Item 1: Business
General
One of 12 FHLBanks, FHLBank Topeka is a federally chartered corporation organized on October 13, 1932 under the authority of the Federal Home Loan Bank Act of 1932, as amended (Bank Act). The FHLBank’s primary business is making collateralized loans and providing other banking services to member institutions and certain qualifying non-members (housing associates). The FHLBank is a cooperative owned by its members and is generally limited to providing products and services only to those members. Each FHLBank operates as a separate corporate entity with its own management, employees and board of directors. The FHLBank is exempt from federal, state and local taxation except real property taxes. The FHLBank does not have any wholly- or partially-owned subsidiaries and the FHLBank does not have an equity position in any partnerships, corporations or off-balance sheet special purpose entities.
Since July 30, 2008, the FHLBank has been supervised and regulated by the Federal Housing Finance Agency (Finance Agency), an independent agency in the executive branch of the U.S. government. Prior to July 30, 2008, the Federal Housing Finance Board (Finance Board) supervised and regulated the FHLBanks. The Finance Agency’s 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.
All federally insured depository institutions and insurance companies whose principal place of business is located in Colorado, Kansas, Nebraska or Oklahoma are eligible to become members of the FHLBank. Except for community financial institutions (CFIs), applicants for membership must demonstrate they are engaged in residential housing finance. CFIs are defined in the Housing and Economic Recovery Act (Recovery Act) as those institutions that have, as of the date of the transaction at issue, less than a specified amount of average total assets over the three years preceding that date (subject to annual adjustment by the Finance Agency director based on the consumer price index). For 2009, this asset cap was $1.0 billion.
Members of the FHLBank are required to purchase capital stock in the FHLBank as a condition of membership and only members are permitted to purchase capital stock. All FHLBank capital stock transactions are governed by its capital plan, which was developed under, is subject to and operates within specific regulatory and statutory requirements.
Member institutions own nearly all of the outstanding capital stock of the FHLBank and may receive dividends on that stock. Former members own capital stock so long as they have outstanding business transactions with the FHLBank. A member must own capital stock in the FHLBank based on the amount of the member’s assets and the level of business activities it engages in with the FHLBank. As a result of these stock purchase requirements, the FHLBank conducts business with related parties in the normal course of its business. For disclosure purposes, the FHLBank includes in its definition of a related party any member institution (or successor) of the FHLBank that is known to be the beneficial owner of more than 5 percent of any class of FHLBank voting securities and any person who is, or at any time since the beginning of the FHLBank’s last fiscal year was, a director or executive officer of the FHLBank, among others. Information on business activities with related parties is provided in Tables 100 and 101 under Item 12 - “Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.”
The FHLBank’s primary business activities are providing collateralized loans, known as advances, to members and housing associates, and acquiring residential mortgage loans from or through members. By law, only certain general categories of collateral are eligible to secure FHLBank credit. The FHLBank also provides members and housing associates with letters of credit and certain correspondent services, such as safekeeping, wire transfers, derivative intermediation and cash management, as well as technical expertise in the asset/liability, risk management and housing/community development areas.
The FHLBank’s primary funding source is consolidated obligations issued through the FHLBanks’ Office of Finance. The Office of Finance is a joint office of the FHLBanks that facilitates the issuance and servicing of the consolidated obligations. The Finance Agency and the U.S. Secretary of the Treasury have oversight over the issuance of FHLBank debt through the Office of Finance. Consolidated obligations are debt instruments that constitute the joint and several obligations of all FHLBanks. The capital markets have traditionally considered the FHLBanks’ consolidated obligations as “Federal agency” debt. As a result, although the U.S. government does not guarantee the FHLBanks’ debt, the FHLBanks have traditionally had ready access to funding at relatively favorable spreads to U.S. Treasuries.
Additional funds are provided by deposits, other borrowings and the issuance of capital stock. Deposits are received from both member and non-member financial institutions. Both the FHLBank itself and FHLBank consolidated obligations are currently rated Aaa/P-1 by Moody’s Investors Service (Moody’s) and AAA/A-1+ by Standard & Poor’s (S&P) based in part on the FHLBank’s relationship with the U. S. government. However, consolidated obligations jointly issued by the FHLBanks as well as deposits or other indebtedness of the FHLBank are not obligations of, nor guaranteed by, the U.S. government.
Business Segments
The FHLBank currently does not segregate its operations by segments.
Advances
The FHLBank makes advances to members and housing associates based on the security of residential mortgages and other eligible collateral. Following is a brief description of the FHLBank’s standard advance product offerings:
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The line of credit product is a variable rate, non-amortizing, prepayable, revolving line advance that provides an alternative to the purchase of Federal funds or repurchase agreement borrowings;
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Short-term fixed rate advances are non-amortizing, non-prepayable loans with terms to maturity from three to 93 days;
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Regular fixed rate advances are non-amortizing loans, prepayable with a fee, with terms to maturity from 94 days to 180 months;
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Adjustable rate advances are non-amortizing loans, which are: (1) prepayable with fee on interest rate reset dates, if the variable interest rate is tied to any one of a number of standard indices including the London Interbank Offered Rate (LIBOR), Treasury bills, Federal funds, or Prime; or (2) prepayable without fee if the variable interest rate is tied to one of the FHLBank’s short-term fixed rate advance products;
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Callable advances can have a fixed or variable rate of interest for the term of the advance and contain an option(s) that allows for the prepayment of the advance without a fee on specified dates;
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Amortizing advances are fixed rate loans, prepayable with fee, that contain a set of predetermined principal payments to be made during the life of the advance;
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Convertible advances are non-amortizing, fixed rate loans that contain an option(s) that allows the FHLBank to convert the fixed rate advance to a prepayable, adjustable rate advance that re-prices monthly based upon the FHLBank’s one-month short-term, fixed rate advance product. Once the FHLBank exercises its option to convert the advance, it can be prepaid without fee on the initial conversion date or on any interest rate reset date thereafter; and
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The standby credit facility is a variable rate, non-amortizing, prepayable, revolving standby credit line that provides a greater level of assurance that secured funding can be provided during a market disruption.
The FHLBank may create customized advances on request including advances with embedded floors and caps. All embedded derivatives in customized advances are evaluated to determine whether they are clearly and closely related to the advances. See Note 9 in the Notes to Financial Statements under Item 8 for information on accounting for embedded derivatives. The types of derivatives used to hedge risks embedded in our advance products are indicated in Tables 78 through 81 under Item 7A - “Quantitative and Qualitative Disclosures About Market Risk - Risk Management - Interest Rate Risk Management.”
The FHLBank also offers a variety of specialized advance products to address housing and community development needs. The products include advances priced at the FHLBank’s cost of funds plus reasonable administrative expenses, as well as advances priced at the FHLBank’s cost of funds. These advance products address needs for low-cost funding to create affordable rental and homeownership opportunities, and for commercial and economic development activities, including those that benefit low- and moderate-income neighborhoods. Refer to Item 1 - “Business - Other Mission-related Activities” for more details.
Table 1 summarizes the FHLBank’s advances outstanding by product as of December 31, 2009 and 2008 (in thousands):
Table 1
Note that an individual advance may be reclassified to a different product type between periods due to the occurrence of a triggering event such as the passing of a call date (i.e., from fixed rate callable advance to regular fixed rate advance) or conversion of an advance (i.e., from fixed rate convertible advance to adjustable rate callable advance).
In addition to members, the FHLBank makes advances to certain non-members (housing associates). To qualify as a housing associate, the applicant must: (1) be approved under Title II of the National Housing Act; (2) be a chartered institution having succession; (3) be subject to the inspection and supervision of some governmental agency; (4) lend its own funds as its principal activity in the mortgage field; and (5) have a financial condition that demonstrates that advances may be safely made. Housing associates are not subject to certain provisions of the Bank Act that are applicable to members, such as the capital stock purchase requirements, but the same regulatory lending requirements generally apply to them as apply to members. Restrictive collateral provisions apply if the housing associate does not qualify as a state housing finance agency (HFA). The FHLBank currently has three housing associates and all three are state HFAs.
The FHLBank, at the time it originates an advance, is required to obtain and maintain a security interest in collateral eligible in one or more of the following categories:
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Fully disbursed, whole first mortgages on 1-4 family residential property (not more than 90 days delinquent) or securities representing a whole interest in such mortgages;
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Securities issued, insured or guaranteed by the U.S. government, U.S. government agencies and mortgage government-sponsored enterprises (GSEs) [including, without limitation, mortgage-backed securities (MBS) issued or guaranteed by Federal National Mortgage Association (Fannie Mae), Federal Home Loan Mortgage Corporation (Freddie Mac) or Government National Mortgage Association (Ginnie Mae)];
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Cash or deposits in an FHLBank;
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Other real estate-related collateral acceptable to the FHLBank, provided such collateral has a readily ascertainable market value and the FHLBank can perfect a security interest in such property (e.g., privately issued collateralized mortgage obligations (CMOs), mortgages on multifamily residential real property); or
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In the case of any CFI, secured loans to small business, small farm and small agri-business or securities representing a whole interest in such secured loans.
The FHLBank may require additional collateral at any time (whether or not such additional collateral would be eligible to originate an advance) or substitutions of collateral by the member or housing associate. As additional security for a member’s indebtedness, the FHLBank has a statutory lien upon that member’s FHLBank stock.
The Bank Act affords any security interest granted to the FHLBank by any member of the FHLBank, or any affiliate of any such member, priority over the claims and rights of any party, including any receiver, conservator, trustee, or similar party having rights of a lien creditor. The only exceptions are claims and rights held by actual bona fide purchasers for value or by parties that are secured by actual perfected security interests, and provided that such claims and rights would otherwise be entitled to priority under applicable law. In addition, the claims of the FHLBank are given certain preferences pursuant to the receivership provisions in the Federal Deposit Insurance Act. Most members provide the FHLBank a blanket lien covering substantially all of the member’s assets and consent for the FHLBank to file a financing statement evidencing the blanket lien. Based on the blanket lien, the financing statement and the statutory preferences, the FHLBank normally does not take control of collateral, other than securities collateral, pledged by blanket lien borrowers. The FHLBank takes control of all securities collateral through delivery of the securities to the FHLBank or an FHLBank-approved, third-party custodian. With respect to non-blanket lien borrowers (typically insurance companies and housing associates), the FHLBank takes control of all collateral. In the event that the financial condition of a blanket lien member warrants such action because of the deterioration of the member’s financial condition, regulatory concerns about the member or other factors, the FHLBank will take control of sufficient collateral to fully collateralize the member’s indebtedness to the FHLBank.
The FHLBank’s potential credit risk from advances is concentrated in commercial banks, thrift institutions, insurance companies and credit unions, but also includes potential credit risk exposure to three housing associates. Table 2 presents information on the FHLBank’s five largest borrowers as of December 31, 2009 and 2008 (in thousands). If the borrower was not one of the five largest borrowers for one of the periods presented, the applicable columns are left blank. The FHLBank had rights to collateral with an estimated fair value in excess of the book value of these advances and, therefore, does not expect to incur any credit losses on these advances.
Table 2
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Table 3 presents the interest income associated with the five borrowers with the highest interest income for the years ended December 31, 2009 and 2008 (in thousands). If the borrower was not one of the five borrowers representing the highest interest income for one of the periods presented, the applicable columns are left blank.
Table 3
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Total advance income excludes net interest settlements on derivatives hedging the advances.
Investments
The FHLBank maintains a portfolio of investments for liquidity and income purposes and to invest its capital within the established statutory and regulatory limits. The FHLBank maintains a portfolio of short-term loans to and investments in highly rated institutions, including overnight Federal funds, term Federal funds, interest-bearing certificates of deposit, bank notes and commercial paper. The FHLBank maintains a longer-term investment portfolio, which includes securities issued by the U.S. government, U.S. government agencies and GSEs as well as MBS that are issued by U.S. government agencies and housing GSEs (GSE securities are not explicitly guaranteed by the U.S. government) or privately issued MBS that carry the highest ratings from Moody’s, Fitch or S&P at date of acquisition.
The FHLBank is prohibited from investing in certain types of securities including:
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Instruments, such as common stock, that represent an ownership in an entity, other than stock in small business investment companies or certain investments targeted to low-income persons or communities;
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Instruments issued by non-U.S. entities other than those issued by U.S. branches and agency offices of foreign commercial banks;
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Non-investment-grade debt instruments other than certain investments targeted to low-income persons or communities, and instruments that were downgraded after purchase by the FHLBank;
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Whole mortgages or other whole loans other than: (1) those acquired under the FHLBank’s MPF Program; (2) certain investments targeted to low-income persons or communities; (3) certain marketable direct obligations of state, local, or tribal government units or agencies, having at least the second highest credit rating from a Nationally-Recognized Statistical Rating Organization (NRSRO); (4) MBS or asset-backed securities (ABS) backed by manufactured housing loans or home equity loans; and (5) certain foreign housing loans authorized under section 12(b) of the Bank Act; and
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Non-U.S. dollar denominated securities.
The Finance Agency limits the FHLBank’s total investment in MBS by requiring that the total book value of MBS owned by the FHLBank not exceed 300 percent of the FHLBank’s previous month-end total regulatory capital on the day it purchases the securities. The definition of total regulatory capital for the MBS limitation includes mandatorily redeemable capital stock, which is reclassified as a liability under generally accepted accounting principles in the United States of America (GAAP), but excludes accumulated other comprehensive income. Under Finance Board Resolution 2008-08, the FHLBanks were granted temporary authority to increase MBS up to 600 percent of previous month-end total regulatory capital under specific conditions. See Item 7 - “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Balance Sheet Analysis - Investments” for further discussion of Finance Board Resolution 2008-08 and actions taken by the FHLBank. The FHLBank is prohibited from purchasing:
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Interest-only or principal-only stripped MBS, CMOs, real estate mortgage investment conduits (REMICs) and eligible ABS;
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Residual-interest or interest-accrual classes of CMOs, REMICs and eligible ABS; and
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Fixed rate MBS, CMOs, REMICs and eligible ABS, or floating rate MBS, CMOs, REMICs and eligible ABS that on the trade date are at rates equal to their contractual cap or that have average lives which vary by more than six years under an assumed instantaneous interest rate change of 300 basis points (bps).
Mortgage Loans Held for Portfolio
The FHLBank purchases or funds various mortgage products from or through its members under the MPF Program. Under the MPF Program, the FHLBank invests in qualifying five- to 30-year conventional conforming and government-insured or guaranteed (by the Federal Housing Administration (FHA), the Department of Veterans Affairs (VA), the Rural Housing Service of the Department of Agriculture (RHS) and the Department of Housing and Urban Development (HUD)) fixed rate mortgage loans on 1-4 family residential properties. Based upon members’ preferences, they may elect to retain or sell servicing rights. Subsequent to any primary mortgage insurance (PMI), the FHLBank and the member share in the credit risk of the loans with the FHLBank assuming the first layer of loss coverage as defined by the First Loss Account (FLA). The member assumes mortgage loan losses in excess of the FLA up to the amount of the credit enhancement obligation (CE obligation) as specified in a master commitment agreement for each pool of mortgage loans purchased from the member. Any losses in excess of the FLA and the CE obligation will be the responsibility of the FHLBank. All loss allocations among members and the FHLBank are based upon specific pools of loans covered by each master commitment agreement between the two parties. Members’ CE obligations must be fully collateralized with assets considered acceptable by FHLBank policy. See Item 1 - “Business - Advances” for a discussion of eligible collateral.
The MPF Program incorporates the following broad underwriting and eligibility guidelines with respect to MPF loans:
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Loans must be conforming loan size, which is established annually by the Finance Agency, as required by the Acquired Member Assets (AMA) Regulation and may not exceed the loan limits set each year by the Finance Agency for the other housing GSEs (e.g., Fannie Mae and Freddie Mac);
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Loans must be fixed rate, fully-amortizing loans with terms from 5 to 30 years (5 to 30 years for service retained loans and 10 to 30 years for service released loans);
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Loans are required to be secured by first liens on residential, owner-occupied, primary 1-4 family residences and second homes (primary residences may be up to four units);
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Condominiums, planned unit developments and manufactured homes are acceptable property types as are mortgages on leasehold estates (although manufactured homes must be on land owned in fee simple by the borrower);
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A maximum loan-to-value ratio (LTV) of 95 percent is permitted, except for FHLBank approved AHP mortgage loans which may have LTVs up to 100 percent (but may not exceed 105 percent total LTV, which compares the property value to the total amount of all mortgages outstanding against a property) and Government MPF Loans, which may not exceed the LTV limits established by the FHA, VA, HUD Section 184 and USDA Guaranteed Rural Housing (GRH) Section 502;
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For each conventional mortgage, which has an LTV of more than 80 percent, standard mortgage insurance issued by an MPF-approved mortgage insurer with no lower than a “AA-” rated claims paying ability assigned by S&P is required;
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Borrowers must be of legal age and capacity to contract for a mortgage;
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Only current production loans (no more than 12 principal and interest payments made by the borrower for servicing retained loans of 10 days or less from the closing date for servicing released loans) are eligible;
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Eligible loan purposes include purchase transactions, cash-out refinances and no-cash-out refinances;
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Credit reports are required with at least two credit scores for each borrower; for borrowers with no credit score, alternative verification of credit is permitted;
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Housing expense should be no greater than 33 percent of gross monthly income and total debt, when including the housing expense, should be no greater than 38 percent of gross monthly income (higher qualifying ratios may be appropriate in some cases);
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Income and other sources of funds, if applicable, must be verified;
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Complete and customary independent property appraisals are required to determine the fair market value of each property;
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Customary property or hazard insurance, and flood insurance, if applicable, must be obtained from insurers acceptably rated as detailed in the MPF Origination Guide;
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Title insurance or, in those areas where title insurance is not customary, an attorney’s opinion of title must be provided to assure the first lien and clear title status of each mortgage. Title insurance is to be provided by an acceptably rated title insurance company as provided in the MPF Guides. Title insurance must be for at least the original principal balance of the MPF loan and on the most current American Land Title Company policy form with applicable endorsements;
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The mortgage documents, mortgage transaction, and mortgaged property must comply with all applicable laws, and loans must be documented using standard Fannie Mae/Freddie Mac uniform instruments;
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Loans that cannot be rated by a rating agency are not eligible for delivery under the MPF Program; and
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Loans that are classified as high cost, high rate, high risk, Home Ownership and Equity Protection Act loans or loans in similar categories defined under predatory or abusive lending laws are not eligible.
A participating member is referred to as a Participating Financial Institution (PFI). Each PFI deals directly with the FHLBank in offering individual or pools of eligible mortgage loans for sale to or funding through the FHLBank under the MPF Program. The FHLBank in turn may purchase or fund some or all of the eligible loans and may offer participations in these mortgage loans to other MPF FHLBanks. The FHLBank has not sold any participation interests in MPF loans to any other FHLBank for the three-year period ended December 31, 2009. Securitized loan pools are not acceptable mortgage assets under the MPF Program. Every PFI provides a measure of credit-loss protection to the FHLBank on mortgage loans generated by the PFI through the MPF Program. In return, the PFI receives a credit enhancement fee (CE fee), which is paid to the PFI monthly based upon the unpaid principal balance of MPF loans outstanding. The credit risk of the mortgage loans is managed by distributing potential credit losses into certain layers and allocating that risk between the borrower, and if applicable, private mortgage insurers, the FHLBank and the PFI.
Under the MPF Program, the first layer of potential credit loss is absorbed by the borrower’s equity in the real estate securing the loan. As is customary for conventional mortgage loans, PMI is required for MPF loans with down payments of less than 20 percent of the property value in order to raise the effective equity level to at least 20 percent. Losses beyond the borrower’s equity layer, including any PMI, are absorbed by the FHLBank up to the FLA predefined limit for each pool of mortgages covered by a master commitment agreement. If losses beyond the FLA layer are incurred for a pool, they are absorbed by the PFI through the CE obligation for that pool provided by the PFI that sold the mortgage loans to the FHLBank. The CE obligation provided by the PFI ensures that the PFI retains a credit stake in the loans it sells to the FHLBank. For managing this risk, the PFI receives monthly CE fees from the FHLBank. The size of each PFI’s CE obligation for a master commitment agreement is calculated on the pool of mortgage loans sold under the MPF Program by the PFI in such a way that the FHLBank is in a position equivalent to that of an investor in a AA-rated MBS. The CE obligation of the PFI and the CE fee paid by the FHLBank are integral parts of the MPF mortgage loans and cannot be stripped off or otherwise separated from the underlying mortgage loans. The actual loss allocation between each PFI and the FHLBank is based upon the specific pool of mortgage loans covered by each master commitment agreement between the two parties.
Since the inception of the MPF Program, the FHLBank has incurred credit losses on MPF loans that are well below national averages. Credit losses under the FLA are defined differently than losses for financial reporting purposes. The differences reside in the timing of the recognition of the loss and how the components of the loss are recognized. Under the FLA, a credit loss is the difference between the recorded loan value and the total proceeds received from the sale of an MPF property after paying any associated expenses. The credit loss is recognized upon sale of the mortgaged property. For financial reporting purposes, when an MPF loan is deemed a loss loan, the difference between the recorded loan value and the appraised value of the property securing the loan (fair market value) less the estimated costs to sell is recognized as a charge to the Allowance for Credit Losses on Mortgage Loans in the period the loss status is assigned to the loan. After foreclosure, any expenses associated with carrying the loan until sale are recognized as Other Real Estate Owned (OREO) expenses in the current period.
