to April 2006, Mr. DeRoberts was associated with Dick DeRoberts & Company, Inc., an independent insurance agency headquartered in Columbus, Ohio. He served as President beginning in 1995. In April 2006, Dick DeRoberts & Company merged with Gardiner Allen Insurance Associates to form Gardiner Allen DeRoberts Insurance LLC where Mr. DeRoberts serves as a partner.
Mr. DuHamel has been a director and the Executive Vice President of FirstMerit Bank, NA, Akron, Ohio, since February 2005 and Treasurer of FirstMerit Bank, NA since March 1996.
Mr. England has been Chairman and Chief Executive Officer of Decatur County Bank, Decaturville, Tennessee since 1990.
Ms. Greenstein has been the President and Chief Executive Officer of Nationwide Bank, Columbus, Ohio since November 2009. She also served as the Senior Vice President-Property and Casualty Product and Pricing for Nationwide Mutual Insurance Company from March 2003 until November 2009.
Mr. Hailer has been a director and President and Chief Executive Officer of North Akron Savings Bank, Akron, Ohio, since 1991.
Mr. Melvin has been President and a director of Perpetual Federal Savings Bank, Urbana, Ohio since 1980.
Mr. Small has been Chairman and Chief Executive Officer of First Defiance Financial Corp. and Chairman of its subsidiary bank, First Federal Bank of the Midwest, of Defiance, Ohio, since 1999. He also served as Chief Executive Officer of First Federal Bank of the Midwest from 1999 until December 2008.
Mr. Stuard has been President and Chief Executive Officer of F&M Bank, Clarksville, Tennessee, since January 1991.
Mr. Wade has served as Executive Director of HOPE of Kentucky, LLC since January 2011. HOPE of Kentucky, LLC is a consortium of Kentucky banks formed to make permanent loans on affordable housing projects. Mr. Wade had worked as a self-employed consultant to affordable housing organizations and real estate developers from August 2010 to January 2011. Mr. Wade was the Chief Executive Officer of Citizens Union Bank, Shelbyville, Kentucky, from 1991 to March 2010. He also served as President of Citizens Union Bank from 1991 through 2007. Mr. Wade has been a Director of First Farmers Bank and Trust Company, Owenton, Kentucky, since 1993 and a Director of Dupont State Bank, Dupont, Indiana, since 2001.
Independent Directors
Finance Agency regulations also govern the eligibility requirements of our independent directors. Each independent director, and each nominee to an independent directorship, must be a U.S. citizen and bona fide resident of our District. At least two of our independent directors must be designated by our Board as public interest directors. Public interest independent directors
must have more than four years experience representing consumer or community interest in banking services, credit needs, housing, or consumer financial protections. All other independent directors must have knowledge of or experience in one or more of the following areas: auditing and accounting; derivatives; financial management; organizational management; project development; risk management practices; and the law. Our Board of Directors nominates candidates for independent directorships. Directors, officers, employees, attorneys, or agents of the FHLBank are permitted to support directly or indirectly the nomination or election of a particular individual for an independent directorship.
Mr. Appleton has served as Executive Director of East Akron Neighborhood Development Corporation (EANDC), Akron, Ohio, for 29 years. The EANDC's mission is to develop East Akron and other communities through housing and economic development activities, such as affordable housing programs and programs to support home ownership. Mr. Appleton's years of experience with EANDC bring insight to the Board that contributes to the FHLBank's corporate objective of maximizing the effectiveness of contributions to Housing and Community Investment programs. Mr. Appleton also served as a member of the FHLBank's Advisory Council from 1997 until 2006.
Ms. Dunn was Senior Vice President of Business Development, General Counsel and Secretary of Cole National Corporation, a New York Stock Exchange listed retailer now owned by Luxottica Group S.p.A., from September 1997 until October 2004. Prior to joining Cole, she had been a partner since 1985 in the Business Practice of the Jones, Day law firm. She currently is engaged in various business activities and serves in leadership positions with a number of civic and philanthropic organizations. Ms. Dunn's experience as a senior officer of a publicly held company and as a law firm partner representing numerous publicly held companies brings perspective to the Board regarding the FHLBank's status as an SEC registrant, corporate governance matters, and the Board's responsibility to oversee the FHLBank's operations.
Mr. Koch is the retired Chairman of the Board and Chief Executive Officer of Charter One Bank, N.A., Cleveland, Ohio. He served as Charter One's Chief Executive Officer from 1987 to 2004, and as its Chairman of the Board from 1995 to 2004, when the bank was sold to Royal Bank of Scotland. Mr. Koch was a director of the Royal Bank of Scotland from 2004 until February 2009. He is currently a director of Assurant Inc. and Home Properties, Inc. Mr. Koch's prior leadership positions within the banking industry and various board positions held contribute skills important to the Board's responsibility for approving a strategic business plan that supports the FHLBank's mission and corporate objectives.
Dr. Mullineaux has held the duPont Endowed Chair in Banking and Financial Services in the Gatton College of Business and Economics at the University of Kentucky since 1984. Previously, he was on the staff of the Federal Reserve Bank of Philadelphia, where he served as Senior Vice President and Director of Research from 1979 until 1984. He also served as a director of Farmers Capital Bank Corporation from 2005 until 2009. He has published numerous articles and lectured on a variety of banking topics, including risk management, financial markets and economics. He has served as the Curriculum Director for the ABA's Stonier Graduate School of Banking since 2001. Dr. Mullineaux brings knowledge and experience to the Board in areas vital to the operation of financial institutions in today's economy.
Mr. Nance has been Executive Director and the Chief Executive Officer of Knoxville's Community Development Corporation (KCDC) Knoxville, Tennessee since 2000. The KCDC strives to improve Knoxville's neighborhoods and communities, including through providing quality affordable housing. Mr. Nance also serves as Vice Chairman of the Tennessee Housing Development Agency, the state's housing finance agency, which promotes the production of more affordable new housing units for very low, low, and moderate, income individuals and families in the state. Mr. Nance's depth of experience with these organizations brings insight to the Board that contributes to the FHLBank's corporate objective of maximizing the effectiveness of its contributions to Housing and Community Investment programs.