A PFI can take advantage of the MPF Program either by selling previously closed loans to the FHLBank or by providing loans on a flow basis. A flow basis loan is also referred to as a “table funded loan,” which means that the PFI has the FHLBank’s funds available to make the mortgage loan to the borrower; the PFI closes the loan “as agent” for the FHLBank and never owns the loan. A variety of MPF products have been developed to meet the differing needs of the FHLBank’s members, but they are all premised on the same risk-sharing concept.
The FHLBank currently has loans or loan commitments under various product types designated as Original MPF, MPF 100, MPF 125, MPF Plus and Original MPF for Government Loans, which are described below:
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Under Original MPF (closed loans), the first layer of shared loss is absorbed by the FHLBank’s FLA. The FLA for this product increases monthly based upon a percentage of the unpaid principal of outstanding mortgage loans (four bps per annum) over the life of a master commitment agreement for the applicable pool of loans. The second shared loss layer is absorbed by the PFI’s CE obligation for that master commitment. Any loan losses beyond the first two shared loss layers for each master commitment are absorbed by the FHLBank;
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Under MPF 100 (table funded loans), the first layer of shared loss is absorbed by the FHLBank’s FLA, which is equal to 1.0 percent (100 bps) of the aggregate principal balance of the loans funded. The second shared loss layer is absorbed by the PFI’s CE obligation for that master commitment. Any loan losses beyond the first two shared loss layers are absorbed by the FHLBank;
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Under MPF 125 (closed loans), the first layer of shared loss is absorbed by the FHLBank’s FLA, which is equal to 1.0 percent (100 bps) of the aggregate principal balance of the loans funded. The second shared loss layer is absorbed by the PFI’s CE obligation for that master commitment. Any loan losses beyond the first two shared loss layers are absorbed by the FHLBank;
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Under MPF Plus (closed loans), the first layer of shared loss is absorbed by the FHLBank’s FLA, which is equal to a specified percentage of the aggregate principal balance of loans in the pool as of the sale date. The second shared loss layer is absorbed by the PFI’s CE obligation for that master commitment. The PFI meets all or a portion of its CE obligation through a supplemental mortgage insurance (SMI) policy. Additional losses not covered by the FLA, the SMI policy or any remaining PFI CE obligation not covered by the SMI are absorbed by the FHLBank; and
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Under Original MPF for Government Loans (closed loans), the loans are insured or guaranteed by the FHA, VA, HUD or RHS. This product has no FLA or CE obligation. The PFI is responsible for all unreimbursed servicing expenses.
For all of the above MPF products except Original MPF for Government Loans, the PFI’s CE obligation is calculated to provide a second loss credit enhancement up to a “AA” rating equivalent for the pool of mortgages. As mentioned previously, any loss allocation between each PFI and the FHLBank is based upon the specific pool of loans covered by each master commitment between the two parties.
Table 4 includes the percentage of principal outstanding balance by each MPF product in the FHLBank’s MPF loan portfolio as of December 31, 2009, 2008 and 2007:
Table 4
The FHLBank’s FLA for an Original MPF product master commitment is initially zero on the day the first MPF loan is purchased, but increases monthly based on the unpaid principal balance. The monthly addition is calculated by taking the unpaid principal balance of loans on the FHLBank’s books (prorated) at the end of the month multiplied by four bps and dividing that product by 12. This calculation is completed for each master commitment. Master commitments are generally considered loan pools for the purposes of FLA, credit enhancements and loan loss allocations. The FHLBank’s FLA for the MPF 100 and MPF 125 product master commitments is calculated by taking 100 bps times the loan amount funded or purchased. In the event of a loss on the sale of a foreclosed property, the FHLBank’s FLA absorbs losses after the coverage provided by the borrower’s equity in the property and PMI, if applicable. The FHLBank’s final exposure to risk in each of the MPF products listed, except Original MPF for Government Loans, is subject to the amount of CE obligation borne by the PFI for the specific loan pool.
Table 5 presents a comparison of the different characteristics for each of the MPF products as of December 31, 2009:
Table 5
Product Name
Size of the FHLBank’s FLA
PFI CE Obligation Description
CE Fee
Paid to PFI
CE Fee Offset?1
Servicing Fee
to PFI
Original MPF
4 bps added each year based on the unpaid balance
After FLA, to bring to the equivalent of “AA”
10 bps/year paid monthly
No
25 bps/year
MPF 100
100 bps fixed based on gross fundings at closing
After FLA, to bring to the equivalent of “AA”
7 to 10 bps/year paid monthly; performance based after 3 years
Yes; after first 3 years, to the extent recoverable in future years
25 bps/year
MPF 125
100 bps fixed based on gross fundings at closing
After FLA, to bring to the equivalent of “AA”
7 to 10 bps/year paid monthly; performance based
Yes; to the extent recoverable in future years
25 bps/year
MPF Plus
Sized to equal expected losses
0 to 20 bps after FLA and SMI, to bring to the equivalent of “AA”
7 bps/year plus 6 to 7 bps/year; performance based (delayed for 1 year); all fees paid monthly
Yes; to the extent recoverable in future years
25 bps/year
Original MPF for
Government Loans
N/A
N/A (unreimbursed servicing expenses only)
N/A2
N/A
44 bps/year
Future payouts of performance-based CE fees are reduced when losses are allocated to the FLA. The offset is limited to fees payable in a given year but could be reduced in subsequent years. The overall reduction is limited to the FLA amount for the life of the pool of loans covered by a master commitment agreement.
Two government master commitments have been grandfathered and paid 2 bps/year. All new government master commitments are not paid a CE fee.
Table 6 presents an illustration of the FLA and CE obligation calculation for each conventional MPF product type listed as of December 31, 2009:
Table 6
Product Name
FLA
CE Obligation Calculation
Original MPF
4 bps x unpaid principal, annually1
(LLCE2 x PSF3) x Gross Fundings
MPF 100
100 bps x loan funded amount
((LLCE x PSF) - FLA) x Gross Fundings
MPF 125
100 bps x loan funded amount
((LLCE x PSF) - FLA) x Gross Fundings
MPF Plus
5 x variable CE Fee
AA equivalent - FLA-SMI4 = PCE5
Starts at zero and increases monthly over the life of the master commitment.
LLCE represents the weighted average loan level credit enhancement score of the loans sold into the pool of loans covered by the master commitment agreement.
The S&P Level’s Pool Size Factor (PSF) is applied at the MPF FHLBank level against the total of loans in portfolio. A PSF is greater than one if the number of loans in portfolio is less than 300 in total.
SMI represents the coverage obtained from the supplemental mortgage insurer. The initial premium for the insurance is determined based on a sample $100 million loan pool. The final premium determination is made during the 13th month of the master commitment agreement, at which time any premium adjustment is determined based on actual characteristics of loans submitted. The SMI generally covers a portion of the PFI’s CE obligation which typically ranges from 200 to 250 bps of the dollar amount of loans delivered into a mortgage pool, but the PFI may purchase an additional level of coverage to completely cover the PFI’s CE obligation. The CE fees paid to PFIs for this program are capped at a maximum of 14 bps, which is broken into two components, fixed and variable. The fixed portion of the CE fee is paid to the SMI insurer for the coverage discussed above, and is a negotiated rate depending on the level of SMI coverage, ranging from 6 to 8 bps. The variable portion is paid to the PFI, and ranges from 6 to 8 bps, with payments commencing the 13th month following initial loan purchase under the master commitment agreement.
PCE represents the CE obligation that the PFI wishes to retain rather than covering with SMI. Under this MPF product, the retained amount can range from 0 to 20 bps.
On April 23, 2008, the FHLBank of Chicago announced that it would no longer purchase mortgage loans from its PFIs under the MPF Program after July 31, 2008. In anticipation of the FHLBank of Chicago ceasing to purchase mortgage loans after July 31, 2008 and in order to minimize potential disruptions in the MPF Program, the FHLBank executed a short-term agreement on July 1, 2008 with the FHLBank of Chicago to acquire up to $300 million in participation interests in mortgage loans originated by specific PFIs in the Chicago district. Under the agreement, all delivery commitments from the selected Chicago district PFIs were to be issued between July 1 and October 31, 2008. During 2008, the FHLBank acquired $231.9 million of out-of-district mortgage loans under this agreement.
On September 23, 2008, the FHLBank of Chicago officially announced to its members the rollout of an MPF product (MPF Xtra) that would provide its members with access to the secondary mortgage market without adding to the interest rate risk on the FHLBank of Chicago’s balance sheet. An agreement was executed with Fannie Mae as the first non-FHLBank investor in MPF assets, and participation by Chicago PFIs was made available beginning November 1, 2008. Since that time, the FHLBank has not acquired any participation interests in mortgage loans originated by PFIs in the Chicago district and currently has no plan to do so in the future.
Quarterly, the FHLBank performs and documents a financial analysis of all PFIs through which the FHLBank has purchased loan participations. This analysis addresses the PFI’s capital, asset quality and earnings. This review also includes a reconfirmation that the PFI continues to meet the four suitability standards/ratios used initially in the PFI approval process. The four suitability standards and their acceptable parameters are: (1) leverage capital ratio greater than or equal to 5 percent; (2) risk-based capital ratio greater than or equal to 9 percent; (3) loan loss reserves to non-performing loans ratio greater than or equal to 75 percent; and (4) non-performing assets to net loans ratio less than or equal to 2 percent. If the PFI fails either of the asset quality ratios (last two of the four parameters), further analysis is conducted on the ratios to determine if only 1-4 family real estate loans are included in the calculation. If the analysis discloses any area of significant concern about the PFI’s operations or condition, the FHLBank determines if any further actions are necessary. For in-district PFIs, possible actions include increasing PFI quality controls and limiting Master Commitment terms. For out-of-district PFIs, possible actions include taking action to further perfect the FHLBank’s security interest since we have discontinued purchasing out-of-district mortgage loans.
FHLBank Topeka does not provide servicing of the acquired mortgage loans. However, the MPF Program allows the PFI to sell the servicing to an MPF-approved servicer. The approved servicer pays the PFI a service-released premium by the fifth business day of the month following the servicer’s boarding the loan onto its servicing system. Also, a PFI may subcontract the servicing function to an approved MPF subservicer. All servicing-retained and servicing-released PFIs are subject to the rules and requirements set forth in the MPF Servicing Guide.
As of December 31, 2009, one FHLBank Topeka PFI and one out-of-district PFI have been approved to acquire servicing rights for FHLBank PFIs under the MPF Program on a concurrent basis. This limitation may reduce the attractiveness of the MPF Program to potential PFIs that do not want to retain servicing; however, a PFI may negotiate with other PFIs to purchase servicing rights.
A majority of the states, and some municipalities, have enacted laws against mortgage loans considered predatory or abusive. Some of these laws impose liability for violations not only on the originator, but also upon purchasers and assignees of mortgage loans. The FHLBank takes measures that it considers reasonable and appropriate to reduce its exposure to potential liability under these laws and is not aware of any claim, action or proceeding asserting that the FHLBank is liable under these laws. However, there can be no assurance that the FHLBank will never have any liability under predatory or abusive lending laws.
Debt Financing - Consolidated Obligations
Consolidated obligations, consisting of bonds and discount notes, are the FHLBank’s primary sources of liabilities and represent the principal funding source used by the FHLBank to fund its advances and mortgage programs and to purchase investments. Consolidated obligations are the joint and several obligations of the FHLBanks, backed only by the financial resources of the 12 FHLBanks. Consolidated obligations are not obligations of the U.S. government, and the U.S. government does not guarantee them. The capital markets have traditionally considered the FHLBanks’ obligations as “Federal agency” debt. Consequently, although the U.S. government does not guarantee the FHLBanks’ debt, the FHLBanks have historically had reasonably stable access to funding at relatively favorable spreads to U.S. Treasuries. The FHLBank’s ability to access the capital markets through the sale of consolidated obligations, across the entire maturity spectrum and through a variety of debt structures, assists the FHLBank in managing its balance sheet effectively and efficiently. Moody’s currently rates the FHLBank consolidated obligations Aaa/P-1, and S&P currently rates them AAA/A-1+. These ratings measure the likelihood of timely payment of principal and interest on consolidated obligations and also reflect the 12 FHLBanks’ status as GSEs, which generally implies the expectation of a very high degree of support by the U.S. government even though its obligations are not guaranteed by the U.S. government.
One of the key measures of performance for a financial institution is the measure of the ability of the institution to cover or make the required payments on its fixed charges. Table 7 documents the FHLBank’s ratio of earnings to fixed charges computation for the years ended December 31, 2009, 2008, 2007, 2006 and 2005 (in thousands):
Table 7
Fixed charges consist of interest expense including amortization of premiums, discounts and concessions related to indebtedness - See Item 8 “Financial Statements and Supplementary Data” for additional information.
The ratio of earnings to fixed charges has been computed by dividing total earnings by fixed charges.
Finance Agency regulations govern the issuance of debt on behalf of the FHLBanks and related activities, and authorize the FHLBanks to issue consolidated obligations, through the Office of Finance as their agent, under the authority of Section 11(a) of the Bank Act. No FHLBank is permitted to issue individual debt under Section 11(a) without Finance Agency approval. The FHLBank is primarily and directly liable for the portion of consolidated obligations issued on its behalf. In addition, the FHLBank is jointly and severally liable with the other 11 FHLBanks for the payment of principal and interest on the consolidated obligations of all 12 FHLBanks under Section 11(a). The Finance Agency, at its discretion, may require any FHLBank to make principal or interest payments due on any consolidated obligations for which the FHLBank is not the primary obligor. Although it has never occurred, to the extent that an FHLBank would be required to make a payment on a consolidated obligation on behalf of another FHLBank, the paying FHLBank would be entitled to reimbursement from the non-complying FHLBank. However, if the Finance Agency determines that the non-complying FHLBank is unable to satisfy its obligations, then the Finance Agency may allocate the non-complying FHLBank’s outstanding consolidated obligation debt among the remaining FHLBanks on a pro rata basis in proportion to each FHLBank’s participation in all consolidated obligations outstanding, or on any other basis the Finance Agency may determine. If the principal or interest on any consolidated obligation issued on behalf of an individual FHLBank is not paid in full when due, the FHLBank may not pay dividends to, or redeem or repurchase shares of stock from, any member of that individual FHLBank.
On April 18, 2006 in Finance Board Resolution Number 2006-06, the Finance Board voted to approve a request from the FHLBank of Chicago to issue subordinated debt for which it would be the sole obligor. Consistent with the resolution, the FHLBank of Chicago issued $1.0 billion in subordinated debt in June 2006 as part of a plan to facilitate an orderly redemption by the FHLBank of Chicago of excess stock held by its member institutions. As of the date of this filing, the FHLBank of Chicago had $1.0 billion of 10-year subordinated notes outstanding.
Prior to 2009, the FHLBank did not incur any direct obligation with respect to consolidated obligations unless it agreed in advance to accept the funding, pursuant to Finance Agency regulations. In some issuance situations, the FHLBank may receive all of the proceeds from a particular issuance of consolidated obligations, but in other cases the proceeds may be divided among several FHLBanks. In addition to an explicit agreement to accept funding, the FHLBank agreed in the fourth quarter of 2008 to accept its allocation of proceeds from scheduled monthly issuances of FHLBank mandated global bullet consolidated obligations (fixed rate, non-callable debt issuances of $1 billion or more) after January 1, 2009. This allocation might be based on the needs specified by the FHLBank, but it also might be based on relative capital of the FHLBank if FHLBank system demand is below or exceeds the minimum size of issuance. This agreement, initially established to support the adoption of a monthly calendar for scheduled 2009 mandated global bullet consolidated obligation issuance remains in effect for 2010. The FHLBanks have the option to pass on any scheduled mandated global bullet consolidated obligation issuance date if eight or more of the FHLBanks agree to pass.
Table 8 presents the par value of the FHLBank’s consolidated obligations and the combined consolidated obligations of the 12 FHLBanks as of December 31, 2009 and 2008 (in millions):
Table 8
Finance Agency regulations provide that the FHLBank must maintain aggregate assets of the following types, free from any lien or pledge, in an amount at least equal to the amount of consolidated obligations outstanding:
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Cash;
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Obligations of, or fully guaranteed by, the U.S government;
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Secured advances;
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Mortgages, which have any guaranty, insurance or commitment from the U.S. government or any agency of the U.S. government;
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Investments described in Section 16(a) of the Bank Act, which, among other items, includes securities that a fiduciary or trust fund may purchase under the laws of the state in which the FHLBank is located; and
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Other securities that are assigned a rating or assessment by an NRSRO that is equivalent to or higher than the rating on consolidated obligations, except securities specifically prohibited in the Investments section of Item 1 - “Business - Investments.”
Table 9 illustrates the FHLBank’s compliance with the Finance Agency’s regulations for maintaining aggregate assets at least equal to the amount of consolidated obligations outstanding for December 31, 2009 and 2008 (in thousands):
Table 9
The Office of Finance has responsibility for facilitating and executing the issuance of the consolidated obligations on behalf of the 12 FHLBanks. It also prepares the 12 FHLBanks’ Combined Quarterly and Annual Financial Reports, services all outstanding debt, serves as a source of information for the FHLBanks on capital market developments, administers REFCORP and the Financing Corporation, and manages the FHLBanks’ relationship with the NRSROs with respect to ratings on consolidated obligations.
Consolidated Bonds. Consolidated bonds satisfy the FHLBank’s term funding needs. Typically, the maturities of these bonds range from one year to 15 years, but the maturities are not subject to any statutory or regulatory limit. Consolidated bonds can be issued and distributed through negotiated or competitively bid transactions with approved underwriters or selling group members.
The FHLBank utilizes the TAP Issue Program for fixed rate, non-callable (bullet) bonds. This competitive auction program uses specific maturities that may be reopened daily during the initial three-month period after the original issue date and as needed through the remaining life of the bond. The goal of the TAP Issue Program is to aggregate frequent smaller issues into a larger bond issue thus giving the larger bond issue greater market liquidity. The FHLBank uses the TAP program primarily to fund non-callable (bullet) advances. The ability to access funding on a smaller and more frequent basis allows the FHLBank to effectively fund member advance activity and reduce interest-rate risk.
Consolidated bonds are generally issued with either fixed or variable rate payment terms that use a variety of standardized indices for interest rate resets including, but not limited to, LIBOR, Federal Funds Effective Rate, Constant Maturity Treasury (CMT) and 11th District Cost of Funds Index (COFI). In addition, to meet the specific needs of certain investors in consolidated obligations, both fixed and variable rate bonds may also contain certain embedded features, which result in complex coupon payment terms and call features. Normally, when such a complex consolidated bond is issued, the FHLBank simultaneously enters into a derivative containing offsetting features to synthetically convert the terms of the complex bond to a simple variable rate callable bond tied to one of the standardized indices.
Consolidated Discount Notes. The Office of Finance also sells consolidated discount notes on behalf of the FHLBanks to meet short- term funding needs. These securities have maturities up to one year and are offered daily through certain securities dealers in a discount note selling group. In addition to the daily offerings of discount notes, the FHLBanks auction specific amounts of discount notes with fixed maturity dates ranging from four to 26 weeks through competitive auctions held twice a week utilizing the discount note selling group. The amount of discount notes sold through the auctions varies based upon market conditions and on the funding needs of the FHLBanks. Discount notes are sold at a discount and mature at par.
Use of Derivatives
The Finance Agency’s Financial Management Policy (FMP) and the FHLBank’s Risk Management Policy (RMP) establish guidelines for the use of derivatives by the FHLBank. The FHLBank can use interest rate swaps, swaptions, interest rate cap and floor agreements, calls, puts, futures, forward contracts and other derivatives as part of its interest-rate risk management and funding strategies. These policies, along with Finance Agency regulations 12 CFR Part 956.5 and Part 956.6, prohibit trading in or the speculative use of derivatives and limit credit risk to counterparties that arises from derivatives. In general, the FHLBank has the ability to use derivatives only to reduce funding costs for consolidated obligations and to manage other risk elements such as: interest-rate risk, mortgage prepayment risk, unsecured credit risk and foreign currency risk.
The FHLBank uses derivatives in three general ways: (1) by designating them as either a fair value or cash flow hedge of an underlying financial instrument, a firm commitment or a forecasted transaction (the swapped consolidated obligation bond transactions discussed in the next paragraph fall into this category); (2) by acting as an intermediary between stockholders and the capital markets; or (3) in asset/liability management but not designated for hedge accounting. For example, the FHLBank uses derivatives in its overall interest rate risk management to adjust the interest rate sensitivity of consolidated obligations to approximate more closely the interest rate sensitivity of assets, including advances, investments and mortgage loans, and/or to adjust the interest rate sensitivity of advances, investments and mortgage loans to approximate more closely the interest rate sensitivity of liabilities. In addition to using derivatives to manage mismatches of interest rate terms between assets and liabilities, the FHLBank also uses derivatives to manage embedded options in assets and liabilities, to hedge the market value of existing assets, liabilities and anticipated transactions, to hedge the duration risk of prepayable instruments and to reduce funding costs as discussed below.