Mr. Ruma has been President and Chief Executive Officer of Virginia Homes Ltd., a Columbus, Ohio area homebuilder, since 1975. He served on the board of the Ohio Housing Finance Agency (OHFA), the state's housing agency, from 2004 to 2009. OHFA helps Ohio's first-time homebuyers, renters, senior citizens, and others find quality, affordable housing that meets their needs. OHFA's programs also support developers and property managers of affordable housing throughout the state. Mr. Ruma's years of experience in the home building industry and with the OHFA bring insight to the Board that contributes to the FHLBank's mission and corporate objectives.
Mr. Wick was employed by NCR Corporation (one of the two largest manufacturers and suppliers of computer banking systems in the world at the time) from 1966 to 1994, when he retired. He continued with NCR into 1997 on a contractual basis. Mr. Wick's work at NCR over the years included training and support for many NCR computer banking system installations; management of NCR customer support and education centers, including its central location in the U.S. for customer banking systems training; and serving as a director in NCR's R&D division where he was responsible for NCR's worldwide engineering human resources function. He's currently the owner of Wick and Associates, a business consulting firm. He also served as a member of the Ohio Board of Education for 8½ years, chairing several key policy committees and serving as a member of the
executive committee. He retired from the State Board in 2009. Mr. Wick's qualifications and insight provide valuable skills to the Board, particularly in the important areas of technology, personnel matters and organizational development. Mr. Wick has been a member of the Council of Federal Home Loan Banks since 2005 and serves as Chairman of the Council.
EXECUTIVE OFFICERS
The following table sets forth certain information (ages as of March 1, 2012) regarding our executive officers.
(1)
On January 19, 2012, Mr. Hehman announced his retirement from the FHLBank effective June 1, 2012. To succeed Mr. Hehman as President and Chief Executive Officer, the FHLBank's Board of Directors appointed Mr. Howell.
Except as described below, all of the executive officers named above have held their current positions for at least the past five years.
Mr. Howell became Executive Vice President-Chief Operating Officer in January 2008. He had served as the FHLBank's Executive Vice President-Mission Asset Activity since January 2007.
Mr. Able became Principal Financial Officer in January 2007. He also has been Senior Vice President-Chief Accounting and Technology Officer since January 2011. Prior to that, he had served as the Senior Vice President-Controller since March 2006.
Mr. Allen became Senior Vice President-Community Investment Officer in January 2012. Previously, he served as the FHLBank's Vice President and Community Investment Officer since July 2011, as Vice President-Housing and Community Investment from January 2009 to June 2011, and as the Assistant Vice President-Housing and Community Investment from November 2007 to December 2008. Prior to that, he served as Assistant Vice President-Credit Services from December 2003 to October 2007.
Mr. Ciresi became the Senior Vice President-Member Services in March 2010. Prior to that, he had served as the FHLBank's Vice President of Marketing since 1990.
Mr. Lawler became the Senior Vice President-Chief Credit Officer in May 2007. Prior to that, he had served as the FHLBank's Senior Vice President-Mortgage Purchase Program since June 2000.
All officers are appointed annually by our Board of Directors.
AUDIT COMMITTEE FINANCIAL EXPERT
The Board of Directors has determined (1) that each of Mr. Billie W. Wade, Chairman of the Audit Committee, and Committee member Mr. Mark N. DuHamel have the relevant accounting and related financial management expertise, and therefore are qualified, to serve as Audit Committee financial experts within the meaning of the regulations of the SEC and (2) that each is independent under SEC Rule 10A-3(b)(1). Mr. Wade has extensive auditing experience in the financial industry and was a partner in a public accounting firm. Mr. DuHamel's experience has principally been in the accounting, finance and treasury disciplines within the financial industry, and has included managing various accounting functions. For additional information regarding the independence of the directors of the FHLBank, see “Item 13. Certain Relationships and Related Transactions, and Director Independence.”
CODES OF ETHICS
The Board of Directors has adopted a “Code of Ethics for Senior Financial Officers” that applies to the principal executive officer and the principal financial officer, as well as all other executive officers. This policy serves to promote honest and ethical conduct, full, fair and accurate disclosure in the FHLBank's reports to regulatory authorities and other public communications, and compliance with applicable laws, rules and regulations. The Code is posted on the FHLBank's Web site (www.fhlbcin.com). If a waiver of any provision of the Code is granted to a covered officer, information concerning the waiver will be posted on our Web site.
The Board of Directors has also adopted a “Standards of Conduct” policy that applies to all employees. The purpose of this policy is to promote a strong ethical climate that protects the FHLBank against fraudulent activities and fosters an environment in which open communication is expected and protected.
Item 11.
Item 11. Executive Compensation.
2011 COMPENSATION DISCUSSION AND ANALYSIS
The following discussion and analysis provides information on our compensation program for executive officers for 2011, including in particular the executive officers named in the Summary Compensation Table below (the Named Executive Officers).
Compensation Program Overview (Philosophy and Objectives)
Our Board of Directors is responsible for determining the philosophy and objectives of the compensation program. The philosophy of the program is to provide a flexible and market-based approach to compensation that attracts, retains and motivates high performing, accomplished financial services executives who, by their individual and collective performance, achieve strategic business initiatives and thereby enhance stockholder value. The program is primarily designed to focus executives on achieving the FHLBank's mission through increased business with member institutions within established risk and profitability tolerance levels, while also encouraging teamwork.
To achieve this, we compensate executive officers using a combination of base salary, short and long-term variable (incentive-based) compensation, retirement benefits and modest fringe benefits. We believe the compensation program communicates short and long-term goals and standards of performance for the FHLBank's mission and key business objectives and appropriately motivates and rewards executives commensurate with their contributions and achievements. The combination of base salary, which rewards individual performance, and short and long-term incentives, which reward teamwork, creates a total compensation opportunity for executives who contribute to and influence strategic plans and who are primarily responsible for the FHLBank's performance.
Oversight of the compensation program is the responsibility of the Personnel Committee (the Committee) of the Board. The Committee annually reviews the components of the compensation program to ensure that it is consistent with and supports the FHLBank's mission, strategic business objectives and annual goals. In carrying out its responsibilities, the Committee may engage executive compensation consultants to assist in evaluating the effectiveness of the compensation program and in determining the appropriate mix of compensation provided to executive officers. Because individuals are not permitted to own the FHLBank's capital stock, all compensation is paid in cash and we have no equity compensation plans or arrangements.