To reduce funding costs, the FHLBank frequently executes derivatives concurrently with the issuance of consolidated obligation bonds (collectively referred to as swapped consolidated obligation bond transactions). This allows the FHLBank to create synthetic variable rate debt at a cost that is often lower than the cost of a comparable variable rate cash instrument issued directly by the FHLBank. This strategy of issuing bonds while simultaneously entering into derivatives enables the FHLBank to more effectively fund the FHLBank’s variable rate assets and, in some instances, allows the FHLBank to offer a wider range of attractively priced advances to its members than would otherwise be possible. The continued attractiveness of these swapped consolidated obligation bond transactions depends on price relationships in both the FHLBank consolidated obligation market and the derivatives market, primarily the interest rate swap market. If conditions in these markets change, the FHLBank may alter the types or terms of the bonds issued and derivatives transacted to better match its assets, to meet its customer needs and to improve its funding costs.
The FHLBank uses interest rate caps and floors, swaptions and callable swaps to manage and hedge prepayment and option risk on the MBS and CMOs held in the FHLBank’s held-to-maturity portfolio. Although these derivatives are valid economic hedges against the prepayment and option risk of the portfolio of MBS and CMOs, they are not specifically linked to individual investment securities and, therefore, do not receive either fair value or cash flow hedge accounting. The derivatives are marked-to-market through earnings. The FHLBank frequently purchases interest rate caps with various terms and strike rates to manage embedded interest rate caps in variable rate MBS and CMOs.
Other common ways in which the FHLBank uses derivatives to manage its assets and liabilities are:
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To preserve a favorable interest rate spread between the yield of an asset (e.g., an advance) and the cost of the supporting 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 if there are non-parallel changes in the interest rate on the advance and/or the interest rate on the bond, or if the rates change at different times;
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To mitigate the adverse earnings effects of the contraction or extension of certain assets (e.g., advances or mortgage assets) and liabilities; and
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To protect the value of existing asset or liability positions or of anticipated transactions.
See Item 7 - “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Financial Review - Balance Sheet Analysis - Derivatives” and Item 7A - “Quantitative and Qualitative Disclosures About Market Risk - Risk Management - Interest Rate Risk Management” for further information on derivatives.
Deposits
The Bank Act allows the FHLBank to accept deposits from its members, housing associates, any institution for which it is providing correspondent services, other FHLBanks or other government instrumentalities. The FHLBank offers several types of deposit programs to its members and housing associates including demand, overnight and term deposits.
Liquidity Requirements. To support deposits, Finance Agency regulations require the FHLBank to have an amount equal to its current deposits invested in obligations of the U.S. government, deposits in eligible banks or trust companies, or advances with maturities not exceeding five years. In addition, the FHLBank must meet the liquidity guidelines outlined in its RMP. See Item 7 - “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Risk Management - Liquidity Risk Management” for further discussion of the FHLBank’s liquidity requirements.
Capital, Capital Rules and Dividends
The FHLBank’s capital stock and retained earnings also provide a source of funding. For the years ended December 31, 2009 and 2008, the FHLBank’s ratio of average equity to average assets was 4.3 percent and 4.2 percent, respectively.
FHLBank Capital Adequacy and Form Rules. The Gramm-Leach-Bliley Act (GLB Act) allows the FHLBanks to have two classes of stock, and each class may have sub-classes. Class A stock is conditionally redeemable on six months’ written notice from the member, and Class B stock is conditionally redeemable on five years’ written notice from the member, subject in each case to certain conditions and limitations that may restrict the ability of the FHLBanks to effectuate such redemptions. Membership is voluntary. However, other than non-member housing associates (see Item 1 - “Business - Advances”), membership is required in order to utilize the FHLBank’s credit and mortgage finance products. Members that withdraw from membership may not reapply for membership for five years.
The GLB Act and the Finance Agency rules and regulations define total capital for regulatory capital adequacy purposes as the sum of an FHLBank’s permanent capital, plus the amounts paid in by its stockholders for Class A stock; any general loss allowance, if consistent with GAAP and not established for specific assets; and other amounts from sources determined by the Finance Agency as available to absorb losses. The GLB Act and Finance Agency regulations define permanent capital for the FHLBanks as the amount paid in for Class B stock plus the amount of an FHLBank’s retained earnings, as determined in accordance with GAAP.
Under the GLB Act and the Finance Agency rules and regulations, the FHLBank is subject to risk-based capital rules. Only permanent capital can satisfy the FHLBank’s risk-based capital requirement. In addition, the GLB Act specifies a 5 percent minimum leverage capital requirement based on total FHLBank capital, which includes a 1.5 weighting factor applicable to permanent capital, and a 4 percent minimum total capital requirement that does not include the 1.5 weighting factor applicable to permanent capital. The FHLBank may not redeem or repurchase any of its capital stock without Finance Agency approval if the Finance Agency or the FHLBank’s Board of Directors determines that the FHLBank has incurred, or is likely to incur, losses that result in, or are likely to result in, charges against the capital of the FHLBank, even if the FHLBank is in compliance with its minimum regulatory capital requirements (risk-based, leverage and total capital). Therefore, a stockholder’s right to have its excess shares of capital stock redeemed is conditional on, among other factors, the FHLBank maintaining its compliance with the three regulatory capital requirements: risk-based, leverage and total capital.
See Item 7 - “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Financial Review - Capital” for additional information regarding the FHLBank’s capital plan.
Dividends. The FHLBank may pay dividends from retained earnings and current income. The FHLBank’s Board of Directors may declare and pay dividends in either cash or capital stock. Under its capital plan, all FHLBank dividends that are payable in capital stock must be paid in the form of Class B Common Stock, regardless of the class upon which the dividend is being paid.
Consistent with Finance Board guidance in Advisory Bulletin (AB) 2003-AB-08, Capital Management and Retained Earnings, the FHLBank adopted a retained earnings policy, which provides guidelines to assess the adequacy of its retained earnings in light of alternative possible future financial and economic scenarios. The FHLBank’s retained earnings target is calculated quarterly and re-evaluated by the Board of Directors as part of each quarterly dividend declaration. The FHLBank’s retained earnings policy includes detailed calculations of four components: (1) market risk, which is based upon the FHLBank’s projected dividend paying capacity under a two-year earnings analysis that includes multiple stress or extreme scenarios (amount necessary for the FHLBank to pay dividends at three-month LIBOR over the period); (2) credit risk, which requires that retained earnings be sufficient to credit enhance all of the FHLBank’s assets from their actual rating levels to the equivalent of triple-A ratings (where advances are considered to be triple-A rated); (3) operations risk, which is equal to 30 percent of the total of the market and credit risk amounts, subject to a $10 million floor; and (4) derivative hedging volatility, which is the projected income impact of derivative hedging activities under 100-basis-point shocks in interest rates (maximum derivative hedging loss under up or down shocks). The retained earnings policy was considered by the Board of Directors when dividends were declared during the last two years, but the retained earnings target calculated in accordance with the policy did not significantly affect the level of dividends declared and paid. Tables 10 and 11 reflect the quarterly retained earnings target calculations utilized during 2009 and 2008 (in thousands), respectively, compared to the actual amount of retained earnings at the end of each quarter:
Table 10
Table 11
Under the FHLBank’s retained earnings policy, any shortage of actual retained earnings with respect to the retained earnings target is to be met over a period generally not to exceed two years from the quarter-end calculation. The policy also provides that meeting the established retained earnings target shall have priority over the payment of dividends, but that the Board of Directors must balance dividends on capital stock against the period over which the retained earnings target is met. The retained earnings target level fluctuates from period to period because it is a function of the size and composition of the FHLBank’s balance sheet and the risks contained therein at that point in time. The December 31, 2008 retained earnings target, in particular the market risk component, was significantly distorted by the relationship between the target rate for overnight Federal funds established by the Federal Open Market Committee (FOMC) and three-month LIBOR as of the calculation date (retained earnings target used for the fourth quarter was calculated as of September 30, 2008, when the overnight Federal funds target rate was 2.00 percent and three-month LIBOR was 4.05 percent). The elevated level of the market risk component was deemed to be an aberration in market conditions at the time of its calculation and did not impact the level of dividends paid in the fourth quarter 2008. The FHLBank’s derivative hedging volatility component of the retained earnings target increased during 2008 as the FHLBank significantly increased its purchases of variable rate Agency CMOs with embedded interest rate caps and purchases of interest rate caps to offset the interest-rate risk of the embedded caps. While we expect that the market risk component of the retained earnings target to decrease in future periods as the existing interest rate caps approach maturity, the derivative hedging volatility component is likely to stay elevated because of the increased usage of these economic hedge instruments and may even increase if the caps increase significantly in value (adds potential downward volatility in derivative values) and/or the FHLBank purchases additional interest rate caps.
Tax Status
Although the FHLBank is exempt from all federal, state and local taxation except for real property taxes, the FHLBank is obligated to make payments to the Resolution Funding Corporation (REFCORP) in the amount of 20 percent of net earnings after operating expenses and AHP expenses. In addition, the 12 FHLBanks must set aside annually the greater of an aggregate of $100 million or 10 percent of their current year’s income before charges for AHP (but after assessments for REFCORP). In accordance with Finance Agency guidance for the calculation of AHP expense, interest expense on mandatorily redeemable capital stock is added back to income before charges for AHP (but after assessments for REFCORP). Assessments for REFCORP and AHP are equivalent to an effective minimum income tax rate of 26.5 percent, but this effective rate will be higher depending upon the amount of interest expense for mandatorily redeemable capital stock recorded by the FHLBank during the year. For the periods ended December 31, 2009, 2008 and 2007, the FHLBank’s interest expense for mandatorily redeemable capital stock was $504,000, $609,000 and $2,101,000, respectively, which did not significantly change the FHLBank’s effective tax rate for 2009, 2008 or 2007. The combined REFCORP assessments and AHP expenses were $85.5 million, $10.3 million and $54.5 million for the periods ended December 31, 2009, 2008 and 2007, respectively. Because of the FHLBank’s tax-exempt status, cash dividends paid to members do not qualify for the corporate dividends received deduction.
Other Mission-related Activities
In addition to supporting residential mortgage lending, one of the core missions of the FHLBank is to support related housing and community development. The FHLBank administers and funds a number of targeted programs specifically designed to fulfill that mission. These programs have provided housing opportunities for thousands of very low-, low- and moderate-income households and strengthened communities primarily in Colorado, Kansas, Nebraska and Oklahoma.
Affordable Housing Program (AHP). Amounts specified by the AHP requirements described in Item 1 - “Business - Tax Status” are reserved for this program. AHP provides cash grants or subsidizes the interest rate on FHLBank advances to members, creating a pool of no-cost or low-cost funds to finance the purchase, construction or rehabilitation of very low-, low- and moderate-income owner occupied or rental housing. In the case of a subsidized advance, the amount charged against the AHP liability is the present value of the differences in cash flows between the AHP advance and a hypothetical advance with an interest rate based upon the FHLBank’s estimated cost of funds rate for a comparable maturity. The discount rate for the cash flow differences is the FHLBank’s estimated cost of funds rate for a comparable maturity. Since inception of the AHP, the majority of AHP awards have been in the form of cash grants. Historically, the outstanding principal of AHP-related advances to total advances outstanding has represented a negligible percentage of the FHLBank’s total advances. In addition to the standard competition for AHP funds, customized programs under the FHLBank’s AHP include:
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Homeownership Set-Aside Program: Rural First-time Homebuyer Program (RFHP) - RFHP provides down payment, closing cost or rehabilitation cost assistance to first-time homebuyers in rural areas and rehabilitation or rebuilding cost assistance to homeowners in rural federally declared disaster areas;
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Homeownership Set-Aside Program: Targeted Ownership Program (TOP) - TOP provides down payment, closing cost or rehabilitation cost assistance in rural and urban areas to disabled first-time homebuyers or first-time homebuyer households with a disabled member of the household; and
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Homeownership Set-Aside program: Mortgage Refinancing Program (MRP) - MRP provides assistance to members to assist in refinancing first mortgages at risk of foreclosure by providing funding for closing cost and principal reduction. This program is newly authorized by the Finance Agency and expires on July 30, 2010. The funding for this use is subject to the terms and conditions of using set-aside funds for this purpose established by regulations issued by the Finance Agency.
Community Investment Cash Advance (CICA) Program. CICA loans to members specifically target underserved markets in both rural and urban areas. CICA loans represented 3.8 percent, 2.6 percent and 2.6 percent of total advances outstanding as of December 31, 2009, 2008 and 2007, respectively. Programs under the FHLBank’s CICA Program, which is not funded through the AHP, include:
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Community Housing Program (CHP) - CHP makes loans available to members for financing the construction, acquisition, rehabilitation and refinancing of owner-occupied housing for households whose incomes do not exceed 115 percent of the area’s median income and rental housing occupied by or affordable for households whose incomes do not exceed 115 percent of the area’s median income. For rental projects, at least 51 percent of the units must have tenants that meet the income guidelines, or at least 51 percent of the units must have rents affordable to tenants that meet the income guidelines. The FHLBank provides advances for CHP-based loans to members at the FHLBank’s estimated cost of funds for a comparable maturity plus a markup for administrative costs;
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Community Housing Program Plus (CHP Plus) - CHP Plus makes $25 million in loans available to members annually to help finance the construction, acquisition or rehabilitation of rental housing occupied by or affordable for households whose incomes do not exceed 80 percent of the area’s median income level. At least 51 percent of the units must have tenants that meet the income guidelines, or at least 51 percent of the units must have rents affordable to tenants that meet the income guidelines. The FHLBank provides advances for CHP Plus-based loans to members at the FHLBank’s estimated cost of funds for a comparable maturity;
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Community Development Program (CDP) - CDP provides advances to members to finance CDP-qualified member financing including loans to small businesses, farms, agri-businesses, public or private utilities, schools, medical and health facilities, churches, day care centers or for other community development purposes that meet one of the following criteria: (1) loans to firms that meet the Small Business Administration’s (SBA) definition of a qualified small business concern; (2) financing for businesses or projects located in an urban neighborhood, census tract or other area with a median income at or below 100 percent of the area median; (3) financing for businesses, farms, ranches, agri-businesses or projects located in a rural community, neighborhood, census tract or unincorporated area with a median income at or below 115 percent of the area median; (4) firms or projects located in a Federal Empowerment Zone, Enterprise Community or Champion Community, Native American Area, Brownfield Area, Federally Declared Disaster Area, Military Base Closing Area or Community Adjustment and Investment Program Area; (5) businesses in urban areas in which at least 51 percent of the employees of the business earn at or below 100 percent of the area median; or (6) businesses in rural areas in which at least 51 percent of the employees of the business earn at or below 115 percent of the area median. The FHLBank provides advances for CDP-based loans to members at the FHLBank’s estimated cost of funds for a comparable maturity plus a mark-up for administrative costs; and
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Housing and Community Development Emergency Loan Program (HELP) - HELP provides up to $25 million in advances annually for members to finance recovery efforts in federally-declared disaster areas. The FHLBank provides advances for HELP-based loans to members at the FHLBank’s estimated cost of funds for a comparable maturity.
Other Housing and Community Development Programs. The FHLBank has also established a number of other voluntary housing and community development programs specifically developed for its members. These programs are not funded through the AHP and include the following:
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Joint Opportunities for Building Success (JOBS) - The FHLBank’s Board of Directors approved up to $1,250,000 in JOBS funding during 2009 of which the FHLBank allocated $1,000,000 to assist members in promoting employment growth in their communities. Distributions totaled $975,000, and $25,000 was not used. Additionally, $25,000 was returned from the prior year. In 2008, $1,225,000 was distributed ($25,000 of which was returned in 2009), and $25,000 was not used. In 2007, the FHLBank approved and distributed $1,250,000 in JOBS funding. A charitable grant program, JOBS funds are allocated annually to support economic development projects. For 2010, the Board of Directors has again approved up to $1,250,000 in grants that may be made available under this program. The following are elements of the JOBS program: (1) funds made available to projects only through FHLBank members; (2) $25,000 maximum funding per member ($25,000 per project) annually; (3) loan pools and similar funding mechanisms are eligible to receive more than one JOBS award annually provided there is an eligible project in the pool for each JOBS application funded; (4) members and project participants agree to participate in publicity highlighting their roles as well as the FHLBank’s contribution to the project and community/region; (5) projects that appear to be “bail outs” are not eligible; and (6) members cannot use JOBS funds for their own direct benefit (e.g., infrastructure improvements to facilitate a new branch location) or any affiliate of the member;
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Community Initiative - The Community Initiative is a flexible direct grant program created to address housing and community development needs within the district that are not fully addressed by the FHLBank’s other programs. In order to provide the maximum flexibility in identifying and addressing housing and community development needs, the program does not have prescribed criteria. The funding made available by the FHLBank for the Community Initiative in 2009 was $22,000, of which $13,000 was actually used. The funding made available for the Community Initiatives in 2008 was $25,000, of which $17,000 was actually used. The funding made available for the Community Initiatives in 2007 was $60,000, of which $26,000 was actually used. The FHLBank has allocated up to $22,000 in funding for this program for 2010; and
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Rural First-time Homebuyer Education Program - The FHLBank provides up to $100,000 annually to support rural homeownership education and counseling while actively encouraging participating organizations to seek supplemental funding from other sources. Goals of the program are to support rural education and counseling in all four states in the district, especially in those areas with RFHP-participating stockholders. The FHLBank used $49,000, $50,000 and $75,000 of the available funds for this program during 2009, 2008 and 2007, respectively. For, 2010, the FHLBank has again allocated $100,000 to this program.
Competition
Advances: Demand for the FHLBank’s advances is affected by, among other things, the cost of alternative sources of liquidity available to its members, including deposits from members’ customers and existing or newly created debt programs explicitly guaranteed by the U.S. government that are available to members. The FHLBank individually competes with its members’ depositors as well as other suppliers of wholesale funding, both secured and unsecured. Such other suppliers of wholesale funds may include investment banks, commercial banks, and U.S. government lending programs. Smaller members generally have access to alternative funding sources through brokered deposits and the sale of securities under agreements to repurchase, while larger members typically have access to a broader range of funding alternatives. Large members may also have independent access to the national and global credit markets. The availability of alternative funding sources to members can significantly influence member demand for the FHLBank’s advances and can change as a result of a variety of factors including, among others, market conditions, product availability through the FHLBank, the member’s creditworthiness and availability of member collateral for other types of borrowings.
Mortgage Loans Held for Portfolio: The FHLBank is subject to significant competition in purchasing conventional, conforming fixed rate mortgage loans and government-guaranteed mortgage loans. The FHLBank faces competition in customer service, the prices paid for these assets, and in ancillary services such as automated underwriting. The most direct competition for purchasing mortgages comes from the other housing GSEs, which also purchase conventional, conforming fixed rate mortgage loans, specifically Fannie Mae and Freddie Mac. To a lesser extent, the FHLBank also competes with regional and national financial institutions that buy and/or invest in mortgage loans. These investors may seek to hold or securitize conventional, conforming fixed rate mortgage loans. The FHLBank continuously reassesses its potential for success in attracting and retaining customers for its mortgage loan products and services, just as it does with its advance products. The FHLBank competes for the purchase of mortgage loans primarily on the basis of price, products, structures and services offered.
Debt Issuance: The FHLBank also competes with the U.S. government (including debt programs explicitly guaranteed by the U.S. government), U.S. government agencies, Fannie Mae, Freddie Mac and other GSEs as well as corporate, sovereign and supranational entities for funds raised through the issuance of unsecured debt in the national and global capital markets. Collectively, Fannie Mae, Freddie Mac and the FHLBanks are generally referred to as the housing GSEs (GSE securities are not explicitly guaranteed by the U.S. government), and the cost of the debt of each can be positively or negatively affected by political, financial or other news that reflects upon any of the three housing GSEs. If the supply of competing debt products increases without a corresponding increase in demand, FHLBank debt costs may rise or less debt may be issued at the same cost than would otherwise be the case. In addition, the availability and cost of funds raised through the issuance of certain types of unsecured debt may be adversely affected by regulatory initiatives that tend to reduce investment by certain depository institutions in unsecured debt with greater price volatility or interest rate sensitivity than similar maturity fixed rate, non-callable instruments of the same issuer.
Derivatives: The sale of callable debt and the simultaneous execution of callable interest rate swaps with options that mirror the options in debt have been an important source of competitive funding for the FHLBank. As such, the depth of the markets for callable debt and mirror-image derivatives is an important determinant of the FHLBank’s relative cost of funds. There is considerable competition among high-credit-quality issuers, especially among the three housing GSEs, for callable debt and for derivatives. There can be no assurance that the current breadth and depth of these markets will be sustained.