The Committee recommends the President's annual compensation package to the Board, which is responsible for approving all compensation provided to the President. Additionally, the Committee is responsible for reviewing and approving the compensation of all officers, including the other Named Executive Officers, and submitting its recommendations to the Board for final approval.
Management Involvement - Executive Compensation
While the Board is ultimately responsible for determining the compensation of the President and all other executive officers, the President and the Human Resources department periodically advise the Committee regarding competitive and administrative issues affecting our compensation program. The President and the Human Resources department also present recommendations to the Committee regarding the compensation of all other executive officers.
Finance Agency Oversight - Executive Compensation
HERA requires that the Director of the Finance Agency prevent an FHLBank from paying compensation to its executive officers that is not reasonable and comparable to that paid for employment in similar businesses involving similar duties and responsibilities. The Finance Agency has issued proposed rules to implement these statutory requirements with respect to the FHLBanks. Until such time as final rules are issued, the FHLBanks have been directed to provide all compensation actions affecting their Named Executive Officers to the Finance Agency for review. Accordingly, following our Board's November 2011 and January 2012 meetings, we submitted the 2012 base salaries as well as short and long-term incentive payments earned for 2011 for our Named Executive Officers to the Finance Agency. At this time, we do not expect the statutory requirements to have a material impact on our executive compensation plans.
Compensation Benchmarking
The compensation program is designed to provide a market competitive compensation package when recruiting and retaining highly talented executives seeking stable, long-term employment. To this end, we gather compensation data from a wide variety of sources, including broad-based national and regional surveys, presentations at FHLBank System meetings, and formal and informal interactions with our (and the FHLBank System's) compensation consultant. Our consultant is associated with McLagan, a nationally recognized compensation consulting firm specializing in the financial services industry. When determining compensation for our executive officers, the Committee and the President use this information to inform themselves regarding trends in compensation practices and as a comparison check against general market data (market check) to evaluate the reasonableness and effectiveness of our total compensation program and its components.
We also participate in an annual Federal Home Loan Bank System Key Position Compensation Survey conducted by Riemer Consulting, which contains executive and non-executive compensation information for various key positions across the 12 FHLBanks.
In setting 2012 compensation, we concentrated our attention on information from the Riemer survey, information relating to 2011 and expected 2012 compensation from other FHLBanks, and trend information and market compensation data updates from our consultant and broad-based surveys. Although McLagan's data for mortgage banks and commercial institutions continues to serve as a reference point (market check), we believe the positions at other FHLBanks generally are more directly comparable to ours. Additionally, the FHLBanks share the same public policy mission, interact routinely with each other, and share a common regulator and common regulatory constraints, including the need for Finance Agency review of all compensation actions affecting our executive officers. However, there are significant differences across the FHLBank System, including differences in the sizes of the various FHLBanks, the complexity of their operations, their cost structures and the types of compensation packages offered. Thus, we do not and, as a practical matter, could not calculate compensation packages for our Named Executive Officers based solely on benchmarking to the other FHLBanks.
Compensation Program Approach
The Committee utilizes a balanced approach for delivering base salary and short and long-term incentive pay with our compensation program. While our short-term incentive compensation plan rewards all officers and staff for the achievement of FHLBank annual strategic business goals, our long-term incentive compensation plan is provided to executive and senior officers for achievement of specific, strategic and mission-related goals for which FHLBank performance is measured over a three-year period. The Committee has not established or assigned specific percentages to each element of the FHLBank's executive compensation program. Instead, the Committee strives to create a program that generally delivers a total compensation opportunity, i.e., base salary, short and long-term incentive compensation and other benefits (including retirement plan contributions), to each executive officer that, when the FHLBank meets its target performance goals, is at or near the median of the other FHLBanks and generally consistent with our market check. However, individual elements of compensation as well as total compensation for individual executives may vary from the median due to an executive's tenure, experience and responsibilities.
While the competitiveness of the compensation program is considered an important factor for attracting and retaining executives, the Committee also reviews all elements of compensation to ensure the program is well designed and fiscally responsible from both a regulatory and corporate governance perspective.
Impact of Risk-Taking on Compensation Program
As is further discussed below, the Committee reviews the overall program to ensure the compensation of executive officers does not encourage unnecessary or excessive risk-taking that could threaten the long-term value of the FHLBank. Risk management is an integral part of our culture. The Committee believes that base salary, which generally exceeds incentive compensation, is a sufficient percentage of total compensation to discourage such risk-taking by our executive officers. The Committee also believes the mix of short and long-term incentive goals, which include risk-related metrics, does not encourage unnecessary or excessive risk and achieves an appropriate balance of incentive for performance between the short and long-term organizational goals. Moreover, the Committee retains the discretion to reduce or withhold incentive compensation payments if it determines an executive has caused the FHLBank to incur such a risk.
In March 2009, at the request of the Committee, McLagan provided an analysis of the FHLBank's executive compensation competitiveness in the context of volatile financial markets and the overall weak labor market. McLagan's report concluded that the FHLBank's conservative approach to executive compensation is competitive, discourages high risk-taking behavior and has
served the FHLBank well. We believe the report's conclusions remain valid because neither the FHLBank's overall compensation nor market conditions have changed significantly since the report was issued. However, in February 2011, the Committee once again engaged McLagan to review certain aspects of our executive incentive plans. Several minor changes to the plans were instituted in 2011 with a recommendation from McLagan that as the demographics of the executive population change, the mix of incentive pay should be revisited to maintain a long-term focus. The Committee is currently reviewing incentive compensation plans for 2012.
Elements of Total Compensation Program
The following table summarizes all compensation to the FHLBank's Named Executive Officers for the years ended December 31, 2011, 2010 and 2009. Discussion of each component follows the table.
Summary Compensation Table
(1)
Includes excess accrued vacation benefits automatically paid in accordance with established policy (applicable to all employees), which for 2011 were as follows: Mr. Hehman, $0; Mr. Able, $12,692; Mr. Howell, $16,962; Mrs. Cossé, $20,596; and Mr. Lawler, $11,725.