Regulatory Oversight, Audits and Examinations
General: The FHLBank is supervised and regulated by the Finance Agency, which is an independent agency in the executive branch of the U.S. government. Prior to July 30, 2008, the Finance Board, an independent agency in the executive branch of the United States Government, supervised and regulated the FHLBanks and the Office of Finance. Upon enactment of the Recovery Act on July 30, 2008, the Finance Agency became the new regulator for the FHLBanks as well as Fannie Mae and Freddie Mac. The Finance Board was merged into the Finance Agency as of October 27, 2008. The Finance Agency is responsible for providing effective supervision, regulation and housing mission oversight of the FHLBank to promote its safety and soundness, support housing finance and affordable housing, and support a stable and liquid mortgage market. The Finance Agency is headed by a director appointed by the President of the United States for a five-year term, with the advice and consent of the Senate. The Director has designated and prescribed functions, powers and duties to a Deputy Director responsible for explicit oversight of the FHLBanks. Currently, these positions are occupied by an acting Director and an acting Deputy Director. The Federal Housing Finance Oversight Board advises the Director with respect to overall strategies and policies in carrying out the duties of the Director. The Federal Housing Finance Oversight Board is comprised of the Secretary of the Treasury, Secretary of HUD, Chairman of the Securities and Exchange Commission (SEC) and the Director, who serves as the Chairperson of the Board. The Finance Agency is funded in part through assessments from the 12 FHLBanks, with the remainder of its funding provided by Fannie Mae and Freddie Mac; no tax dollars or other appropriations support the operations of the Finance Agency or the FHLBanks. To assess the safety and soundness of the FHLBank, the Finance Agency conducts annual, on-site examinations of the FHLBank, as well as periodic on-site and off-site reviews. Additionally, the FHLBank is required to submit monthly information on its financial condition and results of operations to the Finance Agency. This information is available to all FHLBanks.
The Government Corporation Control Act provides that, before a government corporation issues and offers obligations to the public, the Secretary of the Treasury shall prescribe the form, denomination, maturity, interest rate and conditions of the obligations; the manner and time issued; and the selling price. Prior to the third quarter of 2008, the Bank Act authorized the Secretary of the Treasury, at his or her discretion, to purchase consolidated obligations up to an aggregate principal amount of $4 billion. No borrowings under this authority have been outstanding since 1977. During the third quarter of 2008, each FHLBank entered into a Lending Agreement with the U.S. Treasury in connection with the U.S. Treasury’s establishment of the Government Sponsored Enterprise Credit Facility (GSECF), as authorized by the Recovery Act. The FHLBank signed its Lending Agreement on September 8, 2008. The GSECF was designed to serve as a contingent source of liquidity for the housing GSEs, including each of the 12 FHLBanks. The GESCF expired on December 31, 2009. No FHLBank drew on this available source of liquidity during its term. The U.S. Treasury receives the Finance Agency’s annual report to Congress, monthly reports reflecting securities transactions of the FHLBanks, and other reports reflecting the operations of the FHLBanks.
Audits and Examinations: The FHLBank has an internal audit department and the FHLBank’s Board of Directors has an audit committee. The Director of Internal Audit reports directly to the Board of Director’s Audit Committee. In addition, an independent registered public accounting firm audits the annual financial statements of the FHLBank. The independent registered public accounting firm conducts these audits following standards of the Public Company Accounting Oversight Board (United States) and Government Auditing Standards issued by the Comptroller General. The FHLBanks, the Finance Agency and Congress all receive the audit reports. The FHLBank must submit annual management reports to Congress, the President of the United States, the Office of Management and Budget, and the Comptroller General. These reports include a statement of financial condition, a statement of operations, a statement of cash flows, a statement of internal accounting and administrative control systems, and the report of the independent public accounting firm on the financial statements.
The Comptroller General has authority under the Bank Act to audit or examine the Finance Agency and the individual FHLBanks and to decide the extent to which they fairly and effectively fulfill the purposes of the Bank Act. Furthermore, the Government Corporation Control Act provides that the Comptroller General may review any audit of the financial statements conducted by an independent public accounting firm. If the Comptroller General conducts such a review, then he or she must report the results and provide his or her recommendations to Congress, the Office of Management and Budget, and the applicable FHLBank. The Comptroller General may also conduct his or her own audit of any financial statements of any individual FHLBank.
Personnel
As of March 15, 2010, the FHLBank had 192 employees. The employees are not represented by a collective bargaining unit and the FHLBank considers its relationship with its employees good.
Legislation and Regulatory Developments
Future Legislation: Various legislation, including proposals to substantially change the regulatory system for the FHLBanks and other housing GSEs, is from time to time introduced in Congress. Such proposed legislation may change applicable statutes and our operating environment in substantial and unpredictable ways. If enacted, legislation could increase or decrease the cost of doing business, limit or expand permissible activities or affect the competitive balance among the FHLBanks and other housing GSEs. We cannot predict whether any of this potential legislation will be enacted and, if enacted, the effect that it, or any implementing regulations, could have on our business, results of operations or financial condition.
SEC Publishes Final Rule Amending the Rules Governing Money Market Funds: On March 4, 2010, the SEC published a final rule, which amends the rules governing money market funds under the Investment Company Act. The amendments tighten the risk-limiting conditions of Rule 2a-7 by requiring money market funds to maintain a portion of their portfolios in instruments that can be readily converted to cash, reduce the weighted average maturity of portfolio holdings, limit the weighted average final maturity of the portfolio holding regardless of reset dates of adjustable rate securities and limit funds to investing in the highest quality portfolio securities. Application of the rule as it was originally proposed would have excluded FHLBank discount notes, other than overnight discount notes, in the definition of both “daily and weekly liquid assets.” However, the application of the final rule will encompass FHLBank overnight discount notes in the definition of “daily liquid assets” and “weekly liquid assets” and will encompass consolidated obligation discount notes with remaining maturities up to 60 days in the definition of “weekly liquid assets.” The SEC also reduced the maximum weighted average maturity of a money market fund’s portfolio from 90 days to 60 days. Additionally, the SEC’s new rule adopted a maximum weighted average life to maturity of a money market fund’s portfolio of 120 days which was designed to limit the ability of money market funds to invest in longer-term floating rate securities.
Finance Agency Publishes Proposed Rule on Community Financial Institution Collateral. On February 23, 2010, the Finance Agency published a notice of proposed rulemaking to implement Section 1211 of the Recovery Act. Section 1211 expanded the types of eligible collateral that CFIs may pledge to secure FHLBank advances to include secured loans for community development activities and allows FHLBanks to make long-term advances to CFI members for purposes of financing community development activities.
The Finance Agency proposes to implement Section 1211 by defining “community development” and “community development loan.” “Community development loan” is defined in the proposed regulation as a loan that has as its primary purpose community development. “Community development” is defined as the term “community development” is defined by the CFI’s primary federal regulator. Federal regulators generally define “community development” as: (1) affordable housing for low- or moderate-income individuals; (2) community services targeted to low- or moderate-income individuals; (3) activities that promote economic development by financing businesses or farms under a certain size; and (4) activities that revitalize or stabilize low- or moderate-income geographies, designated disaster areas, or distressed or underserved nonmetropolitan middle-income geographies. Comments on the proposed rulemaking are due by April 26, 2010.
Finance Agency Publishes Proposed Rule on Temporary Increases of Minimum Capital: On February 8, 2010, the Finance Agency published a notice of proposed rulemaking that sets forth standards and procedures the Finance Agency will employ to determine whether to require or rescind a temporary increase in the minimum capital level for a regulated entity. Pursuant to the proposed rulemaking, if the Director determines that a temporary increase in the minimum capital level is necessary, the Director will provide notice to the affected regulated entity 30 days in advance of the effective date of such increase. In making a determination to increase temporarily a minimum capital requirement, the Director will consider the necessity and consistency of such an increase with the prudential regulation and safe and sound operations of a regulated entity. Comments on the proposed rulemaking are due by April 9, 2010.
Finance Agency Publishes Final Regulation on Reporting of Fraudulent Financial Instruments: On January 27, 2010, the Finance Agency published a final regulation on reporting of fraudulent financial instruments. Previously, on June 17, 2009, the Finance Agency published a proposed regulation setting forth reporting requirements with respect to fraudulent or suspected fraudulent financial instruments. The proposed rule was intended to implement Section 1379E of the Federal Housing Enterprises Financial Safety and Soundness Act of 1992, as amended by the Recovery Act, which subjects the FHLBanks to both fraud reporting and internal control requirements. The final regulation requires Fannie Mae, Freddie Mac and the FHLBanks (collectively, Regulated Entities) to establish and maintain adequate and efficient controls, policies, procedures, and an operational training program to discover and report fraud or possible fraud in connection with the purchase or sale of any loan or financial instrument. When a Regulated Entity discovers fraud or suspected possible fraud, either through its internal controls or notification by outside parties, the fraud or suspected possible fraud is to be reported to the Finance Agency. The Finance Agency clarified in the final rule that the regulation applies to all programs and products of the Regulated Entities. The scope of the due diligence requirements for discovering fraud or possible fraud was not contained in the final regulation, but the Finance Agency noted that guidance will be provided to further define the due diligence requirements for specific programs and products. The final regulation became effective February 26, 2010.
Finance Agency Publishes Proposed Rule on Minority and Women Inclusion: On January 11, 2010, the Finance Agency published a notice of proposed rulemaking implementing section 1116 of the Recovery Act, which requires the Finance Agency, Fannie Mae, Freddie Mac and the FHLBanks to promote diversity and the inclusion of women and minorities in all activities, consistent with the demographic diversity of the United States. The proposed rule requires each FHLBank to establish an Office of Minority and Women Inclusion, or designate an office, responsible for carrying out the requirements of the proposed regulation. The proposed rule requires each FHLBank to establish an equal opportunity program applying to all areas of the business, including management, employment and contracting, at every level of the organization and to report annually to the Finance Agency certain demographic data concerning diversity in employment and contracting. It requires each FHLBank to establish an outreach program to ensure the inclusion of minorities, women and individuals with disabilities, and businesses owned by them in contracts entered into by the FHLBank. Comments on the proposed rule were originally due by March 12, 2010. However, on March 8, 2010, the Finance Agency extended the comment period on the proposed rule to April 26, 2010.
Finance Agency Publishes Proposed Rule on FHLBank Directors’ Compensation and Expenses: On October 23, 2009, the Finance Agency published a proposed rule implementing section 1202 of the Recovery Act, which repealed the statutory caps on the annual compensation that can be paid to FHLBank directors. The proposed rule would require each FHLBank’s board of directors annually to adopt a written policy to provide for the payment of reasonable compensation and expenses to the directors of the FHLBank. At a minimum, the proposed rule would require the compensation policy to: (1) identify the activities or functions for which director attendance or participation is necessary and which may be compensated; (2) explain and justify the methodology used to determine the amount of compensation to be paid to the directors; and (3) include provisions requiring that compensation paid must reflect the amount of time a director has spent on official business, and that compensation be reduced, as necessary, to reflect lesser attendance at board or committee meetings. Under the proposed rule, the FHLBank must submit to the Director of the Finance Agency a copy of its compensation policy no fewer than 30 calendar days prior to the first payment to be made under the policy. The proposed rule would specify the authority of the Director of the Finance Agency to disapprove compensation arrangements that do not conform to the reasonableness standards imposed by the Bank Act and the proposed rule. Comments on the proposed rule were due by December 7, 2009.
Finance Agency Publishes Final Rule Establishing Capital Classifications and Critical Capital Levels for the FHLBanks: On August 4, 2009, the Finance Agency published a final rule on Capital Classifications and Critical Capital Levels for the FHLBanks. The final rule is substantially similar to the interim final rule previously issued by the Finance Agency on January 30, 2009. The final rule established criteria based on the amount and type of capital held by a FHLBank for four capital classifications as follows:
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Adequately Capitalized - FHLBank meets both risk-based and minimum capital requirements.
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Undercapitalized - FHLBank does not meet one or both of its risk-based or minimum capital requirements.
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Significantly Undercapitalized - FHLBank has less than 75 percent of one or both of its risk-based or minimum capital requirements.
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Critically Undercapitalized - FHLBank total capital is two percent or less of total assets.
Under the regulation, the Finance Agency will make a capital classification for each FHLBank at least quarterly and notify the FHLBank in writing of any proposed action and provide an opportunity for the FHLBank to submit information relevant to such action. The Finance Agency is permitted to make discretionary classifications. The regulation delineates the types of prompt corrective actions the Finance Agency may order in the event an FHLBank is not adequately capitalized, including submission of a capital restoration plan by the FHLBank and restrictions on its dividends, stock redemptions, executive compensation, new business activities, or any other actions the Finance Agency determines will ensure safe and sound operations and capital compliance by the FHLBank.
Finance Agency Publishes Proposed Rule on the Board of Directors of the Federal Home Loan Bank System Office of Finance: On August 4, 2009, the Finance Agency published a notice of proposed rulemaking which recommended changes to the size and structure of the Office of Finance board of directors and how the Office of Finance board exercises oversight over the process for preparing the FHLBank System’s combined financial reports. Under the proposal, the Office of Finance board of directors would be composed of 15 to 17 part-time members, including the 12 FHLBank presidents and three to five independent directors. In addition, the proposed rule would amend the composition of the Audit Committee, which would be composed solely of the independent directors of the Office of Finance board of directors. Furthermore, the proposed rule would provide the Audit Committee the responsibility for overseeing the Office of Finance’s preparation of accurate financial reports, including selection and appointment of the Office of Finance’s internal and external auditors. Finally, the proposed rule would give the Audit Committee responsibility for ensuring the FHLBanks adopt consistent accounting policies and procedures as they relate to the combined financial reports for the FHLBanks. Comments on the proposed rule were initially due October 5, 2009. On October 2, 2009, the Finance Agency published an extension of the comment period in the Federal Register, making comments on the proposed rule due November 4, 2009.
Finance Agency Publishes Proposed Rule on Executive Compensation Limits: On June 5, 2009, the Finance Agency published a notice of proposed rulemaking setting forth requirements and processes with respect to compensation provided to executive officers of the FHLBanks. The proposed rule was issued to effect sections 1113 and 1117 of the Recovery Act. Section 1113 addresses the authority of the Director to prohibit and withhold compensation of executive officers of the FHLBanks, and Section 1117 provides the Director with temporary authority to approve, disapprove or modify the executive compensation of the FHLBanks. The proposed rule also sets forth provisions on the Director’s authority to prior approve agreements or contracts of executive officers that provide compensation in connection with termination of employment. Additionally, the proposed rule sets forth provisions to ensure the FHLBanks comply with processes used by the Finance Agency in its oversight of executive compensation, including the processes that require the submission of relevant information by the FHLBanks to the Finance Agency. Comments on the proposed rule were due by August 4, 2009.
On October 27, 2009, the Finance Agency issued Advisory Bulletin 2009-AB-02, Principles for Executive Compensation at the Federal Home Loan Banks and the Office of Finance: In the Advisory Bulletin, the Finance Agency outlined several principles for sound incentive compensation practices to which the FHLBanks should adhere in setting executive compensation policies and practices. The Advisory Bulletin requires that: (1) executive compensation must be reasonable and comparable to that offered to executives in similar positions at other comparable financial institutions; (2) executive incentive compensation should be consistent with sound risk management and preservation of the par value of an FHLBank’s capital stock; (3) a significant percentage of an executive’s incentive-based compensation should be tied to longer-term performance and outcome-indicators; (4) a significant percentage of an executive’s incentive-based compensation should be deferred and made contingent upon performance over several years; and (5) the board of directors of each FHLBank and the Office of Finance should promote accountability and transparency in the process for setting compensation. In evaluating compensation at the FHLBanks, the proposed rule states that the Director will consider the extent to which an executive’s compensation is consistent with the above principles.
Finance Agency Publishes Final Rule on FHLBank Membership for Community Development Financial Institutions: On May 15, 2009, the Finance Agency published a proposed rule to implement the provisions of the Recovery Act authorizing Community Development Financial Institutions (CDFIs) to become members of the FHLBanks. CDFIs include: (1) community development loan funds; (2) venture capital funds; and (3) state-chartered credit unions that are not federally insured. Those CDFIs that are certified by the CDFI Fund would be eligible to become members of the FHLBank. The proposed rule set forth the eligibility and procedural requirements for CDFIs that wish to become FHLBank members. On January 5, 2010, the Finance Agency issued a final rule establishing the eligibility and procedural requirements for CDFIs that wish to become FHLBank members. The final rule became effective on February 4, 2010.
Finance Agency Issues Guidance on OTTI: On April 28, 2009 and May 7, 2009, the Finance Agency provided the FHLBanks with guidance on the process for determining OTTI with respect to private-label MBS and adoption of related accounting guidance. The goal of the Finance Agency guidance was to promote consistency among all FHLBanks in making such determinations, based on the understanding that investors in the consolidated obligations of the FHLBanks can better understand and utilize the information in the combined financial reports if it is prepared on a consistent basis. In order to achieve this goal and move to a common analytical framework, the Finance Agency required all FHLBanks to early adopt OTTI-related accounting guidance and follow certain guidelines for determining OTTI. See Item 7 - “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Critical Accounting Policies and Estimates” for additional discussion on the FHLBank’s OTTI policies and processes.
Finance Agency Publishes Interim Rule Allowing the Establishment of a Temporary Mortgage Refinance Program under an FHLBank’s Existing Set-Aside Authority: On October 17, 2008, the Finance Agency published an interim final rule in the Federal Register amending the AHP regulation to allow an FHLBank to establish a temporary mortgage refinance program under its existing set-aside authority. This rule supersedes a proposed rule published by the Finance Board on April 16, 2008 that would have authorized the FHLBanks to establish AHP homeownership set-aside programs for the purpose of refinancing or restructuring low- or moderate-income households’ nontraditional or subprime mortgage loans. Because of the passage of the Recovery Act, the Finance Agency published the interim final rule, which replaces the proposed rule. The interim final rule permits set-aside funds to be used for two new purposes. First, they may be used to reduce the outstanding principal balance of the refinanced loan below the maximum 90 percent LTV ratio established by the HOPE for Homeowners Program to make monthly payments affordable for the household and, second, they may be used to pay FHA-approved loan closing costs. Based on comments received on the interim final rule and the continuing adverse conditions of the mortgage market, on August 4, 2009, the Finance Agency published an interim final rule authorizing FHLBanks to provide AHP subsidy through their members to assist in the refinancing of eligible households’ mortgages under eligible Federal, State and local programs for targeted refinancing in addition to the HOPE for Homeowners Program. In addition, the interim final rule provides greater flexibility to the FHLBanks by permitting FHLBanks to adopt multiple housing needs under their Second District Priority scoring criteria under the AHP competitive application program. The FHLBanks’ authority under the interim final rule to establish and provide AHP grants under a mortgage refinancing homeownership set-aside program expires on July 30, 2010. The comment period for the interim final rule closed on October 5, 2009.
Finance Agency Publishes Final Rule Concerning the Nomination and Election of Directors: On September 26, 2008, the Finance Agency published an interim final regulation to implement the provisions of the Recovery Act concerning the nominations, balloting, voting and reporting of results for director elections. On October 7, 2009, the Finance Agency published a final rule concerning the nomination and election of directors. The final rule is similar to the interim final rule, but makes the following substantive changes:
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Requires the board of directors of each FHLBank annually to determine how many of its independent directorships should be designated as public interest directorships. To qualify as a public interest director, an individual must have more than four years of experience in representing consumer or community interests on banking services, credit needs, housing, or financial consumer protections.
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Sets forth new provisions for filling a vacancy on the board of directors whereby the board of directors of the FHLBank will fill the unexpired term by a majority vote of the remaining FHLBank directors.
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Amends the election requirement for independent directors. The interim final rule provided that an independent director nominee must receive at least 20 percent of the eligible votes to be cast in the election to be elected. The final rule provides that if an FHLBank’s board of directors nominates only one person for each directorship, receipt of 20 percent of the eligible votes by that nominee is required for that nominee to be elected. If, however, an FHLBank’s board of directors nominates more persons for the type of independent directorship to be filled than there are directorships of that type to be filled in the election, then there is no minimum vote count requirement and the person with the highest number of votes will be declared elected.
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Clarifies the requirements for subsequent elections in the event an independent director cannot be elected based on the failure to meet the 20 percent requirement.
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Establishes the actions a director, officer, attorney, employee or agent may take in supporting the candidacy, nomination or election of an individual for a member or independent directorship.
The final rule became effective on November 6, 2009.
Finance Agency Publishes Proposed Rule on Golden Parachute and Indemnification Payments: On September 16, 2008, the Finance Agency published an interim final regulation on golden parachute and indemnification payments. On September 19, 2008, the Finance Agency removed certain restrictions from the rule. On September 23, 2008, the Finance Agency rescinded the aspects of the rule pertaining to indemnification payments, but left intact the regulation as it pertains to golden parachute payments. On November 14, 2008, the Finance Agency published a proposed amendment to the interim final regulation which addressed indemnification payments. On January 29, 2009, the Finance Agency published the final regulation on golden parachute payments. On June 29, 2009, the Finance Agency published a proposed rule addressing prohibited and permissible golden parachute payments and indemnification payments. The proposed rule issued June 29, 2009 addresses in more detail prohibited and permissible golden parachute payments and re-proposes substantially the same indemnification payments amendment that was first proposed on November 14, 2008. Comments on the proposed rule were due by July 29, 2009.
Finance Board Temporary Increase on the Purchase of Mortgage-Backed Securities: On March 24, 2008, the Finance Board authorized, pursuant to Resolution 2008-08, Temporary Authorization to Invest in Additional Agency Mortgage Securities, a temporary increase in the FHLBanks’ MBS investment authority from 300 percent of capital to 600 percent of regulatory capital, subject to certain conditions including that before making its first purchase under Resolution 2008-08, an FHLBank’s Board of Directors must approve an appropriate strategy governing the types of Agency MBS the FHLBank will acquire and the qualitative and quantitative market risk management standards the FHLBank will apply, including, at a minimum, an estimate of the effect the purchases will have on the FHLBank’s overall risk position and limits. The FHLBank’s Board of Directors approved appropriate strategies to allow the FHLBank to acquire additional Agency MBS/CMOs on March 27, 2008, subject to a limit of 400 percent of total regulatory capital. The FHLBank submitted required information to the Finance Board on March 31, 2008 and began acquiring Agency MBS/CMOs under this expanded authority in April 2008. The FHLBank acquired $2.7 billion of par value in Agency MBS under this expanded authority during 2008. On December 17, 2009, the FHLBank’s board of directors adopted a resolution authorizing the FHLBank to acquire additional Agency MBS in an amount such that the FHLBank’s total MBS portfolio shall not exceed 500 percent of capital immediately after such purchase. The FHLBank submitted required information to the Finance Agency on December 18, 2009 and began acquiring Agency MBS under this expanded authority in early January 2010. The expanded authority under Resolution 2008-08 expires on March 31, 2010. The FHLBank’s MBS authority will return to 300 percent of its regulatory capital on that date. The FHLBank will not be required to sell or dispose of any MBS in excess of 300 percent of its regulatory capital, but will be unable to purchase additional MBS until such time as its MBS balance falls below the 300 percent of regulatory capital limit.
Treasury Senior Preferred Stock Agreements with Fannie Mae and Freddie Mac: On September 7, 2008, the U.S. Treasury and the Finance Agency entered into Senior Preferred Stock Agreements whereby the U.S. Treasury would provide Fannie Mae and Freddie Mac each with up to $100 billion, which is designed to ensure that both Fannie Mae and Freddie Mac have a positive net worth. The Agreements do not have an expiration date and will last until all debt and MBS are repaid or the facility has been fully utilized. On February 28, 2009, the U.S. Treasury increased the Agreements to $200 billion each from the original level of $100 billion each. On December 24, 2009, the U.S. Treasury amended the cap on its funding commitment under these Agreements to increase as necessary to accommodate any cumulative reduction in net worth over the next three years. At the conclusion of the three-year period, the remaining commitment will then be fully available to be drawn per the terms of the Agreements.
U.S. Treasury Announces Increase in Supplementary Financing Program Account Balance: On February 23, 2010, the U.S. Treasury announced that it plans to increase the balance of its Supplementary Financing Program (SFP) from its current level of $5 billion to $200 billion. Under the SFP, the U.S. Treasury issues bills and places the proceeds in an account for the Federal Reserve. The increased balance under the SFP will be completed by auction during March and April 2010 in the form of eight $25 billion, 56-day SFP bills.
FDIC Rule Concluding the Debt Guarantee Program: On September 16, 2009, the Federal Deposit Insurance Corporation (FDIC) published a notice of proposed rulemaking that presented alternatives for phasing out the Debt Guarantee Program (DGP), a component of the Temporary Liquidity Guarantee Program (TLGP), which provides FDIC guarantees of certain senior unsecured bank debt. On October 23, 2009, the FDIC published a final rule amending the DGP to provide for the establishment of a limited six-month emergency guarantee facility. Under the rule, for most insured depository institutions and other entities participating in the DGP, the DGP concluded on October 31, 2009 with the FDIC’s guarantee expiring no later than December 31, 2012. To the extent certain entities become unable to issue non-guaranteed debt to replace maturing senior unsecured debt because of market disruptions or other circumstances, the emergency guarantee facility will be available on an application basis. If the application is approved, the FDIC will guarantee the applicant’s senior unsecured debt issued on or before April 30, 2010. The final rule became effective October 23, 2009.
FDIC Extends Transaction Account Guarantee Program and Charges Risk-Based Assessments: On June 30, 2009, the FDIC published a notice of proposed rulemaking that presented alternatives for phasing out the Transaction Account Guarantee (TAG) program, a component of the TLGP, which provides FDIC guarantees for all funds held at participating banks in qualifying non-interest bearing transaction accounts. On September 1, 2009, the FDIC published a final rule extending the TAG program with a modified fee structure, which extends the TAG program for six months until June 30, 2010. Each insured depository institution that participates in the extended TAG program will be subject to increased fees during the extension period for the FDIC’s guarantee depending on the entity’s risk category, but participating entities had an opportunity to opt out of the extended TAG program until November 2, 2009. The final rule became effective October 1, 2009.
Federal Reserve Publishes Proposed Rule on “Truth in Lending”: On August 26, 2009, the Board of Governors of the Federal Reserve System published a proposed rule regarding “Truth in Lending.” The proposed rule would create several new regulatory protections for consumers in the residential mortgage market through amendments to Regulation Z, which implements the Truth in Lending Act. In its current form, the proposed rule would prohibit the payment of yield spread premiums to loan originators including creditors that receive table funding. If the proposed rule were to apply to PFIs under the FHLBanks’ MPF 100 product, the adoption of the rule may jeopardize the ability of the FHLBanks to continue the MPF 100 product because the fees paid to PFIs under the MPF 100 product are based in part on the interest rate of the mortgage loans and, therefore, would probably not comply with the rule. Comments on the proposed rule were due by December 24, 2009.
FDIC Rule on Risk-Based Assessments: On March 4, 2009, the FDIC published a final rule that would increase the deposit insurance assessment for those FDIC-insured institutions that have outstanding FHLBank advances and other secured liabilities above a specified level. The final rule differs from the proposed rule published on October 16, 2008 in that an institution’s ratio of secured liabilities to domestic deposits must be greater than 25 percent for an adjustment to exist, rather than 15 percent as stated in the proposed regulation. The secured liability adjustment is simply one component of a new assessment structure which in total is designed to restore the Deposit Insurance Fund to its required level in five years. Any surcharge added to an FHLBank member’s deposit insurance assessment that includes FHLBank advances could adversely impact the attractiveness of FHLBank advances. On December 22, 2008, the FDIC published a final rule that raises the current rates uniformly by 7 bps for the quarterly assessment beginning January 1, 2009 only. The FDIC also amended the restoration plan on March 4, 2009 to extend the period of the restoration plan to seven years.
Federal Reserve Program to Purchase Direct Obligations of FHLBanks: On November 25, 2008, the FOMC announced an initiative to commence purchasing up to $100 billion of the debt of the housing GSEs. Following this announcement, FHLBank term debt pricing improved relative to U.S. Treasury securities and interest rate swaps. On March 18, 2009, the FOMC announced that it was directing the Federal Reserve to increase its projected purchases of GSE debt from $100 billion to $200 billion. On September 23, 2009, the FOMC announced its intention to gradually slow the pace of these purchases and to execute them by the end of the first quarter of 2010. On November 4, 2009, the FOMC announced its intention to reduce the aggregate amount of GSE debt that they intended to purchase to about $175 billion. As of December 31, 2009, the Federal Reserve had purchased a total of $159.9 billion of GSE term debt, leaving approximately $15.1 billion in potential future purchases.
Federal Reserve Term Asset-Backed Securities Loan Facility: On November 25, 2008, the Federal Reserve Board announced the creation of the Term Asset-Backed Securities Loan Facility (TALF), a facility established to help market participants meet the credit needs of households and small businesses by supporting the issuance of ABS collateralized by student loans, auto loans, credit card loans and loans guaranteed by the Small Business Administration (SBA). Under the TALF, the Federal Reserve will lend up to $200 billion on a non-recourse basis to holders of certain AAA-rated ABS backed by newly and recently originated consumer and small business loans. On February 6, 2009, the Federal Reserve released revised terms and conditions of the TALF. On February 10, 2009, the Federal Reserve announced it was prepared to increase the size of the program to up to $1 trillion. On August 17, 2009, the Federal Reserve announced an extension of the TALF from the previous expiration date of December 31, 2009. The Federal Reserve will approve TALF loans against newly issued ABS and legacy commercial MBS through March 31, 2010 and against newly issued commercial MBS through June 30, 2010.
Federal Bank and Thrift Regulatory Agencies’ Proposal to Lower Risk Weights for Claims on or Guaranteed by Fannie Mae and Freddie Mac: On October 27, 2008, the Federal Bank and Thrift Regulatory Agencies published a notice of proposed rulemaking which would lower the capital risk weighting of certain claims on or guaranteed by Fannie Mae and Freddie Mac from 20 percent to 10 percent. The notice specifically requested comments on the potential effects of the proposed rule on FHLBank debt. The comment period for the proposed rulemaking closed on November 26, 2008.
Federal Reserve Limits Interest Paid on Balances: On October 9, 2008, the Federal Reserve System published an interim final rule amending Regulation D (Reserve Requirements of Depository Institutions) to direct the Reserve Banks to pay interest on balances held at Reserve Banks to satisfy reserve requirements and balances held in excess of required reserve balances. Consequently, as a pass-through correspondent for institutions that are eligible to receive interest from the Federal Reserve, the FHLBank had been receiving interest on its balances held at the Federal Reserve Bank of Kansas City. On May 29, 2009, the Federal Reserve published a final rule amending Regulation D that prohibited the payment of interest on FHLBank balances held at Reserve Banks unless they are required reserve balances by interest-eligible respondent institutions for which the FHLBank acts as correspondent. In addition, the final rule required that the FHLBank pass such interest back to the respondents. The final rule became effective July 2, 2009.
Temporary Authority of the Secretary of the Treasury: The Recovery Act granted the Secretary of the Treasury the temporary authority (through December 31, 2009) to purchase any obligations and other securities issued by the Regulated Entities if he determined that such purchase was necessary to provide stability to financial markets, to prevent disruptions in the availability of mortgage finance, and to protect the taxpayers. In connection with this authority, on September 9, 2008, the FHLBank entered into a Lending Agreement with the U.S. Treasury. Each of the other 11 FHLBanks also entered into their own Lending Agreements that were identical to the Lending Agreement entered into by the FHLBank. Pursuant to its terms, the Lending Agreement terminated on December 31, 2009. None of the FHLBanks borrowed from the U.S. Treasury under the Lending Agreements while they were in effect.
U.S. House Passes The Wall Street Reform and Consumer Protection Act of 2009: On December 11, 2009, the U.S. House passed The Wall Street Reform and Consumer Protection Act of 2009. The legislation as currently written changes the formula used by the FDIC to determine the amount that depository institutions must pay for deposit insurance by requiring FDIC assessments to be based on a depository institution’s liabilities, including borrowings from the FHLBank, rather than solely domestic deposits as is currently the case. When combined with current FDIC regulations that also assess a depository institution’s liabilities above a certain threshold, the legislation could result in some community banks being assessed twice by the FDIC for the same borrowing from the FHLBank.
U.S. House Agriculture and Financial Services Committees Approve Over-the-Counter Derivatives Markets Act of 2009: On October 13, 2009, the House Agriculture Committee approved the Over-the-Counter Derivatives Markets Act of 2009. On October 15, 2009, the House Financial Services Committee approved similar legislation. The legislation as currently written would require swap dealers and major swap participants to register with the Commodity Futures Trading Commission (CFTC) and to be subject to the CFTC’s regulations. The legislation would require clearing of standardized security-based swaps by a registered clearing agency and would require the trading of standardized security-based swaps on a registered national securities exchange. If it becomes law, the legislation could impact the operations of all FHLBanks depending on its final form and applicability.
Mortgage Cram-Down Legislation: In the 111th Congress, several bills have been introduced that are designed to require lenders to modify the mortgage terms of individuals who are at risk of losing their homes to foreclosure. This legislation could increase the cost of doing business for financial institutions such as the FHLBanks that invest in mortgages or own MBS, particularly private-label MBS. The Helping Families Save Their Homes Act was signed by the President on May 20, 2009. While it contained mortgage modification provisions, it did not contain any mortgage cram-down provisions.
Where to Find Additional Information
We file annual, quarterly and current reports and other information with the SEC. You may read and copy such material at the public reference facilities maintained by the SEC at 100 F Street, NE, Washington, DC 20549. Please call the SEC at 1-800-732-0330 for more information on the public reference room. You can also find our SEC filings at the SEC’s Web site at www.sec.gov. We provide a link on our Web site at www.fhlbtopeka.com to the SEC’s Web site to provide access our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 (Exchange Act), as soon as reasonably practicable after we electronically file such material with, or furnish it to, the SEC.
Item 1A:
Item 1A: Risk Factors
Our business has been and may continue to be adversely impacted by recently enacted legislation and other ongoing actions by the U. S. government in response to recent disruptions in the financial markets. Recent disruptions in the financial markets have significantly impacted the financial services industry, the FHLBank and our members. In response to the economic downturn and the continuing recession, the U.S. government has extended certain governmental programs that have and may continue to adversely impact our access to and cost of funds and our competitive position for providing advances. These and future governmental programs could create increased funding costs on consolidated obligations and decreased borrowing activity with our members that could have a material adverse impact on our financial condition and results of operations. See Item 1 - “Business - Legislation and Regulatory Developments” for further discussion of government programs and initiatives.
These initiatives or proposed initiatives have adversely impacted our competitive position with respect to accessing financing as well as the rate that we pay for borrowed funds. For example, the U.S. government’s financial backing of Fannie Mae and Freddie Mac have resulted in the debt securities of Fannie Mae and Freddie Mac being marginally more attractive to investors at various times than the debt securities of the FHLBanks. Additionally, the FDIC’s TLGP initially resulted in the debt securities of larger commercial banks being more attractive to investors at certain times than FHLBank debt. The lack of new supply in TLGP paper since the expiration of the program has resulted in the tightening of the relative spread on TLGP investments to FHLBank debt reducing the yield differential between FHLBank bonds and TLGP securities.
The U.S. Treasury’s program to purchase equity interests in certain financial institutions, as well as funds obtained under the TLGP, initially provided our members with additional access to liquidity that was in direct competition with advances. However, the expiration of the TLGP combined with the general improvement in the U.S. financial sector should reverse the decrease in member demand for advances initially attributed to these programs.
The U.S. Congress has proposed and is considering broad legislation for regulatory reform of financial institutions currently encompassed in the Wall Street Reform and Consumer Protection Act. Although the content of the legislation is changing, the proposed legislation may contain provisions related to reporting of certain derivative transactions, regulation of the derivatives market, and oversight of mortgages by a new federal regulator. Additionally, potential legislation imposing taxes or penalties on large financial institutions may increase the cost of funding for member institutions and negatively affect the demand for FHLBank advances.
To the extent that these initiatives, proposed initiatives and other actions by the U.S. Congress or U.S. government in response to the financial crisis cause a significant decrease in the aggregate amount of advances, our financial condition, results of operations and member value may be adversely affected. See Item 1 - “Business - Competition” for further discussion of the reduction in member borrowings as a result of competition arising from actions of the U.S. government.
We may become liable for all or a portion of the consolidated obligations of one or more of the other FHLBanks. We are jointly and severally liable with the other FHLBanks for all consolidated obligations issued on behalf of all 12 FHLBanks through the Office of Finance. We cannot pay any dividends to members or redeem or repurchase any shares of our capital stock unless the principal and interest due on all our consolidated obligations have been paid in full. If another FHLBank were to default on its obligation to pay principal or interest on any consolidated obligation, the Finance Agency may allocate the outstanding liability among one or more of the remaining FHLBanks on a pro rata basis or on any other basis the Finance Agency may determine. As a result, our ability to pay dividends to our members or to redeem or repurchase shares of our capital stock could be affected not only by our own financial condition, but also by the financial condition of one or more of the other FHLBanks. However, no Federal Home Loan Bank has ever defaulted on its debt obligations since the FHLBank System was established in 1932.
We are subject to a complex body of laws and regulations that could change in a manner detrimental to our operations. The FHLBanks are GSEs organized under the authority of the Bank Act, and, as such, are governed by federal laws and regulations adopted and applied by the Finance Agency. In addition, Congress may amend the Bank Act or pass other legislation that significantly affects the rights and obligations of the FHLBanks and the manner in which the FHLBanks carry out their housing-finance mission and business operations, such as the passage of the Recovery Act, which created the Finance Agency as the single regulator for Fannie Mae, Freddie Mac and the FHLBanks and addressed other reform issues that have impacted the FHLBank.
We cannot predict whether new regulations will be promulgated by the Finance Agency or whether Congress will enact new legislation, and we cannot predict the effect of any new regulations or legislation on our operations. Changes in regulatory or statutory requirements could result in, among other things, an increase in our cost of funding, a change in our permissible business activities, or a decrease in the size, scope or nature of our lending, investment or MPF Program activities, which could negatively affect our financial condition and results of operations.
We share a regulator with Fannie Mae and Freddie Mac. The Finance Agency currently serves as the federal regulator of the FHLBanks and the Office of Finance, Fannie Mae and Freddie Mac . Because the business models of Fannie Mae and Freddie Mac are significantly different from that of the FHLBanks, there is a risk that actions by the Finance Agency toward Fannie Mae and Freddie Mac may have an unfavorable impact on the FHLBank’s operations and/or financial condition.
There is a risk that our funding costs and access to funds could be adversely affected by changes in investors’ perception of the systemic risks associated with Fannie Mae and Freddie Mac. For example, the conservatorship of Fannie Mae and Freddie Mac, the U.S. Treasury financing agreements, and negative accounting and other announcements by Fannie Mae and Freddie Mac have created pressure on debt pricing from time to time, as investors have perceived GSE debt instruments as bearing increased risk. Although these actions resulted in somewhat decreased spreads on GSE debt, including FHLBank debt relative to U.S. Treasury securities, investor concerns negatively affected the FHLBanks’ business and financial condition. In addition, the special status of Fannie Mae and Freddie Mac debt securities could result in higher relative funding costs on FHLBank debt. As a result of the foregoing, we may have to pay a higher rate of interest on consolidated obligations to make them attractive to investors relative to Fannie Mae and Freddie Mac debt securities. If we maintain our existing pricing on advances, the resulting increase in the cost of issuing consolidated obligations could cause our advances to be less profitable and reduce our net interest spreads (the difference between the interest rate received on advances and the interest rate paid on consolidated obligations). If we change the pricing of our advances in response to this potential decrease in net interest spreads, the advances may no longer be as attractive to our members, and any outstanding advance balances may decrease. In either case, the increased cost of issuing consolidated obligations could negatively affect our financial condition and results of operations.
Our funding depends upon our ability to access the capital markets. Our primary source of funds is the sale of consolidated obligations in the capital markets, including the short-term discount note market. Our ability to obtain funds through the sale of consolidated obligations depends in part on prevailing conditions in the capital markets (including investor demand and the effect of the reduction of liquidity in financial markets, which are beyond the FHLBank’s control) at the time. The severe financial and economic disruptions, which began in the fourth quarter of 2007, deteriorated further in the fall of 2008 with the conservatorship of Fannie Mae and Freddie Mac and the bankruptcy of Lehman Brothers. While the financial and economic disruptions persisted into the first quarter of 2009, its severity decreased as we progressed through the remainder of 2009. These market disruptions combined with the U.S. government’s measures enacted to mitigate their effects altered the traditional bases on which market participants value GSE debt securities, particularly FHLBank consolidated obligations, and consequently affected our funding costs and practices. In the depths of the crisis, the FHLBank’s cost of issuing term debt increased significantly relative to U.S. Treasury obligations and LIBOR and resulted in the FHLBank becoming more reliant on the issuance of consolidated discount notes, with maturities of one year or less. Had there also been any significant disruption in the short-term debt markets during the same time period, it could have had a serious effect on our business and the business of the other FHLBanks. If such a significant market disruption in the short-term debt markets had occurred for an extended time, we might not have been able to obtain short-term funding on acceptable terms and the high cost of longer-term liabilities would likely have caused us to increase advance rates, which could have adversely affected demand for advances and, in turn, our results of operations. Alternatively in such a scenario, continuing to fund longer-term variable rate assets with very short-term liabilities could have adversely impacted our results of operations if the cost of those short-term liabilities had risen to levels above the yields on the long-term variable rate assets being funded. Accordingly, we cannot make any assurance that we will be able to obtain funding on terms acceptable to us in the future, if we are able to obtain funding at all in the case of another severe financial and economic disruption. If we cannot access funding when needed, our ability to support and continue our operations would be adversely affected, negatively affecting our financial condition and results of operations.
Changes in interest rates could significantly affect our earnings. Changes in interest rates that are detrimental to our investment position could negatively affect our financial condition and results of operations. Like many financial institutions, we realize income primarily from earnings on our invested capital as well as the spread between interest earned on our outstanding advances, mortgage loans and investments and interest paid on our borrowings and other liabilities. Although we use various methods and procedures to monitor and manage our exposures to risk due to changes in interest rates, we may experience instances when our interest-bearing liabilities will be more sensitive to changes in interest rates than our interest-earning assets, or vice versa. These impacts could be exacerbated by prepayment and extension risk, which is the risk that mortgage-related assets will be refinanced in low interest-rate environments or will remain outstanding at below-market yields when interest rates increase.