(2)
Amounts shown for 2011 reflect total payments pursuant to the 2011 Short-Term Non-Equity Incentive Plan and the 2009-2011 Long-Term Non-Equity Incentive Plan, as follows:
(3) Represents change in the actuarial present value of accumulated pension benefits only, which is primarily dependent on changes in interest rates, years of benefit service and salary. No above market or preferential earnings are paid on deferred compensation.
(4) Amounts represent matching contributions to the qualified defined contribution pension plan in 2011. For Mr. Hehman, 2011 also includes perquisites totaling $11,232 which included personal use of an FHLBank-owned vehicle ($10,068), spousal travel ($764), and a membership in a waiting area designated for frequent airline travelers ($400).
Salary
Base salary is both a key component of the total compensation program and a key factor when attracting and retaining executive talent. While base salaries for the Named Executive Officers are influenced by a number of factors, they generally
target the median of the competitive market. Other factors affecting an executive's base salary include length of time in position, relevant experience, individual achievement, and the size and scope of assigned responsibilities as compared to the responsibilities of other executives. Base salary increases traditionally take effect at the beginning of each calendar year and are granted after a review of the individual's performance and leadership contributions to the achievement of our annual business plan goals and strategic objectives.
Each of the Named Executive Officers received a base salary increase in 2011. Total salary increases, including merit and market adjustments, ranged from 2.3 percent to 3.4 percent. For the Named Executive Officers other than the President, the Committee's actions were based on the President's recommendation for each executive, which took into consideration market data, and an evaluation of each executive's annual performance. Mr. Hehman's merit increase was 2.5 percent. In recommending and approving the 2011 increase, the Committee and Board took into consideration the directors' appraisals of Mr. Hehman's performance during the year and noted, in particular, that directors had rated him especially highly on qualities of importance during challenging economic times - leadership, strategic vision and direction, and safe and sound operations appropriately balanced with strong financial results.
In October 2011, the Committee recommended and the Board approved a 3.5 percent salary increase pool for 2012 for all employees, comprised of 2.25 percent for merit increases and 1.25 percent for market and promotional adjustments. At meetings in November 2011, the Committee recommended, and the Board approved, the following 2012 base salaries for the Named Executive Officers: Mr. Hehman, $639,800; Mr. Able, $236,000; Mr. Howell, $319,200; Mrs. Cossé, $275,000; and, Mr. Lawler, $229,000. In 2012, total salary increases, including merit and market adjustments, ranged from 2.2 percent to 5.4 percent.
As in prior years, for the Named Executive Officers other than the President, the Committee's actions were based on the President's recommendations for each individual executive, which took into consideration recent market data corresponding to the positions and an evaluation of the executive's performance over the past year. In determining Mr. Hehman's 2012 salary, the Committee and Board discussed his outstanding leadership, particularly in the challenging economic environment and regulatory uncertainty, as reflected in the directors' individual evaluations of his performance. Therefore, the Committee recommended, and the Board subsequently approved, a salary increase for Mr. Hehman of 3.0 percent.
Short-Term Non-Equity Incentive Plan Compensation
The Executive Incentive Compensation (STI) Plan is an annual cash-based incentive compensation plan designed to promote and reward higher levels of performance for accomplishing Board-approved goals. The annual STI goals generally reflect desired financial, operational and public mission objectives for the current fiscal year. Each goal is assigned an incentive weight reflecting its relative importance and potential impact on our strategic initiatives and annual business plan, and each is assigned a quantitative threshold, target and maximum level of performance.
When establishing the annual STI goals and corresponding performance levels, the Board anticipates that we will successfully achieve threshold level of performance nearly every year. The target level is aligned with expected performance and is anticipated to be reasonably achievable in a majority of plan years. The maximum level of performance reflects a graduated level of difficulty from the target performance level and requires superior performance to achieve.
Each executive officer, including the Named Executive Officers, is assigned an annual incentive award opportunity, stated as a percentage of base salary, which corresponds to the individual's level of organizational responsibility and ability to contribute to and influence overall performance. The annual incentive award opportunity established for executives is designed to be comparable with the annual incentive opportunities for executives with similar duties and responsibilities at other financial institutions, primarily other FHLBanks, and generally consistent with our market check. The Board believes the annual incentive opportunity and plan design provide an appropriate, competitive reward to all officers, including the Named Executive Officers, commensurate with the achievement levels expected for the incentive goals.
The authorization for payment of STI awards, if any, earned by participants in the annual incentive plan generally is granted following certification of the year-end performance results by the Board at its January meeting. The annual cash incentive payments are determined based on the actual achievement level for each goal in comparison with the performance levels established for that goal.
If actual performance falls below the threshold level of performance, no payment is made for that goal. If actual performance exceeds the maximum level, only the value assigned as the performance maximum is paid. When actual performance falls between the assigned threshold, target and maximum performance levels, an interpolated achievement is calculated for that goal. The achievement for each goal is then multiplied by the corresponding incentive weight assigned to that goal and the
results for each goal are summed to arrive at the final incentive award payable to the executive. The Board has sole discretion to increase or decrease any STI awards, including the ability to approve an additional incentive payment for extraordinary individual performance.
For calendar year 2011, the Board approved a total of ten goals in the functional areas of Member Asset Activity, Franchise Value Promotion and Stockholder Risk/Return. The mix of financial and non-financial goals measures performance across the FHLBank's mission and corporate objectives and is intended to discourage unnecessary or excessive risk-taking. Because we consider risk management to be an essential component in the achievement of our mission and corporate objectives, the goals below include a separate risk-related metric.
The following table presents the incentive weights, target performance levels, and the actual results achieved for the 2011 STI goals.
(1) Adjusted Net Income is a non-GAAP measure and is equal to Regulatory Net Income adjusted to remove the non-interest income impact of hedge accounting and further adjusted to amortize Advance prepayment fees over their remaining weighted average term (at the time of prepayment) instead of when they occur.
During 2011, the Board, the Committee and the President periodically reviewed the STI goals presented above to determine progress toward the goals. Although the Board and the President discussed various external factors that were affecting achievement of the performance measures, the Board did not take any actions to revise or change the STI goals during 2011.
The incentive award opportunities for the 2011 plan year were as follows:
At its January 2012 meeting, following certification of the 2011 performance results and in accordance with those results, the Board authorized the distribution to the Named Executive Officers of the STI awards shown in Note 2 to the Summary Compensation Table. For the 2011 plan year, we cumulatively achieved approximately 75 percent of the available maximum incentive opportunity. This was a decrease in overall FHLBank performance from the 81 percent achieved for 2010 primarily because the FHLBank did not reach target performance on its stockholder return goal in 2011. For both periods, the FHLBank did not reach its target levels on the goals related to average Advances, primarily due to the decrease in members' Advance demand as their liquidity needs in 2010 and 2011 remained well below the highs reached in late 2008.
Both the STI Plan and the LTI Plan described below include clawback provisions. These provisions allow the FHLBank to recover any incentive paid to a participant based on achievement of financial or operational goals that subsequently are deemed to be inaccurate, misstated or misleading. Our Board believes these clawback requirements will serve as deterrents to any manipulation of financial statements or performance metrics in a manner that would assure and/or increase an incentive payment.
Long-Term Non-Equity Incentive Plan Compensation
The Executive Long-Term Incentive (LTI) Plan is a cash-based, performance unit plan designed to promote higher levels of performance and long-term employment retention by selected executive and senior officers, including the Named Executive Officers, for accomplishing Board-approved long-term goals. Since the LTI Plan was initially created, the Board has established a new three-year performance period each year, commencing each January 1, so that three overlapping performance periods are in effect at one time. The LTI goals reflect desired financial, operational and public mission objectives measured over each three-year period, which we believe promotes and encourages our long-term success and financial viability and thereby enhances our value to our stockholders. Historically, the Board of Directors has approved LTI goals in the areas of Operating Efficiency, Risk Adjusted Profitability, Market Penetration and Affordable Housing/Community Investment. In early 2010, the Board added a Market Capitalization goal beginning with the 2010-2012 performance period. Each approved LTI goal is assigned an incentive weight reflecting its relative importance and potential impact on the strategic long-term initiatives, and each is assigned a quantitative threshold, target and maximum level of performance.
At the beginning of each performance period, the Board establishes a base award opportunity for each executive officer in the form of a grant of a fixed number of performance units, with an assigned value of $100 per unit, equal to a percentage of the participant's base salary. The value of each performance unit then fluctuates as a function of the actual performance in comparison with the performance levels established for each LTI goal. Generally, the higher the level of an executive officer's organizational responsibility, the higher the LTI award opportunity. The award opportunity established for each executive officer for target performance is designed to be comparable with the LTI opportunities available to executives with similar duties and responsibilities at other financial institutions, primarily other FHLBanks, and generally consistent with our market check.
When establishing LTI goals for a performance period and the corresponding performance levels, the Board anticipates the successful achievement of the threshold level of performance nearly every performance period. The target level is aligned with expected performance and is anticipated to be reasonably achievable. The maximum level reflects a graduated level of difficulty from the target performance level and requires exceptional performance for the FHLBank to achieve.
LTI incentive awards are calculated based on the actual performance or achievement level for each LTI goal at the end of each three-year performance period, with interpolations made for results between achievement levels. The achievement level for each LTI goal then is multiplied by the corresponding incentive weight assigned to that goal. The results for each goal are summed and multiplied by the executive officer's respective number of performance units to arrive at the final LTI award payable.
If, however, actual performance fails to meet the threshold (minimum) level for the Affordable Housing/Community Investment goal, no LTI award is paid to any participant for that performance period. If actual performance falls below the threshold level of performance for any other LTI goal, no payment is made for that goal. Also, if actual performance exceeds the performance maximum for an LTI goal, only the maximum for that goal is paid. The Board also has sole discretion to increase or decrease LTI awards up to ten percent to recognize performance not captured by the total achievement level of the LTI goals.
The Board established the following 2011 - 2013 LTI goals and related incentive weights for each goal:
During 2011, as with the STI Plan, the Board, the Committee and the President periodically reviewed progress toward LTI goals for each ongoing performance period. At its January 2012 meeting, following certification of the performance results for the 2009 - 2011 performance period and in accordance with those results, the Board authorized the distribution of LTI Plan payments to eligible officers including the Named Executive Officers. Cumulatively, we achieved approximately 56 percent of the available maximum incentive opportunity for FHLBank goals. The LTI Plan payments for the 2009 - 2011 performance period are shown in Note 2 to the Summary Compensation Table.
The following table presents the incentive weights, target performance level, and the actual results achieved for the 2009 - 2011 LTI goals.
At the February 2012 meeting, the Board also reviewed the measurements and achievement levels for each LTI goal for the remaining three-year performance periods operating concurrently. Based on the results to date, we project an achievement level between the target and maximum levels of performance for the 2010 - 2012 and 2011 - 2013 performance periods.
Non-Equity Incentive Plan Compensation Grants - 2011
The following table provides information on grants made under the STI Plan for 2011 and the LTI Plan for the 2011 - 2013 performance period.
2011 Grants of Plan-Based Awards
Non-Equity Incentive Plan Compensation Grants - 2012
At its February and March 2012 meetings, the Board reviewed the 2012 short and long-term non-equity incentive plan compensation grants. In setting the plans, the Board considered the proposed Finance Agency guidance on executive compensation. Although the Board has approved in principal the new goals and plan structure to meet the Finance Agency guidance, regulatory review is pending, and therefore, the plans are subject to change. We intend to file a Form 8-K of the final plan structure after the Finance Agency review is complete.
Retirement Benefits
We maintain a comprehensive retirement program for executive officers comprised of two qualified pension plans - a defined benefit plan and a defined contribution plan - and a non-qualified pension plan. For our qualified plans, we participate in the Pentegra Defined Benefit Plan for Financial Institutions and the Pentegra Defined Contribution Plan for Financial Institutions. Prior to 2010, the non-qualified plan, the Benefit Equalization Plan (BEP), had two components, one restoring benefits that eligible highly compensated employees would have received were it not for Internal Revenue Service limits on benefits from the defined benefit plan (DB/BEP) and the other restoring benefits these persons would have received but for IRS limits on contributions to the defined contribution plan (DC/BEP). The latter component of the DC/BEP was effectively terminated on December 23, 2009. Generally, benefits under the BEP vest (or vested) and are (or were) payable according to the corresponding provisions of the qualified plans.