Changes in our credit ratings may adversely affect our ability to issue consolidated obligations on acceptable terms. Our consolidated obligations currently have the highest credit rating from Moody’s and S&P. A revision in or withdrawal of those ratings could adversely affect us in a number of ways. It could result in a revision or withdrawal of the ratings of the consolidated obligations of the FHLBanks. It could require the posting of additional collateral for derivatives transactions and might influence counterparties to limit the types of transactions they would be willing to enter into with us or cause counterparties to cease doing business with us. We have issued letters of credit to support deposits of public unit funds with our members. In some circumstances, loss of our current rating could result in our letters of credit no longer being acceptable to pledge for public unit deposits or other transactions. We have also executed various standby bond purchase agreements with two state HFAs in which we provide a liquidity facility for bonds issued by the HFAs by agreeing to purchase the bonds in the event they are tendered and cannot be remarketed in accordance with specified terms and conditions. If our current short-term ratings are reduced, suspended or withdrawn, the issuers will have the right to terminate these standby bond purchase agreements, resulting in the loss of future fees that would be payable to us under these agreements.
We may not be able to meet our obligations as they come due or meet the credit and liquidity needs of our members in a timely and cost-effective manner. We seek to be in a position to meet our members’ credit and liquidity needs and to pay our obligations without maintaining excessive holdings of low-yielding liquid investments or being forced to incur unnecessarily high borrowing costs. In addition, in accordance with the Finance Agency’s requirement to maintain five calendar days of contingent liquidity, we maintain a contingency liquidity plan designed to protect against temporary disruptions in access to the FHLBank debt markets in response to a rise in capital markets volatility. However, regulatory actions, such as the SEC’s regulation amending the rules governing money market funds, may increase our cost of funds and/or may increase the cost of maintaining liquidity requirements established in policy or regulation. Our efforts to manage our liquidity position, including carrying out our contingency liquidity plan, may not enable us to meet our obligations and the credit and liquidity needs of our members, which could have an adverse effect on our net interest income, and thereby, our financial condition and results of operations.
Changes in the credit standing at other FHLBanks, including the credit ratings assigned to those FHLBanks, could adversely affect us. The FHLBanks issue consolidated obligations that are the joint and several liability of all 12 FHLBanks. Significant developments affecting the credit standing of one of the other 11 FHLBanks, including revisions in the credit ratings of one of the other FHLBanks, could adversely affect the cost of consolidated obligations. An increase in the cost of consolidated obligations would affect our cost of funds and negatively affect our financial condition. The consolidated obligations of the FHLBanks have been rated Aaa/P-1 by Moody’s and AAA/A-1+ by S&P. As of March 15, 2010, two FHLBanks had ratings of AA+, but each was assigned a stable outlook by S&P. No FHLBank was assigned a negative outlook by S&P. FHLBank Topeka and the remaining nine FHLBanks were rated AAA with a stable outlook by S&P. All 12 FHLBanks were rated Aaa by Moody’s. Changes in the credit standing or credit ratings of one or more of the other FHLBanks could result in a revision or withdrawal of the ratings of the consolidated obligations by the rating agencies at any time, negatively affecting our cost of funds and may negatively affect our ability to issue consolidated obligations for our benefit.
We face competition for loan demand, purchases of mortgage loans and access to funding which could adversely affect our earnings. Our primary business is making advances to our members. We compete with other suppliers of wholesale funding, both secured and unsecured, including U.S. government-guaranteed programs, investment banks, commercial banks and, in certain circumstances, other FHLBanks. Our members have access to alternative funding sources, which may offer more favorable terms on their loans than we offer on our advances, including more flexible credit or collateral standards. In addition, many of our competitors are not subject to the same regulation that is applicable to us. This enables those competitors to offer products and terms that we are not able to offer.
The availability of alternative funding sources to our members may significantly decrease the demand for our advances. Any change we might make in pricing our advances, in order to compete more effectively with these competitive funding sources, may decrease our profitability on advances. A decrease in the demand for our advances, or a decrease in our profitability on advances, would negatively affect our financial condition and results of operations.
Likewise, our MPF business is subject to significant competition. The most direct competition for purchases of mortgage loans comes from other buyers of conventional, conforming, fixed rate mortgage loans, such as Fannie Mae and Freddie Mac. Increased competition can result in the acquisition of a smaller market share of the mortgage loans available for purchase and, therefore, lower income from this business activity.
We also compete in the capital markets with Fannie Mae, Freddie Mac, other GSEs and U.S. government-guaranteed programs, as well as corporate, sovereign and supranational entities for funds raised through the issuance of consolidated obligations, and other debt instruments. We face increased competition in the Agency/GSE and other related debt markets as a result of new debt programs, including those explicitly guaranteed by the U.S. and foreign governments. Our ability to obtain funds through the issuance of debt depends in part on prevailing market conditions in the capital markets (including investor demand), such as effects on the reduction in liquidity in financial markets, which are beyond our control. Accordingly, we may not be able to obtain funding on terms that are acceptable to us. Increases in the supply of competing debt products in the capital markets may, in the absence of increases in demand, result in higher debt costs to us or lesser amounts of debt issued at the same cost than otherwise would be the case. Although our supply of funds through issuance of consolidated obligations has kept pace with our funding needs, we cannot assure that this will continue in the future.
The yield on or value of our MBS investments may be adversely affected by increased delinquency rates and credit losses related to mortgage loans that back our MBS investments. Delinquencies and losses with respect to residential mortgage loans have generally increased, particularly in the nonprime sector, including subprime and alternative documentation loans. In addition, residential property values in many states have declined or remained stable, after extended periods during which those values appreciated. If delinquency and/or default rates on mortgages continue to increase, and/or there is a rapid decline in residential real estate values, we could experience reduced yields or losses on our MBS investments. In addition, market prices for many of the private-label MBS we hold are below their amortized cost due to market uncertainty and illiquidity. The significant widening of credit spreads that began in December 2007 and reduced the fair value of our MBS portfolio, which includes Agency and private-label MBS, has mostly reversed itself. Despite the overall improvement in the market prices of our MBS since the end of 2008, we could experience additional other-than-temporary impairments on certain investment securities in the future, which could result in significant losses. Furthermore, market illiquidity has increased the amount of management judgment required to value private-label MBS and certain other securities. Subsequent valuations may result in significant changes in the value of private-label MBS and other investment securities. If we decide to sell securities due to credit deterioration, the price we may ultimately realize will depend on the demand and liquidity in the market at that time and may be materially lower than the fair value reflected in our financial statements.
In addition, on May 20, 2009, Congress enacted loan modification legislation. The legislation provides that if a servicer of residential mortgages agrees to enter into a residential loan modification, workout, or other loss mitigation plan with respect to a residential mortgage originated before the date of enactment of the legislation, including mortgages held in a securitization or other investment vehicle, to the extent that the servicer owes a duty to investors or other parties to maximize the net present value of such mortgages, the servicer is deemed to have satisfied that duty and will not be liable to those investors or other parties, if certain criteria are met. Those criteria include the following: (1) default on the mortgage has occurred, is imminent, or is reasonably foreseeable; (2) the mortgagor occupies the property securing the mortgage as his or her principal residence; and (3) the servicer reasonably determined that the application of the loss mitigation plan to the mortgage will likely provide an anticipated recovery on the outstanding principal mortgage debt that will exceed the anticipated recovery through foreclosure. At this time, the FHLBank is unable to predict what impact, if any, this legislation may have on the ultimate recoverability of its private label MBS investment portfolio; however, the modifications may result in reductions in the value of the FHLBank’s private label MBS portfolio and increases in credit and noncredit losses the FHLBank incurs on such securities.
On February 10, 2010, Freddie Mac and Fannie Mae announced that they would buy out guaranteed loans that are delinquent by 120 days or greater. Freddie Mac will buy out “substantially all” of its 120+ delinquent loans in March 2010. Fannie Mae expects to begin its buyouts in April 2010 and complete the buyouts over the subsequent few months. Additionally, both agencies intend to continue to buy out loans as they become 120 days delinquent. These buyouts will result in prepayments of the FHLBank’s Agency investments, which we may not be able to replace at similar yields. The FHLBank currently estimates that the accelerated prepayments caused by these buyouts during 2010 could be in the range of $350 - $500 million for the FHLBank but is not expected to have a significant impact on the FHLBank’s 2010 earnings.
Loan modification and liquidation programs could have an adverse impact on the value of our MBS investments. As mortgage loans continue to experience increased delinquencies and loss severities, mortgage servicers continue their efforts to modify these loans in order to mitigate losses. Such loan modifications increasingly may include reductions in interest rates and/or principal on these loans. Losses from such loan modifications may be allocated to investors in MBS backed by these loans in the form of lower interest payments and/or reductions in future principal amounts received.
Many servicers are contractually required to advance principal and interest payments on delinquent loans backing MBS investments, regardless of whether the servicer has received payment from the borrower, provided that the servicer believes it will be able to recoup the advanced funds from the underlying property securing the mortgage loan. Once the related property is liquidated, the servicer is entitled to reimbursement for these advances and other expenses incurred while the loan was delinquent. Such reimbursements, combined with decreasing property values in many areas, may result in higher losses than we may have expected or experienced to date being allocated to our MBS investments backed by such loans.
Securities or mortgage loans pledged as collateral by the FHLBank’s borrowers could be adversely affected by the devaluation or inability to liquidate the collateral in the event of a default by the borrower. Although the FHLBank obtains sufficient collateral on advances to protect it from credit losses, changes in market conditions or other factors may cause the collateral to deteriorate in value, which could lead to a credit loss in the event of a default by a borrower and adversely affect our financial condition and results of operations. A reduction in liquidity in the financial markets or otherwise, could have the same affect.
Counterparty credit risk could adversely affect us. We assume unsecured credit risk when entering into money-market transactions and financial derivatives transactions with counterparties. The insolvency, or other inability of a significant counterparty to perform on its obligations under such transactions or other agreements, could have an adverse effect on our financial condition and results of operations.
Defaults by one or more of our institutional counterparties on its obligations to us could adversely affect our results of operations or financial condition. We have a high concentration of credit risk exposure to financial institutions as counterparties, which are currently perceived to present a higher degree of risk than they were perceived to present in the past due to the continued reduced liquidity in financial markets for certain financial transactions, difficulties in the current housing market and the deterioration in the financial performance and condition of financial institutions in general. Our primary exposures to institutional counterparty risk are with: (1) obligations of mortgage servicers that service the loans we have as collateral on advances; (2) third-party providers of credit enhancements on the MBS that we hold in our investment portfolio, including mortgage insurers, bond insurers and financial guarantors; (3) third-party providers of supplemental mortgage insurance for mortgage loans purchased under the MPF programs; (4) derivative counterparties; and (5) unsecured money market and Federal funds investment transactions. The liquidity and financial condition of some of our counterparties may have been adversely affected by the continued reduced liquidity in the financial markets for certain financial transactions and difficulties in the housing market. A default by a counterparty with significant obligations to us could adversely affect our ability to conduct operations efficiently and at cost-effective rates, which in turn could adversely affect our results of operations or financial condition.
We rely upon derivatives to lower our cost of funds and reduce our interest-rate, option and prepayment risk, and we may not be able to enter into effective derivative instruments on acceptable terms. We use derivatives to: (1) obtain funding at more favorable rates; and (2) reduce our interest-rate risk, option risk and mortgage-prepayment risk. Management determines the nature and quantity of hedging transactions using derivatives based on various factors, including market conditions and the expected volume and terms of advances. As a result, our effective use of derivatives depends upon management’s ability to determine the appropriate hedging positions in light of: (1) our assets and liabilities; and (2) prevailing and anticipated market conditions. In addition, the effectiveness of our hedging strategies depends upon our ability to enter into derivatives with acceptable counterparties, on terms desirable to us and in the quantities necessary to hedge our corresponding obligations, interest-rate risk or other risks. The cost of entering into derivative instruments has increased as a result of: (1) consolidations, mergers and bankruptcy or insolvency of financial institutions, which have led to fewer counterparties, resulting in less liquidity in the derivatives market; and (2) increased uncertainty related to the potential changes in legislation and regulations regarding over-the-counter derivatives. If we are unable to manage our hedging positions properly, or are unable to enter into derivative hedging instruments on desirable terms, we may incur higher funding costs and be unable to effectively manage our interest-rate risk and other risks, which could negatively affect our financial condition and results of operations.
We may not be able to pay dividends at rates consistent with past practices. Our Board of Directors may only declare dividends on our capital stock, payable to members, from our retained earnings and current income. Our ability to pay dividends also is subject to statutory and regulatory requirements, including meeting all regulatory capital requirements. For example, the potential promulgation of regulations by the Finance Agency that would require higher levels of retained earnings or mandated revisions to our retained earnings policy could lead to higher levels of retained earnings, and thus, lower amounts of net income available to be paid out to our members as dividends. Failure of the FHLBank to meet any of its regulatory capital requirements would prevent us from paying any dividend.
Further, events such as changes in our market-risk profile, credit quality of assets held and increased volatility of net income caused by the application of certain GAAP may affect the adequacy of our retained earnings and may require us to increase our target level of retained earnings and correspondingly reduce our dividends from historical dividend payout ratios in order to achieve and maintain the targeted amounts of retained earnings under our retained earnings policy.
Our ability to declare dividends may be restricted by Finance Agency rules regarding excess stock. Pursuant to Finance Agency regulations, any FHLBank with excess stock greater than one percent of its total assets will be prohibited from further increasing member excess stock by paying stock dividends or otherwise issuing new excess stock. If our total assets are significantly decreased, our ability to issue dividends in stock may be impaired which could, in turn, adversely affect demand for our advances. Additionally, Finance Agency regulations on capital classifications could restrict the FHLBank’s ability to pay a dividend.
Lack of a public market and restrictions on transferring our stock could result in an illiquid investment for the holder. Under the GLB Act, Finance Agency regulations and our capital plan, our Class A Common Stock may be redeemed upon the expiration of a six-month redemption period and our Class B Common Stock after a five-year redemption period following our receipt of a redemption request. Only capital stock in excess of a member’s minimum investment requirement, capital stock held by a member that has submitted a notice to withdraw from membership or capital stock held by a member whose membership has been terminated may be redeemed at the end of the redemption period. Further, we may elect to repurchase excess capital stock of a member at any time at our sole discretion.
We cannot guarantee, however, that a member will be able to redeem its investment even at the end of the redemption periods. The redemption or repurchase of our capital stock is prohibited by Finance Agency regulations and our capital plan if the redemption or repurchase of the capital stock would cause us to fail to meet our minimum regulatory capital requirements. Likewise, under such regulations and the terms of our capital plan, we could not honor a member’s capital stock redemption request if the redemption would cause the member to fail to maintain its minimum capital stock investment requirement. Moreover, since our capital stock may only be owned by our members (or, under certain circumstances, former members and certain successor institutions), and our capital plan requires our approval before a member may transfer any of its capital stock to another member, we cannot assure that a member would be allowed to sell or transfer any excess capital stock to another member at any point in time.
We may also suspend the redemption of capital stock if we reasonably believe that the redemption would prevent us from maintaining adequate capital against a potential risk, or would otherwise prevent us from operating in a safe and sound manner. In addition, approval from the Finance Agency for redemptions or repurchases is required if the Finance Agency or our Board of Directors were to determine that we have incurred, or are likely to incur, losses that result in, or are likely to result in, charges against our capital. Under such circumstances, we cannot assure that the Finance Agency would grant such approval or, if it did, upon what terms it might do so. We may also be prohibited from repurchasing or redeeming our capital stock if the principal and interest due on any consolidated obligations issued by the FHLBank through the Office of Finance has not been paid in full or if we become unable to comply with regulatory liquidity requirements or satisfy our current obligations.
Accordingly, there are a variety of circumstances that would preclude us from redeeming or repurchasing our capital stock that is held by a member. Since there is no public market for our capital stock and transfers require our approval, we cannot assure that a member’s purchase of our capital stock would not effectively become an illiquid investment.
Changes in the application of relevant accounting standards, especially those related to the accounting for derivatives, could materially increase earnings volatility. We are subject to earnings volatility because of our use of derivatives and the application of GAAP for those derivatives. This earnings volatility is caused by hedge ineffectiveness, which is the difference in the amounts recognized in our earnings for the changes in fair value of a derivative and the related hedged item, and by the changes in the fair values of derivatives that do not qualify for hedge accounting (referred to as economic hedges where the change in fair value of the derivative is not offset by any change in fair value on a hedged item). If we did not apply hedge accounting, the result could be an increase in volatility of our earnings from period to period. Proposals from the Financial Accounting Standards Board (FASB) to eliminate the current option to hedge the benchmark rate would result in the FHLBank marking the hedged item to full fair value and could result in a significant number of current highly effective benchmark hedges failing to be highly effective if converted to full fair value hedges, which would result in increased earnings volatility. Such increases in earnings volatility could affect our ability to pay dividends, our ability to meet our retained earnings target, and our members’ willingness to hold the stock necessary for membership and/or activity with us, such as advance and mortgage loan activities.
We rely heavily upon information systems and other technology. We rely heavily upon information systems and other technology to conduct and manage our business. To the extent that we experience a failure or interruption in any of these systems or other technology, we may be unable to conduct and manage our business effectively, including, without limitation, our funding, hedging and advance activities. While we have implemented disaster recovery and business continuity plans, we can make no assurance that these plans will be able to prevent, timely and adequately address, or mitigate the negative effects of any such failure or interruption. Any failure or interruption could significantly harm our customer relations, risk management and profitability, which could negatively affect our financial condition and results of operations.
We could be negatively affected by local and national business and economic conditions, as well as other events that are outside of our control. Local and national economic conditions could be less favorable than expected or could have a more direct and pronounced effect on our business than expected. For example, conditions affecting interest rates, money supply, inflation and capital markets, including those stemming from policies of governmental entities such as the Federal Reserve Board or the U.S. Treasury, have a significant impact on our operations. Changes in these conditions could adversely affect our ability to increase and maintain the quality of our interest-earning assets and could increase the costs of our interest-bearing liabilities. For example, a prolonged or worsening economic downturn or the continued deterioration of property values could cause higher delinquency and default rates on our outstanding mortgage loans and even cause a loss on our advances, although we have never incurred a credit loss on an advance.
Furthermore, natural disasters, acts of terrorism and other events outside of our control, especially if they occur in our four-state district, could negatively affect us, including damaging our members’ businesses, our real property and the collateral for our advances and mortgage loans, and in other ways. For example, if there is a natural disaster or other event, such as the terrorist attacks of September 11, 2001, that limits or prevents the FHLBank System from accessing the capital markets for a period of time, our business would be significantly affected, including our ability to provide advances to our members.
We could experience losses on our MBS/CMO and HFA investments as a result of losses in the home mortgage loan market or the failure of a third-party insurer. Increased delinquency rates and credit losses related to mortgage loans pooled into MBS/CMO and HFA securities, which are insured by one of the monoline mortgage insurance companies, could adversely affect the yield on or value of the FHLBank’s MBS/CMO and HFA investments. The magnitude of the losses in the home mortgage loan market could potentially overwhelm one or more of the monoline mortgage insurance companies resulting in such company’s failure to perform. If the collateral losses exceed the coverage ability of the insurance company, the MBS/CMO or HFA bond holders could experience losses of principal.
A third-party insurer (obligated under PMI or SMI) of portions of the FHLBank’s MPF Program loans could also fail to perform as expected. Should a PMI third-party insurer fail to perform, it would increase the FHLBank’s credit risk exposure because the FHLBank’s FLA is the next layer to absorb credit losses on mortgage loan pools. Likewise, if an SMI third-party insurer fails to perform, it would increase the FHLBank’s credit risk exposure because it would reduce the participating member’s CE obligation loss layer since SMI is purchased by PFIs to cover all or a portion of their CE obligation exposure for mortgage pools.
The government support for the home mortgage market could have an adverse impact on our mortgage loans held for portfolio. Government policy and actions by the U.S. Treasury, the Federal Reserve, Fannie Mae, Freddie Mac, and the FDIC have been focused on lowering the home mortgage rates. These actions may increase the rate of mortgage prepayments which may adversely affect the earnings on our mortgage investments.
Merger or consolidation of our members may result in a loss of business to us. The financial services industry periodically experiences consolidation. If future consolidation occurs within our district, it may reduce the number of current and potential members in our district, resulting in a loss of business to us and a potential reduction in our profitability. If our advances are concentrated in a smaller number of members, our risk of loss resulting from a single event (such as the loss of a member’s business due to the member’s acquisition by a nonmember) would become proportionately greater.
Member failures, out-of-district consolidations and changes in member business with us may adversely affect our financial condition and results of operations. Over the last two years, the financial services industry has experienced increasing defaults on, among other things, home mortgage, commercial real estate, and credit card loans, which caused increased regulatory scrutiny and required capital to cover non-performing loans. These factors have led to an increase in both the number of financial institution failures and the number of mergers and consolidations. During 2009, we experienced member failures, member consolidations and significant changes in the level of advance business with certain members. If the number of member institution failures, consolidations and decreases in business continues to increase, these activities may reduce the number of current and potential members in our district. The resulting loss of business could negatively impact our financial condition and the results of operations, as well as our operations generally.
Further, while member failures may cause us to liquidate pledged collateral if the outstanding advances are not repaid, the failures of the past three years have been resolved either through repayment directly from the FDIC or through the purchase and assumption of the advances by another surviving financial institution. The ability to liquidate the pledged collateral as well as the value of the collateral may cause financial statement losses. Additionally, as members become financially distressed, we may, at the request of their regulators, decrease lending limits or, in certain circumstances, cease lending activities to certain members if they do not have adequate eligible collateral to support additional borrowings. If member banks are unable to obtain sufficient liquidity from us, it may cause further deterioration of that member institution. This may negatively impact our reputation and, therefore, negatively impact our financial condition and results of operations.
Our controls and procedures may fail or be circumvented, and risk management policies and procedures may be inadequate. We may fail to identify and manage risks related to a variety of aspects of our business, including without limitation, operational risk, interest-rate risk, legal and compliance risk, human capital risk, liquidity risk, market risk and credit risk. We have adopted controls, procedures, policies and systems to monitor and manage these risks. Our management cannot provide complete assurance that such controls, procedures, policies and systems are adequate to identify and manage the risks inherent in our business and because our business continues to evolve, we may fail to fully understand the implications of changes in our business, and therefore, we may fail to enhance our risk governance framework to timely or adequately address those changes. Failed or inadequate controls and risk management practices could have an adverse effect on our financial condition, results of operations, and the value of the FHLBank to our membership.
Item 1B:
Item 1B: Unresolved Staff Comments
Not applicable.
Item 2:
Item 2: Properties
The FHLBank occupies approximately 62,796 square feet of leased office space at One Security Benefit Place, Suite 100, Topeka, Kansas. The FHLBank also maintains in Topeka a leased off-site back-up facility with approximately 3,000 square feet. Small offices are leased in Nebraska and Oklahoma for member account management personnel.
Item 3:
Item 3: Legal Proceedings
The FHLBank is subject to various pending legal proceedings arising in the normal course of business. After consultation with legal counsel, management does not anticipate that the ultimate liability, if any, arising out of these matters will have a material adverse effect on the FHLBank’s financial condition or results of operations.
Item 4:
Item 4: (Removed and Reserved)
PART II
Item 5:
Item 5: Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
As a cooperative, members own almost all the Class A Common Stock and Class B Common Stock of the FHLBank with the remainder of the capital stock held by former members that are required to retain capital stock ownership to support outstanding advances executed and mortgage loans sold while they were members. Note, however, that the portion of the FHLBank capital stock subject to mandatory redemption is treated as a liability and not as capital, including the capital stock of former members. There is no public trading market for the FHLBank’s capital stock.
All member directors of the FHLBank are elected by and from the membership, and the FHLBank conducts its business in advances and mortgage loan acquisitions almost exclusively with its members. Depending on the class of capital stock, it may be redeemed at par value either six months (Class A Common Stock) or five years (Class B Common Stock) after the FHLBank receives a written request by a member, subject to regulatory limits and to the satisfaction of any ongoing stock investment requirements applying to the member under the FHLBank’s capital plan. The FHLBank may repurchase shares held by members in excess of the members’ required stock holdings at its discretion at any time at par value. Par value of all common stock is $100 per share. As of December 31, 2009, the FHLBank had 887 stockholders and 3,120,681 shares of Class A Common Stock and 13,130,646 shares of Class B Common Stock outstanding, including 185,141 shares of Class A Common Stock and 39,225 shares of Class B Common Stock subject to mandatory redemption by members. The FHLBank is not currently required to register either class of its stock under the Securities Act of 1933 (as amended). The Recovery Act amended the Exchange Act to require the registration of a class of common stock of each FHLBank under Section 12(g) and for each FHLBank to maintain such registration and to be treated as an “issuer” under the Exchange Act, regardless of the number of members holding such a class of stock at any given time. Pursuant to a Finance Agency regulation, the FHLBank was required to file a registration statement in order to register one of its classes of stock pursuant to section 12(g)(1) of the Exchange Act. The FHLBank’s registration was effective July 14, 2006.
The FHLBank paid quarterly stock dividends during the years ended December 31, 2009, 2008 and 2007, which includes dividends treated as interest expense for mandatorily redeemable shares. Dividends paid on capital stock are outlined in Tables 12 and 13 (in thousands):
Table 12
The cash dividends listed are cash dividends paid for partial shares and dividends paid to former members. Stock dividends are paid in whole shares.
Table 13
The cash dividends listed are cash dividends paid for partial shares and dividends paid to former members. Stock dividends are paid in whole shares.
Management anticipates that the FHLBank will continue to pay quarterly dividends in the future, primarily in shares of Class B Common Stock. Dividends may be paid in cash or Class B Common Stock as authorized under the FHLBank’s capital plan and approved by its Board of Directors. The FHLBank believes that dividends paid in the form of stock are advantageous to members because FHLBank stock dividends generally qualify as tax-deferred stock dividends under the Internal Revenue Code (IRC) and are, therefore, not taxable at the time declared and credited to a member. Dividends paid in stock can be utilized by members to support future activity with the FHLBank or can be redeemed by the member if the amounts represent excess stock, subject to stock redemption request procedures and limitations. The FHLBank’s dividends generally increase as short-term interest rates rise and decrease as short-term interest rates fall. The dividend percent paid has historically been a function of or closely tied to the FHLBank’s net income for a dividend period.The FHLBank has a retained earnings policy that was considered by the Board of Directors when dividends were declared during 2007, 2008 and 2009, but the retained earnings target calculated in accordance with the policy did not significantly affect the level of dividends declared and paid in any of those periods. See Item 1 - “Business - Capital, Capital Rules and Dividends” for more information regarding the FHLBank’s retained earnings policy, and also see Item 7 - “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Capital” for a discussion of restrictions on dividend payments in the form of capital stock. FHLBank management does not expect that its retained earnings policy will significantly affect dividends paid during 2010. Management expects that the FHLBank will continue to be able to make additions to retained earnings while paying Class B Common Stock dividends at or above short-term market interest rates and Class A Common Stock dividends (paid in cash or in Class B Common Stock) at or slightly below short-term market interest rates, on average. While recent Class A Common Stock dividend rates at 0.75 percent per annum have been well above short-term interest rates such as overnight Federal funds (average of 0.16 percent for 2009), they will not remain at such levels when short-term interest rates begin to rise. There is also a possibility that dividend levels might be reduced in order to meet the target level of retained earnings under the policy since the target level fluctuates from period to period, because it is a function of the size and composition of the FHLBank’s balance sheet and the risks contained therein.
On December 28, 2006, the Finance Board adopted a final rule (effective January 29, 2007) limiting the ability of the FHLBank to create member excess stock under certain circumstances. Under the rule, any FHLBank with excess stock greater than one percent of its total assets will be barred from further increasing member excess stock by paying stock dividends or otherwise issuing new excess stock. The FHLBank anticipates that it will be able to manage its excess capital stock position in order to continue to pay stock dividends, but cannot guarantee that it will always be able to do so in the future.
Item 6:
Item 6: Selected Financial Data
Table 14
Selected Financial Data (dollar amounts in thousands):
Item 7:
Item 7: Management’s Discussion and Analysis of Financial Condition and Results of Operations
This Management’s Discussion and Analysis of Financial Condition and Results of Operations reviews the financial condition of the FHLBank as of December 31, 2009 and 2008, and results of operations for the years ended December 31, 2009, 2008 and 2007. This discussion should be read in conjunction with the FHLBank’s audited financial statements and related notes for the year ended December 31, 2009 included in Item 8 of this report.
FINANCIAL REVIEW
Overview
Total assets declined 27.2 percent to $42.6 billion as of December 31, 2009 from $58.6 billion as of December 31, 2008. The overall decrease was primarily due to a $13.6 billion decline in advances and a $3.1 billion decrease in investments. Nearly half of the decrease in advance balances is the result of U.S. Central Federal Credit Union paying down $5.4 billion during the first quarter of 2009, largely as a consequence of government assistance received by U.S. Central Federal Credit Union and its placement into conservatorship by the National Credit Union Administration on March 20, 2009. The remaining decrease is the result of a broad-based advance decline as FHLBank members have generally experienced growth in deposits, decline in loan demand, and access to debt programs explicitly guaranteed by the U.S. government. Total investments (including interest-bearing deposits at the Federal Reserve as of December 31, 2008) decreased as the FHLBank managed its balance sheet in order to maintain appropriate liquidity, capital and leverage ratios subsequent to the large decrease in advances.
On the liability side of the balance sheet, consolidated obligation discount notes, which are typically used to fund short-term advances and investments, decreased by $14.7 billion. Discount notes as a percentage of total consolidated obligations dropped from 49 percent as of the end of 2008 to 30 percent as of the end of 2009. This decrease was primarily a function of: (1) the shrinkage in short-term FHLBank advances during 2009; (2) the shrinkage in short-term FHLBank investments; and (3) the improvement in the financial markets during 2009 that has allowed the FHLBank to issue swapped callable debt at lower sub-LIBOR costs than in late 2008 and early 2009.
The FHLBank’s net income for 2009 was $236.7 million compared to $28.4 million for 2008. The significant changes in the components of net income are as follows:
§
$11.7 million increase in net interest income (increase income);
§
$56.9 million decrease related to net gains (losses) on trading securities (decrease income);
§
$327.0 million increase related to net gains (losses) on derivatives and hedging activities (decrease in losses, which results in an increase in income);
§
$4.2 million decrease in other-than-temporary impairment losses on held-to-maturity securities (increase income); and
§
$75.2 million increase in assessments (decrease income).
As indicated above, the significant increase in net income was mainly due to the positive impact of gains recorded related to derivatives and hedging activities. These gains were partially offset by losses recorded due to changes in market values of trading securities. Most of the market value changes on trading securities and gains on derivatives are a result of credit spreads returning to more normal, historical relationships or levels during 2009 and are primarily reversals of losses on derivatives (partially offset by gains on trading securities) recorded in the fourth quarter of 2008. See “Net Gain (Loss) on Derivative and Hedging Activities” and “Net Gain (Loss) on Trading Securities” in this Item 7 for additional discussion.
The FHLBank’s return on average equity (ROE) increased to 11.2 percent for 2009 compared to 1.2 percent for 2008. The increase can be primarily attributed to the net positive impact of market value changes on trading securities and net gains (losses) on derivatives and hedging activities as mentioned above.
The average dividend rates paid during 2009 were 0.75 percent and 2.76 percent for Class A Common Stock and Class B Common Stock, respectively, with an overall average dividend rate of 2.61 percent for 2009. This was a decrease over average dividends paid during 2008 of 2.04 percent and 4.70 percent for Class A Common Stock and Class B Common Stock, respectively, with an overall average dividend rate of 4.34 percent for 2008. The decrease in dividend rates can be attributed to the decrease in average short-term interest rates from 2008 to 2009 (see Table 15). We anticipate that average 2010 dividend rates will increase slightly from the 2009 levels, especially if short-term interest rates increase during 2010. Refer to this Item 7 - “Capital Distributions” for further information regarding FHLBank dividend payments.
Financial Market Trends
The primary external factors that affect net interest income are market interest rates and the general state of the economy. Table 15 presents selected market interest rates as of the dates or periods shown.
Table 15
Source is Bloomberg (Overnight Federal funds rate is the effective rate for the yearly averages and the target rate for the ending rates).
Mortgage Bankers Association weekly 30-year fixed rate mortgage contract rate obtained from Bloomberg.
The FOMC has continued to maintain the Federal funds target rate at a range of zero to 0.25 percent and stated in its March 16, 2010 meeting that economic conditions dictate that the Federal funds rate will likely be kept at “exceptionally” low levels for an extended period. The FOMC also noted that while economic activity has continued to strengthen and the deterioration of the labor market is lessening, the rate of economic recovery is likely to be moderate and inflation is likely to remain restrained for a time.
Short-term LIBOR rates fell significantly during 2009. The decrease in the short-term portion of the LIBOR interest rate curve is primarily the result of excess demand from market participants with larger amounts of cash to invest than the supply of eligible money market investments. To some extent, the decrease in LIBOR also tends to indicate that financial markets see less risk in lending short-term funds to other financial institutions, especially from late 2008 to mid-2009 as the financial market crisis began to subside. In some instances, the decrease in short-term LIBOR results in decreases in the FHLBank’s borrowing costs including debt that is directly swapped to one-month or three-month LIBOR and debt that, while not directly tied to LIBOR, normally tracks the general direction of LIBOR. Conversely, decreases in LIBOR also result in decreases in yields on some FHLBank assets including investments and advances directly indexed to short-term LIBOR and assets that, while not directly indexed to LIBOR, normally track the general direction of the short-term portion of the LIBOR rate curve.
Short-term U.S. Treasury rates remained relatively low throughout 2009, while the long-term portion of the U.S. Treasury rate curve (one-year and beyond) moved up from the historically low levels at the end of 2008. The low short-term rate environment experienced in 2009 is likely primarily due to reduced inflationary expectations and persistently strong demand for U.S. Treasury debt. The long-term portion of the U.S. Treasury rate curve increased during 2009 but remained somewhat range bound by a number of factors, including the direct purchase of these securities by the Federal Reserve Bank under its quantitative easing program. The combination of low short-term interest rates and increasing long-term interest rates has caused a very steep interest rate curve, with the difference between short-term and long-term rates being historically wide. However, the FHLBank continues to expect higher short-term and long-term interest rates in the future due to the inflationary impact from the current and anticipated volumes of U.S. Treasury issuance and concerns about the potential decrease in demand for U.S. Treasuries, Agency debentures and Agency MBS after the Federal Reserve Bank’s quantitative easing program has ended. In some instances, higher interest rates increase the cost of issuing FHLBank consolidated obligations and typically increase the cost of advances for its members.
In addition to the low absolute interest rates in 2009, spreads of FHLBank debt relative to similar term U.S. Treasury instruments significantly improved (narrowed) during 2009. For example, the spread between the on-the-run FHLBank two-year bullet debt and the two-year U.S. Treasury note was 82 bps as of December 31, 2008. This spread decreased to 11 bps as of December 31, 2009. The spread between the on-the-run FHLBank five-year bullet debt and the five-year U.S. Treasury note was 130 bps as of December 31, 2008. This spread decreased to 25 bps as of December 31, 2009. The theoretical swap level of the on-the-run FHLBank two-year bullet improved from three-month LIBOR plus 17.1 bps on December 31, 2008 to three-month LIBOR minus 9.8 bps on December 31, 2009. The theoretical swap level of the on-the-run FHLBank five-year bullet improved from three-month LIBOR plus 73.4 bps on December 31, 2008 to three-month LIBOR minus 1.8 bps on December 31, 2009. We believe that at least a portion of these improvements in the FHLBank’s spread to U.S. Treasuries and swap levels are likely due primarily to purchases of FHLBank debt by the Federal Reserve Bank, and, secondarily from stronger demand for FHLBank debt from other market participants, improving financial market conditions and improving market perceptions of the FHLBank system. We are uncertain, however, if these improved levels will continue into the future, especially when U.S. government ends the direct purchase of Agency securities by the Federal Reserve Bank under its quantitative easing program on March 31, 2010.
In November 2008, the Federal Reserve announced that it would begin purchasing Agency MBS and the direct obligations of the housing-related GSEs, including the FHLBank, in order to reduce the cost and increase the availability of credit for the purchase of homes. In March 2009, the FOMC expanded the program to purchase Agency MBS to a maximum of $1.25 trillion and expanded the GSE direct obligation purchase program to a maximum total of $200 billion. In September 2009, the FOMC announced the program’s commitment to purchase the maximum $1.25 trillion of Agency MBS and decided to gradually slow the pace of its purchases of Agency MBS and GSE direct obligations in order to promote a smooth transition to the completion of the program, and extended the targeted completion date of the programs from December 31, 2009 to the end of the first quarter of 2010. In November 2009, the FOMC reduced the maximum amount of GSE direct obligations it intended to buy by $25 billion to a maximum of approximately $175 billion. As of March 17, 2010, the Federal Reserve Bank had purchased a cumulative total of approximately $1.24 trillion in Agency MBS and $170.6 billion in Agency debentures which is approximately 99 percent and 97 percent of the program maximums, respectively. Of the GSE direct obligations purchased, the Federal Reserve has purchased $37.3 billion in FHLBank mandated Global bullets through March 17, 2010. During 2009, the Federal Reserve purchased $31.4 billion in FHLBank consolidated obligations. The weighted average maturity date of the FHLBank consolidated obligations purchased by the Federal Reserve in 2009 was October 28, 2012. From the beginning of the purchase program on December 5, 2008, the total amount of FHLBank consolidated obligations purchased by the Federal Reserve through December 31, 2009 was $34.4 billion with a weighted average maturity date of October 3, 2012. These purchases by the Federal Reserve helped stabilize the U.S. Treasury, Agency debenture and Agency MBS markets throughout 2009. When the purchases reach the program maximum or when the program expires, the cost to issue FHLBank consolidated obligations bonds will likely increase.
During the first quarter of 2009, the FOMC directed the Federal Reserve to initiate purchases of U.S. Treasuries. The Federal Reserve Bank completed its U.S. Treasury purchase program in October 2009. The total amount of U.S. Treasuries purchased under the program was $300 billion.
Primarily due to the implicit support from the U.S. government, investors continue to view short-term FHLBank consolidated obligations as carrying a strong credit profile. This resulted in strong investor demand for FHLBank discount notes and short-term bonds throughout 2009. Because of this strong demand, the cost to issue short-term consolidated obligations remained low throughout 2009. We are unsure how long these low debt issuance costs will persist; however, we anticipate that in 2010 demand for short-term consolidated obligations will fall and yields will rise due to declining demand from investors and increases in short-term interest rates.
Several recent developments have the potential to impact the demand for FHLBank short-term consolidated obligations including discount notes, floating rate consolidated obligations and short-term consolidated obligation bonds in the coming months. On February 23, 2010, the SEC published a final rule, which amends the rules governing money market funds under the Investment Company Act (see Item 1 - “Business - Legislation and Regulatory Developments”). Management anticipates that limiting the remaining maturity of money market fund investments in Agency consolidated obligations included in the SEC definition of “daily or weekly liquid assets” to 60 days or less will adversely impact the demand for discount notes and other consolidated obligations with longer maturities and will likely result in an increase in the FHLBank’s cost of funds. Additionally, reducing the maximum weighted average maturity of a money market fund’s portfolio from 90 days to 60 days and limiting the maximum weighted average life to maturity of a money market fund’s portfolio to 120 days will likely reduce money market funds’ demand for longer-term consolidated obligation discount notes, floating rate securities and short-term consolidated obligation bonds. Even without the SEC changes in the final rule, the demand for Agency discount notes by money market funds has declined steadily due to an overall decline in money market fund balances, which is the result of balances moving into other asset classes causing the Agency discount notes share in money market funds’ asset mixes to decline. Because money market funds are such a large and important investor base for FHLBank short-term obligations, lower demand from money market funds for FHLBank discount notes, floating rate consolidated obligation bonds and short-term consolidated obligation bonds will likely result in higher costs to issue these instruments and typically increase the cost of advances for its members.
On January 28, 2010, the U.S. Senate approved a $1.9 trillion increase to the debt ceiling. Subsequently, the measure was approved by the U.S. House of Representatives on February 4, 2010 and became public law on February 12, 2010. Congress previously increased the debt ceiling by $290 billion on December 24, 2009. The increase in the debt ceiling in 2010 allows for an increase in the U.S. Treasury’s Supplementary Financing Account by increasing its issuance of Treasury bills under the SFP. On February 23, 2010, the U.S. Treasury announced that it would issue $200 billion in SFP Treasury bills over the next two months. Prior to the increase in the debt ceiling, the U.S. Treasury was paying down Treasury bills in order to make room for issuance of longer-term Treasury securities. This decrease in outstanding Treasury bill supply was a primary contributor to the FHLBank’s improved cost on discount note issuance during the fourth quarter of 2009 as these instruments are often considered to be a similar investment. An increased supply of Treasury bills will likely lead to increased discount note costs in early 2010. Additionally, in order to drain excess reserves, other tools will likely eventually be employed by the Federal Reserve that will result in increased supply in the short-term debt market and increased competition for discount notes. These include, but are not limited to, issuance of non-SFP U.S. Treasury bills and reverse repos. Increased supply and competition will likely increase discount note costs.
As indicated previously, the cost to issue consolidated obligations for terms of two years or greater improved in 2009 relative to LIBOR and U.S. Treasury obligations. These longer term consolidated obligations are now trading at levels in the range experienced prior to the financial market disruptions in the second and third quarters of 2008. We believe this improvement is primarily the result of the FOMC’s direct purchases of FHLBank debentures and, secondarily, from stronger demand for Agency debt from other market participants, improving financial market conditions and improving market perceptions of the FHLBank system. The cost to issue consolidated obligations for terms of two years or greater is likely to increase following the expiration of the Federal Reserve’s program to purchase GSE direct obligations on March 31, 2010. While domestic investor demand for consolidated obligations remains relatively strong, foreign holdings of Agency securities (debentures and MBS) has steadily declined during 2009. Increased reliance on a smaller number of investors might result in higher debt costs for the FHLBank. However, because of the short-term maturity of its advances (including long-term adjustable rate advances tied to the FHLBank’s short-term advance rates) and short-term investments, the FHLBank continues to fund a portion of its advances and investments with short-term consolidated obligation discount notes. Discount notes as a percentage of total consolidated obligations dropped from 49 percent as of the end of 2008 to 30 percent as of the end of 2009, which was a function of: (1) the shrinkage in short-term FHLBank advances during 2009; (2) the shrinkage in short-term FHLBank investments during 2009; and (3) the improvement in the financial markets during 2009 that has allowed the FHLBank to issue swapped callable debt at lower sub-LIBOR costs than in late 2008 and early 2009. The use of discount notes allows the FHLBank to adjust its balance sheet as advance demand expands and contracts, much like it did in 2009.