The pension plans provide benefits based on a combination of an employee's tenure (or length of service) and annual compensation. As such, the benefits provided by the pension plans are one component of the total compensation opportunity for executive officers and, the Board believes, serve as valuable retention tools since pension benefits increase as executives' tenure and compensation with the FHLBank grow.
Qualified Defined Benefit Pension Plan. The Pentegra Defined Benefit Plan for Financial Institutions (Pentegra DB) is a funded tax-qualified plan that is maintained on a non-contributory basis, i.e., employee contributions are not required. Participants' pension benefits vest upon completion of five years of service.
The pension benefits payable under the Pentegra DB plan are determined using a pre-established formula that provides a single life annuity payable monthly at age 65 or normal retirement. The benefit formula for employees hired prior to January 1, 2006, which includes all Named Executive Officers, is 2.5 percent for each year of benefit service multiplied by the highest three-year average compensation. Average compensation is defined as base salary and annual bonus (STI compensation) and excludes any incentive payments received from the LTI Plan. In the event of retirement prior to attainment of age 65, a reduced
pension benefit is payable under the plan, with payments commencing as early as (attainment of) age 45. The Pentegra DB plan also provides certain actuarially equivalent forms of benefit payments other than a single life annuity, including a limited lump sum distribution option.
Non-Qualified Defined Benefit Pension Plan. Executive officers and other employees whose pay exceeds IRS pension limitations are eligible to participate in the Defined Benefit component of the Benefit Equalization Plan (DB/BEP), an unfunded, non-qualified pension plan that mirrors the Pentegra DB plan in all material respects. In determining whether a restoration of retirement benefits is due an eligible employee, the DB/BEP utilizes the identical benefit formula applicable to the Pentegra DB plan. In the event that the benefits payable from the Pentegra DB plan have been reduced or otherwise limited, the executive's lost benefits are payable under the terms of the DB/BEP. Because the DB/BEP is a non-qualified plan, the benefits received from this plan do not receive the same tax treatment and funding protection associated with the qualified plan.
The following table provides the present value of benefits payable to the Named Executive Officers upon retirement at age 65 from the Pentegra DB plan and the DB/BEP, and is calculated in accordance with the formula currently in effect for specified years-of-service and remuneration for participating in both plans. Our pension benefits do not include any reduction for a participant's Social Security benefits.
2011 Pension Benefits
(1)
For pension plan purposes, the calculation of credited service begins upon completion of a required waiting period following the date of employment. Accordingly, the years shown are less than the executive's actual years of employment. Because IRS regulations generally prohibit the crediting of additional years of service under the qualified plan, such additional service also is precluded under the DB/BEP, which only restores those benefits lost under the qualified plan.
(2)
See Note 18 of the Notes to Financial Statements for details regarding valuation assumptions.
Qualified Defined Contribution Plan. The Pentegra Defined Contribution Plan for Financial Institutions (Pentegra DC) is a tax-qualified defined contribution plan to which we make tenure-based matching contributions. Matching contributions begin upon completion of one year of employment and subsequently increase based on length of employment to a maximum of six percent of eligible compensation. Eligible compensation in the Pentegra DC plan is defined as base salary and annual bonus (STI compensation) and excludes any incentive payments received from the LTI Plan.
Under the Pentegra DC plan, a participant may elect to contribute up to 100 percent of eligible compensation on either a before-tax, i.e., 401(k), or after-tax basis. The plan permits participants to self-direct investment elections into one or more investment funds. All returns are at the market rate of the related fund. Investment fund elections may be changed daily by the participants. A participant may withdraw vested account balances while employed, subject to certain plan limitations, which include those under IRS regulations. Participants also are permitted to revise their contribution/deferral election once each pay period. However, the revised election is only applicable to future earnings and may also be limited by IRS regulations.
Fringe Benefits and Perquisites
Executive officers are eligible to participate in the traditional fringe benefit plans made available to all other employees, including participation in the pension plans, medical, dental and vision insurance program and group term life and long term disability (LTD) insurance plans, as well as annual leave (i.e., vacation) and sick leave policies. Executives participate in our
subsidized medical, dental and vision insurance and group term life and LTD insurance programs on the same basis and terms as do all our employees. Executive officers also receive on-site parking at our expense.
In accordance with Board policy, the perquisites provided by the FHLBank represent a small fraction of an executive officer's annual compensation and are provided in accordance with market practices for executives in similar positions and with similar responsibilities. During 2011, the President and the Executive Vice President were each provided with an FHLBank-owned vehicle for their business and personal use. The operating expenses associated with the vehicle, including an automobile club membership for emergency roadside assistance, also were provided. An executive officer's personal use of an FHLBank-owned vehicle, including use for the daily commute to and from work, is reported as a taxable fringe benefit. Additionally, with prior approval, our current Travel Policy permits a spouse to accompany an executive officer on authorized business trips. The transportation and other related expenses associated with the spouse's travel are reimbursed by the FHLBank and reported as a taxable fringe benefit. We also maintain a membership in our President's name in an airline waiting area designated for frequent travelers. During 2011, these perquisites totaled $11,232 for Mr. Hehman, as shown in the Summary Compensation Table. Perquisites did not individually or collectively exceed $10,000 for any other Named Executive Officer and are therefore excluded from the Summary Compensation Table.
Other than normal pension benefits and eligibility to participate in our retiree supplemental benefits program (if hired prior to August 1, 1990), no perquisites or other special benefits are provided to our executive officers in the event of a change in control, resignation, retirement or other termination of employment.
President and Chief Executive Officer Retirement and Transition
In January 2012, David H. Hehman, President and Chief Executive Officer, announced his retirement effective June 1, 2012. Mr. Hehman joined the FHLBank in 1977 and has served as President and Chief Executive Officer since 2003. Upon his retirement, Mr. Hehman will be eligible to receive his defined benefit pension plan benefit and defined contribution account balance under our DB/BEP, and Pentegra DB and DC plans. Additionally, Mr. Hehman will receive all accrued but unused vacation, if any, and will have the option to convert his life and long-term disability insurance coverages to individual coverage policies at his expense. Because Mr. Hehman was hired prior to August 1, 1990 and meets the “Rule of 80” with respect to his age and years of service, he will have the option to participate in the supplemental retiree benefits option which includes medical coverage subject to current retiree health insurance premiums and $5,000 in life insurance paid for by the FHLBank.
To succeed Mr. Hehman as President and Chief Executive Officer, our Board of Directors unanimously appointed Andrew S. Howell who currently serves as the Executive Vice President and Chief Operating Officer. The Board of Directors plans to recommend Mr. Howell's total compensation package as President and Chief Executive Officer at a future date subject to review by the Finance Agency. Mr. Howell joined the FHLBank in 1989.
Employment Arrangements and Severance Benefits
Pursuant to the FHLBank Act, all employees of the FHLBank are “at will” employees. Generally, the President works at the pleasure of the Board and all other employees work at the pleasure of the President. Accordingly, an employee may resign employment at any time and an employee's employment may be terminated at any time for any reason, with or without cause and with or without notice.
We have a severance policy under which employees, including executive officers, may receive benefits in the event of termination of employment resulting from job elimination, substantial job modification, job relocation or a planned reduction in staff that causes an involuntary termination of employment. Under this policy, an officer is entitled to one month pay for every full year of employment, pro-rated for partial years of employment, with a minimum of one month and a maximum of six months severance pay. At our discretion, executive officers and employees receiving benefits under this policy may also receive outplacement assistance as well as continuation of health insurance coverage on a limited basis.
We have no termination of employment, severance or change-in-control arrangements with any Named Executive Officer.
COMPENSATION COMMITTEE REPORT
The Personnel Committee of the Board of the Directors of the FHLBank has furnished the following report for inclusion in this annual report on Form 10-K:
The Personnel Committee has reviewed and discussed the 2011 Compensation Discussion and Analysis set forth above with the FHLBank's management. Based on such review and discussions, the Personnel Committee recommended to the Board of Directors that the Compensation Discussion and Analysis be included in this annual report on Form 10-K.
Carl F. Wick (Chair)
Grady P. Appleton
B. Proctor Caudill, Jr. (Vice Chair)
Stephen D. Hailer
Charles J. Koch
Michael R. Melvin
COMPENSATION OF DIRECTORS
As required by Finance Agency Regulations and the FHLBank Act, we have established a formal policy governing the compensation and travel reimbursement provided to our directors. The goal of the policy is to compensate Board members for work performed on behalf of the FHLBank. Under our policy, compensation is comprised of per meeting fees, subject to an annual cap, and reimbursement for reasonable FHLBank travel-related expenses. The meeting fees are intended to compensate directors for time spent reviewing materials sent to them, preparing for meetings, participating in other FHLBank activities and attending the meetings of the Board of Directors and its committees.
To appropriately compensate directors for fulfilling their increasing responsibilities, 2012 fees were modestly increased so as to continue to attract and retain valued guidance and expertise. The following table sets forth the per meeting fees and the annual caps for 2011 and 2012:
In addition, annual fees are paid as follows for certain Board Committee assignments that involve significant time and responsibilities.
However, the Board Chair does not receive additional compensation for chairing any committee and no director may receive fees totaling more than the annual amount paid to the Board Chair.
During 2011, total directors' fees and travel expenses incurred by the FHLBank were $1,049,250 and $274,153, respectively.
With prior approval, our current Travel Policy permits a spouse to accompany a director on an authorized business trip. The transportation and other related expenses associated with the spouse's travel are reimbursed by the FHLBank and reported as a taxable fringe benefit. During 2011, 14 directors received reimbursement for spousal travel expenses.
The following table sets forth the meeting fees earned by each director and expenses paid to each director for the year ended December 31, 2011.
2011 Directors Compensation Table
(1)
Total expenses are comprised of spousal travel expenses reimbursed to the director by the FHLBank; directors' travel expenses are not included.
The following table summarizes the total number of board meetings and meetings of its designated committees held in 2010 and 2011.
COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION
The Personnel Committee of the Board of Directors is charged with responsibility for the FHLBank's compensation policies and programs. None of the 2011 or 2012 Personnel Committee members is or previously was an officer or employee of the FHLBank. Additionally, none of the FHLBank's executive officers served or serve on the board of directors or the compensation committee of any entity whose executive officers served on the FHLBank's Personnel Committee or Board of Directors. This Committee was and is composed of the following members:
Carl F. Wick (Chair)
Carl F. Wick (Chair)
Grady P. Appleton
Grady P. Appleton
Robert E. Brosky
B. Proctor Caudill, Jr. (Vice Chair)
B. Proctor Caudill, Jr. (Vice Chair)
Stephen D. Hailer
Stephen D. Hailer
Charles J. Koch
Charles J. Koch
Michael R. Melvin
Michael R. Melvin
Item 12.
Item 12.
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.
We have one class of capital stock, Class B Stock, all of which is owned by our current and former member institutions. Individuals, including directors and officers of the FHLBank, are not permitted to own our capital stock. Therefore, we have no equity compensation plans.
The following table lists institutions holding five percent or more of outstanding capital stock at February 29, 2012 and includes any known affiliates that are members of the FHLBank:
The following table lists capital stock outstanding as of February 29, 2012 held by member institutions that have an officer or director who serves as a director of the FHLBank:
Item 13.
Item 13. Certain Relationships and Related Transactions, and Director Independence.
DIRECTOR INDEPENDENCE
Because we are a cooperative, capital stock ownership is a prerequisite to transacting any business with us. Transactions with our stockholders are part of the ordinary course of - and are essential to the purpose of - our business.
Our capital stock is not permitted to be publicly traded and is not listed on any stock exchange. Therefore, we are not governed by stock exchange rules relating to director independence. If we were so governed, arguably none of our industry directors, who are elected by our members, would be deemed independent because all are directors and/or officers of members that do business with us. Messrs. Wick, Appleton, Koch, Mullineaux, Nance and Ruma and Ms. Dunn, our seven non-industry directors, have no transactions, relationships or arrangements with the FHLBank other than in their capacity as directors. Therefore, our Board of Directors has determined that each of them is independent under the independence standards of the New York Stock Exchange.
The Finance Agency director independence standards specify independence criteria for members of our Audit Committee. Under these criteria, all of our directors are independent.
TRANSACTIONS WITH RELATED PERSONS
See Note 23 of the Notes to Financial Statements for information on transactions with stockholders, including information on transactions with Directors' Financial Institutions and concentrations of business, and transactions with nonmember affiliates, which information is incorporated herein by reference.
See also “Item 11. Executive Compensation - Compensation Committee Interlocks and Insider Participation.”
Review and Approval of Related Persons Transactions. Ordinary course transactions with Directors' Financial Institutions and with members holding 5 percent or more of our capital stock are reviewed and approved by our management in the normal course of events so as to assure compliance with Finance Agency Regulations.
As required by Finance Agency Regulations, we have a written conflict of interest policy. This policy requires directors (1) to disclose to the Board of Directors any known personal financial interests that they, their immediate family members or their business associates have in any matter to be considered by the Board and in any other matter in which another person or entity does or proposes to do business with the FHLBank and (2) to recuse themselves from considering or voting on any such matter. The scope of the Finance Agency's conflict of interest Regulation (available at www.fhfa.gov) and our conflict of interest policy (posted on our Web site at www.fhlbcin.com) is similar, although not identical, to the scope of the SEC's requirements governing transactions with related persons. In March 2007, our Board of Directors adopted a written related person transaction policy that is intended to close any gaps between Finance Agency and SEC requirements. The policy includes procedures for identifying, approving and reporting related person transactions as defined by the SEC. One of the tools that we used to monitor non-ordinary course transactions and other relationships with our directors and executive officers is an annual questionnaire that uses the New York Stock Exchange criteria for independence. Finally, our Insider Trading Policy provides that any request for redemption of excess stock (except for de minimis amounts) held by a Director's Financial Institution must be approved by the Board of Directors or by the Executive Committee of the Board.
We believe these policies are effective in bringing to the attention of management and the Board any non-ordinary course transactions that require Board review and approval and that all such transactions since January 1, 2011 have been so reviewed and approved.
Item 14.
Item 14.
Principal Accountant Fees and Services.
The following table sets forth the aggregate fees billed to the FHLBank for the years ended December 31, 2011 and 2010 by its independent registered public accounting firm, PricewaterhouseCoopers LLP:
Audit fees were for professional services rendered for the audits of the FHLBank's financial statements.
Audit-related fees were for assurance and related services primarily related to accounting consultations and control advisory services.
The FHLBank is exempt from all federal, state and local income taxation. Therefore, no fees were paid for tax services during the years presented.
There were no other fees paid during the years presented.
The Audit Committee approves the annual engagement letter for the FHLBank's audit. The Audit Committee also establishes a fixed dollar limit for other recurring annual accounting related consultations, which include the FHLBank's share of FHLBank System-related accounting issues. The status of these services is periodically reviewed by the Audit Committee throughout the year with any increase in these services requiring pre-approval. All other services provided by the independent accounting firm are specifically approved by the Audit Committee in advance of commitment.
The FHLBank paid additional fees to PricewaterhouseCoopers, LLP in the form of assessments paid to the Office of Finance. The FHLBank is assessed its proportionate share of the costs of operating the Office of Finance, which includes the expenses associated with the annual audits of the combined financial statements of the 12 FHLBanks. These assessments, which totaled $44,000 and $50,000 in 2011 and 2010, respectively, are not included in the table above.
PART IV
Item 15.
Item 15.
Exhibits and Financial Statement Schedules.
(a)
Financial Statements. The following financial statements of the Federal Home Loan Bank of Cincinnati, set forth in Item 8 above, are filed as a part of this registration statement.
Report of Independent Registered Public Accounting Firm
Statements of Condition as of December 31, 2011 and 2010
Statements of Income for the years ended December 31, 2011, 2010 and 2009
Statements of Capital for the years ended December 31, 2011, 2010 and 2009
Statements of Cash Flows for the years ended December 31, 2011, 2010 and 2009
Notes to Financial Statements
(b)
Exhibits.
See Index of Exhibits
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, as of the 16th day of March 2012.
FEDERAL HOME LOAN BANK OF CINCINNATI
(Registrant)
By:
/s/ David H. Hehman
David H. Hehman
President and Chief Executive Officer (principal executive officer)
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities indicated as of the 16th day of March 2012.
Signatures
Title
/s/ David H. Hehman
President and Chief Executive Officer
David H. Hehman
(principal executive officer)
/s/ Donald R. Able
Senior Vice President - Chief Accounting and
Donald R. Able
Technology Officer
(principal financial officer)
/s/ Grady P. Appleton*
Director
Grady P. Appleton
/s/ B. Proctor Caudill, Jr.*
Director (Vice Chair)
B. Proctor Caudill, Jr.
/s/ James R. DeRoberts*
Director
James R. DeRoberts
/s/ Mark N. DuHamel*
Director
Mark N. DuHamel
/s/ Leslie D. Dunn*
Director
Leslie D. Dunn
/s/ James A. England*
Director
James A. England
/s/ J. Lynn Greenstein*
Director
J. Lynn Greenstein
/s/ Stephen D. Hailer*
Director
Stephen D. Hailer
/s/ Charles J. Koch*
Director
Charles J. Koch
/s/ Michael R. Melvin*
Director
Michael R. Melvin
/s/ Donald J. Mullineaux*
Director
Donald J. Mullineaux
/s/ Alvin J. Nance*
Director
Alvin J. Nance
/s/ Charles J. Ruma*
Director
Charles J. Ruma
/s/ William J. Small*
Director
William J. Small
/s/ William S. Stuard Jr.*
Director
William S. Stuard Jr.
/s/ Billie W. Wade*
Director
Billie W. Wade
/s/ Carl F. Wick*
Director (Chair)
Carl F. Wick
* Pursuant to Power of Attorney
/s/ David H. Hehman
David H. Hehman
Attorney-in-fact
INDEX OF EXHIBITS
* Numbers coincide with Item 601 of Regulation S-K.
**
Indicates management compensation plan or arrangement.