On December 24, 2009, the U.S. Treasury announced that it was amending the Preferred Stock Purchase Agreements with Fannie Mae and Freddie Mac, which were established when the Agencies were put into conservatorship. The amendment effectively removed the cap established under these commitments and amended the requirement that Fannie Mae and Freddie Mac reduce the size of their retained portfolio in 2010 to be based on the maximum allowable size of the portfolio ($900 billion per institution) instead of the actual size of the portfolios at the end of 2009. The U.S. Treasury’s actions were intended to demonstrate the government’s support for Fannie Mae and Freddie Mac and its support of the role they play in the housing market. This show of support might also strengthen how the market perceives the implicit guarantee on FHLBank consolidated obligations and increase demand for these obligations.
On February 10, 2010, Freddie Mac and Fannie Mae announced that they would buy out guaranteed loans that are delinquent by 120 days or greater. See Item 1A - “Risk Factors” for additional discussion. It is likely that both agencies will increase their issuance of discount notes, short-term callable and bullet bonds, and floating rate bonds to fund these buyouts. This increase will likely provide additional upward pressure on the cost of similar instruments issued by the FHLBank.
As of February 1, 2010, the Federal Reserve closed most of its special liquidity facilities, which were initiated as a result of the severe financial market turmoil in the fall of 2008. Those facilities that were closed include the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility, the Commercial Paper Funding Facility, the Primary Dealer Credit Facility and the Term Securities Lending Facility. Additionally, the Federal Reserve held the last Term Auction Facility (TAF) auction on March 8, 2010 (after several previous announcements regarding reductions in auction sizes) due to improvements in the short-term funding markets. TAF funds were an alternative to FHLBank advances for certain FHLBank members, and therefore, these actions may increase demand for advances from these members.
Critical Accounting Policies and Estimates
The preparation of the FHLBank’s financial statements in accordance with GAAP requires management to make a number of judgments and assumptions that affect the FHLBank’s reported results and disclosures. Several of the FHLBank’s accounting policies are inherently subject to valuation assumptions and other subjective assessments and are more critical than others in terms of their importance to the FHLBank’s results. These assumptions and assessments include the following:
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Accounting related to derivatives;
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Fair-value determinations;
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Accounting for other-than-temporary impairment of investments;
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Accounting for deferred premium/discount associated with MBS; and
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Determining the adequacy of the allowance for credit losses.
Changes in any of the estimates and assumptions underlying the FHLBank’s critical accounting policies could have a material effect on the FHLBank’s financial statements.
The FHLBank’s accounting policies that management believes are the most critical to an understanding of the FHLBank’s financial results and condition and require complex management judgment are described below.
Accounting for Derivatives. The FHLBank carries derivative instruments at fair value on the Statement of Condition. Any change in the fair value of a derivative is recorded each period in current period earnings or other comprehensive income, depending upon whether the derivative is designated as part of a hedging relationship and, if it is, the type of hedging relationship. A majority of the FHLBank’s derivatives are structured to offset some or all of the risk exposure inherent in its lending, mortgage purchase, investment and funding activities. The FHLBank is required to recognize unrealized gains or losses on derivative positions, regardless of whether offsetting gains or losses on the underlying assets or liabilities being hedged may be recognized in a symmetrical manner. Therefore, the accounting framework introduces the potential for considerable income variability from period-to-period. Specifically, a mismatch can exist between the timing of income and expense recognition from assets or liabilities and the income effects of derivative instruments positioned to mitigate market risk and cash flow variability. Therefore, during periods of significant changes in interest rates and other market factors, the FHLBank’s reported earnings may exhibit considerable variability. The FHLBank emphasizes hedging techniques that are effective under the hedge accounting requirements. However, in some cases, the FHLBank has elected to retain or enter into derivatives that are economically effective at reducing its risk but do not meet the hedge accounting requirements, either because the cost of the derivative hedge was economically superior to non-derivative hedging alternatives or because no non-derivative hedging alternative was available. As required by Finance Agency regulation and the FHLBank’s RMP, derivative instruments that do not qualify as hedging instruments may be used only if a non-speculative purpose is documented by the FHLBank at the inception of the derivative transaction.
A hedging relationship is created from the designation of a derivative financial instrument as either hedging the FHLBank’s exposure to changes in the fair value of a financial instrument or changes in future cash flows attributable to a balance sheet financial instrument or anticipated transaction. Fair value hedge accounting allows for the offsetting fair value of the hedged risk in the hedged item to also be recorded in current period earnings. Highly effective hedges that use interest rate swaps as the hedging instrument and that meet certain stringent criteria can qualify for “shortcut” fair value hedge accounting. Shortcut accounting allows for the assumption of no ineffectiveness, which means that the change in fair value of the hedged item can be assumed to be equal to the change in fair value of the derivative. If the hedge is not designated for shortcut accounting, it is treated as a “long haul” fair value hedge, where the change in fair value of the hedged item must be measured separately from the derivative, and for which effectiveness testing must be performed regularly with results falling within established tolerances. If the hedge fails effectiveness testing, the hedge no longer qualifies for hedge accounting and the derivative is marked to estimated fair value through current period earnings without any offsetting change in estimated fair value related to the hedged item. As of July 1, 2008, the FHLBank discontinued using shortcut hedge accounting for all new derivative transactions.
For derivative transactions that potentially qualify for long haul fair value hedge accounting treatment, management must assess how effective the derivatives have been, and are expected to be, in hedging offsetting changes in the estimated fair values attributable to the risks being hedged in the hedged items. Hedge effectiveness testing is performed at the inception of the hedging relationship and on an ongoing basis for long haul fair value hedges. The FHLBank performs testing at hedge inception based on regression analysis of the hypothetical performance of the hedging relationship using historical market data. The FHLBank then performs regression testing on an ongoing basis using accumulated actual values in conjunction with hypothetical values. Specifically, each month the FHLBank uses a consistently applied statistical methodology that employs a sample of 30 historical interest rate environments and includes an R-squared test, a slope test and an F-statistic test. These tests measure the degree of correlation of movements in estimated fair values between the derivative and the related hedged item. For the hedging relationship to be considered effective, the R-squared must be greater than or equal to 0.80, the slope must be between or equal to -0.80 and -1.20, and the computed F statistic must be greater than or equal to 4.0.
Given that a derivative qualifies for long haul fair value hedge accounting treatment, the most important element of effectiveness testing is the price sensitivity of the derivative and the hedged item in response to changes in interest rates and volatility as expressed by their effective durations. The effective duration will be influenced mostly by the final maturity and any option characteristics. In general, the shorter the effective duration, the more likely it is that effectiveness testing would fail because of the impact of the short-term LIBOR side of the interest rate swap. In this circumstance, the slope criterion is the more likely factor to cause the effectiveness test to fail.
The estimated fair values of the derivatives and hedged items do not have any cumulative economic effect if the derivative and the hedged item are held to maturity, or contain mutual optional termination provisions at par. Since these fair values fluctuate throughout the hedge period and eventually return to par value on the maturity or option exercise date, the earnings impact of fair value changes is only a timing issue for hedging relationships that remain outstanding to maturity or the call termination date.
For derivative instruments and hedged items that meet the requirements as described above, the FHLBank does not anticipate any significant impact on its financial condition or operating performance. For derivative instruments where no identified hedged item qualifies for hedge accounting, changes in the market value of the derivative are reflected in monthly income. As of December 31, 2009 and 2008, the FHLBank held a portfolio of derivatives that are marked to market with no offsetting qualifying hedged item. This portfolio includes interest rate caps and floors hedging MBS, interest rate swaps hedging trading securities, interest rate swaps hedging duration of equity (DOE) risk and interest rate swaps used to lower the FHLBank’s cost of funds. The total fair value of these positions, including accrued net interest, was $(25.6) million and $(187.9) million as of December 31, 2009 and 2008, respectively. While the fair value of these derivative instruments, with no offsetting qualifying hedged item, will fluctuate with changes in interest rates and the impact on the FHLBank’s earnings can be material, the change in market value of trading securities being hedged by economic hedges is expected to partially offset that impact. The change in fair value of the derivatives classified as economic hedges is only partially offset by the change in the market value of trading securities being hedged by economic hedges because the amount of economic hedges exceeds the amount of swapped trading securities. As of December 31, 2009, the FHLBank’s economic hedges consisted of: (1) notional amount of interest rate caps and floors of $6.6 billion hedging changes in interest rates and overall duration of variable rate MBS; (2) notional amount of interest rate swaps of $3.4 billion hedging the cost of consolidated obligation bonds; (3) notional amount of interest rate swaps of $1.5 billion hedging GSE debentures in trading securities; and (4) notional amount of interest rate swaps and caps of $0.3 billion for intermediary transactions. The total par value of trading securities related to economic hedges was $1.5 billion as of December 31, 2009, which matches the notional amount of interest rate swaps hedging the GSE debentures in trading securities on that date. As of December 31, 2008, the FHLBank’s economic hedges consisted of: (1) notional amount of interest rate caps and floors of $6.7 billion hedging changes in interest rates and overall duration of variable rate MBS; (2) notional amount of interest rate swaps of $0.9 billion hedging the cost of consolidated obligation bonds; (3) notional amount of interest rate swaps of $1.6 billion hedging GSE debentures in trading securities; and (4) notional amount of interest rate swaps and caps of $0.2 billion for intermediary transaction. The total par value of trading securities related to economic hedges was $1.6 billion as of December 31, 2008, which matches the notional amount of interest rate swaps hedging the GSE debentures in trading securities on that date. For asset/liability management purposes, all non-mortgage-backed securities currently classified as trading are matched to interest rate swaps that effectively convert the securities from fixed rate investments to variable rate instruments. See Tables 62 through 64 under this Item 7, which show the relationship of gains/losses on economic derivative hedges and gains/losses on the non-mortgage-backed trading securities being hedged by economic derivatives. The FHLBank’s projections of changes in fair value of the derivatives have been consistent with actual results. For the balance sheet risks that these derivatives hedge, changes in value historically have been directionally consistent with changes in actual interest rates.
Fair Value. As of December 31, 2009 and 2008, certain of the FHLBank’s assets and liabilities, including investments classified as trading, and all derivatives were presented in the Statement of Condition at fair value. Under GAAP, fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Fair values play an important role in the valuation of certain of the FHLBank’s assets, liabilities and derivative transactions. The fair values generated by the FHLBank directly impact the Statements of Condition, Statements of Income, Statements of Capital and Statements of Cash Flows as well as risk-based capital, DOE and market value of equity (MVE) disclosures. Management also estimates the fair value of collateral that borrowers pledge against advance borrowings and other credit obligations to confirm that the FHLBank has sufficient collateral to meet regulatory requirements and to protect itself from a credit loss.
Fair values are based on market prices when they are available. If market quotes are not available, fair values are based on discounted cash flows using market estimates of interest rates and volatility, or on prices of similar instruments. Pricing models and their underlying assumptions are based on management’s best estimates for discount rates, prepayment speeds, market volatility and other factors. FHLBank management validates its financial models at least annually and the models are calibrated to values from outside sources on a monthly basis. The FHLBank validates modeled values to outside valuation services routinely to determine if the values generated from discounted cash flows are reasonable. The assumptions used may have a significant effect on the reported fair values of assets and liabilities, including derivatives, and the related income and expense. See Note 16 of the Notes to the Financial Statements included under Item 8 - “Financial Statements and Supplementary Data” for a detailed discussion of the assumptions used to calculate fair values. The use of different assumptions as well as changes in market conditions could result in materially different net income and retained earnings.
As of December 31, 2009, the FHLBank had no fair values that were classified as level 3 valuations for financial instruments that are measured on a recurring or nonrecurring basis at fair value. However, the FHLBank has recorded other-than-temporary impairment charges on eight held-to-maturity securities, which were written down to their fair values and considered level 3 valuations as of the dates of impairment. The number of unobservable inputs and assumptions was apparent based on validation with other market participant data and valuation sources, and management concluded that the pricing derived for these particular investments should be considered a level 3 valuation.
Accounting for Other-Than-Temporary Impairment of Investments. The continued broad-based deterioration of credit performance related to residential mortgage loans and the accompanying decline in U.S. residential real estate values have increased the level of credit risk to which the FHLBank is exposed in its investments in mortgage-related securities, primarily private-label MBS. The FHLBank’s investments in mortgage-related securities are directly or indirectly supported by underlying mortgage loans. Due to the decline in values of residential U.S. real estate and difficult conditions in the credit markets, the FHLBank closely monitors the performance of its investment securities classified as held-to-maturity on at least a quarterly basis (or more frequently if a loss-triggering event occurs, such as a material downgrade by the rating agencies) to evaluate its exposure to the risk of loss on these investments in order to determine whether a loss is other-than-temporary.
When the fair value of a debt security is less than its amortized cost as of the balance sheet date, an entity is required to assess whether: (1) it has the intent to sell the debt security; (2) it is more likely than not that it will be required to sell the debt security before its anticipated recovery; (3) or it does not expect to recover the entire amortized cost basis of the security. If any of these conditions is met, an OTTI on the security must be recognized.
In instances in which a determination is made that a credit loss (defined as the difference between the present value of the cash flows expected to be collected and the amortized cost basis) exists, but the FHLBank does not intend to sell the debt security, nor is it more likely than not that the FHLBank will be required to sell the debt security before the anticipated recovery of its remaining amortized cost basis (i.e., the amortized cost basis less any current-period credit loss), the presentation and amount of the OTTI recognized in the Statements of Income has changed. In these instances, the OTTI is separated into: (1) the amount of the OTTI related to the credit loss; and (2) the amount of the OTTI related to all other factors. If the FHLBank’s analysis of expected cash flows results in a present value of expected cash flows that is less than the amortized cost basis of a security (that is, a credit loss exists), an OTTI is considered to have occurred. If there is no credit loss, any impairment is not other-than-temporary. If the FHLBank determines that an OTTI exists, it accounts for the investment security as if it had been purchased on the measurement date of the OTTI at an amortized cost basis equal to the previous amortized cost basis less OTTI recognized in non-interest income. The difference between the new amortized cost basis and the cash flows expected to be collected is accreted into interest income prospectively over the remaining life of the investment security based on the amount and timing of estimated future cash flows (with no effect on earnings unless the security is subsequently sold or there are additional decreases in cash flows expected to be collected). See additional discussion regarding the recognition and presentation of OTTI in Note 1 of the Notes to the Financial Statements included under Item 8 - “Financial Statements and Supplementary Data.”
Beginning in the first quarter of 2009, to ensure consistency in determination of the OTTI for investment securities among all FHLBanks, the FHLBanks began using the same key modeling assumptions for purposes of their cash flow analysis. During the second quarter of 2009, the FHLBanks formed an OTTI Governance Committee consisting of representatives from each FHLBank. The OTTI Governance Committee develops the modeling assumptions to be used by the FHLBanks to produce expected cash flows for use in analyzing credit losses and OTTI for residential private-label MBS.
Guidance provided by the Finance Agency, some of which was based upon written guidance and other of which was provided only through informal comments to the FHLBanks, indicated that an FHLBank may use an alternative risk model with alternative loan information data if certain conditions are met. The written guidance also indicated that an FHLBank that does not have access to the required risk model and loan information data sources or does not meet the conditions for using an alternative risk model as required under the Finance Agency guidance may engage another FHLBank to perform the cash flow analysis underlying its OTTI determination.
Private-label MBS are evaluated by estimating projected cash flows using models that incorporate projections and assumptions typically based on the structure of the security and certain economic environment assumptions such as delinquency and default rates, loss severity, home price appreciation/depreciation, interest rates and securities’ prepayment speeds while factoring in the underlying collateral and credit enhancement. A significant input to such analysis is the forecast of housing price changes for the relevant states and metropolitan statistical areas, which are based on an assessment of the relevant housing markets. See additional discussion regarding the projections and assumptions in Note 6 of the Notes to the Financial Statements included under Item 8 - “Financial Statements and Supplementary Data.” The loan level cash flows and losses are allocated to various security classes, including the security classes owned by the FHLBank, based on the cash flow and loss allocation rules of the individual security.
For certain private-label MBS where underlying collateral data is not available, alternative procedures as determined by each FHLBank are used to assess these securities for OTTI. These evaluations are inherently subjective and consider a number of qualitative factors. In addition to monitoring the credit ratings of these securities for downgrades, as well as placement on negative outlook or credit watch, management evaluates other factors that may be indicative of OTTI. These include, but are not limited to, an evaluation of the type of security, the length of time and extent to which the fair value of a security has been less than its cost, any credit enhancement or insurance, and certain other collateral-related characteristics such as FICO credit scores, LTV ratios, delinquency and foreclosure rates, geographic concentration and the security’s past performance.
Each FHLBank is responsible for making its own determination of OTTI and performing the required present value calculations using appropriate historical cost bases and yields. FHLBanks that hold common private-label MBS are required to consult with one another to ensure that any decision that a commonly-held private-label MBS is other-than-temporarily impaired, including the determination of fair value and the credit loss component of the unrealized loss, is consistent between or among those FHLBanks. The process of estimating the future cash flows of the private-label MBS requires a significant amount of judgment to formulate the assumptions that are utilized in this process. The assumptions utilized by the FHLBank for the majority of its private-label MBS are reviewed and approved by the FHLBanks’ OTTI Governance Committee.
Deferred Premium/Discount Associated with MBS. When the FHLBank purchases MBS, it often pays an amount that is different than the unpaid principal balance. The difference between the purchase price and the contractual note amount is a premium if the purchase price is higher and a discount if the purchase price is lower. Accounting guidance permits the FHLBank to amortize (or accrete) the premiums (or discounts) in a manner such that the yield recognized on the underlying asset is constant over the asset’s estimated life. The FHLBank typically pays more than the unpaid principal balances when the interest rates on the MBS are greater than prevailing market rates for similar MBS on the transaction date. The net purchase premiums paid are then amortized using the level-yield method over the expected lives of the MBS as a reduction in yield (decreases interest income). Similarly, if the FHLBank pays less than the unpaid principal balance because interest rates on the MBS are lower than prevailing market rates on similar MBS on the transaction date, the net discounts are accreted in the same manner as the premiums, resulting in an increase in yield (increases interest income). The level-yield amortization method is applied using expected cash flows that incorporate prepayment projections that are based on mathematical models which describe the likely rate of consumer mortgage loan refinancing activity in response to incentives created (or removed) by changes in interest rates. Changes in interest rates have the greatest effect on the extent to which mortgage loans may prepay, although, during the current disruption in the financial market, tight credit and declining home prices, consumer mortgage refinancing behavior is also significantly affected by the borrower's credit score and the value of the home in relation to the outstanding loan value. Generally, however, when interest rates decline, mortgage loan prepayment speeds are likely to increase, which accelerates the amortization of premiums and the accretion of discounts. The opposite occurs when interest rates rise. The FHLBank uses a third-party data service that provides estimates of cash flows, from which the FHLBank determines expected asset lives for the MBS. The level-yield method uses actual prepayments received and projected future mortgage prepayment speeds, as well as scheduled principal payments, to determine the amount of premium/discount that must be recognized and will result in a constant monthly yield until maturity. Amortization of MBS premiums could accelerate in falling interest-rate environments or decelerate in rising interest-rate environments. Exact trends will depend on the relationship between market interest rates and coupon rates on outstanding MBS, the historical evolution of mortgage interest rates, the age of the underlying mortgage loans, demographic and population trends, and other market factors such as increased foreclosure activity, falling home prices, tightening credit standards by mortgage lenders and the other housing GSEs, and other repercussions from the current financial market crisis.
Provision for Credit Losses.
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Advances. The FHLBank has never experienced a credit loss on an advance and management currently does not anticipate any credit losses on advances. Based on the collateral held as security for advances, management’s credit analysis and prior repayment history, no allowance for losses on advances is deemed necessary. The FHLBank is required by statute to obtain and maintain security interests in sufficient collateral on advances to protect against losses, and to accept as collateral on such advances only certain qualified types of collateral, which are primarily U.S. government or government Agency/GSE securities, certain residential mortgage loans, deposits in the FHLBank and other real estate related assets. See Item 1 - “Business - Advances” for a more detailed collateral discussion.
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Mortgage Loans. The FHLBank estimates the allowance for loan loss on homogeneous pools of mortgage loans or on an individual mortgage loan basis to assess the credit losses that are inherent in the portfolio but have not been realized.
o Homogeneous Pools of Mortgage Loans - The assessment of loan loss for the pools of loans entails breaking the loan pool into strata based on each of the current classifications of each loan (i.e., current, delinquent, non-performing, referred to foreclosure). The FHLBank then determines the probability of default for each strata of loans based on a short- and mid-term horizon utilizing historical statistics. In addition, the FHLBank determines the pool’s historical loss statistics based on a short- and mid-term horizon. The FHLBank then utilizes the loan balances, probability of default and historical loss statistics to determine the expected loan loss for the pool.
o Individual Mortgage Loans - The FHLBank calculates an allowance for loan loss on individual loans if events or circumstances make it probable that the FHLBank will not be able to collect all amounts due according to the contractual terms for a subset of the mortgage loans. The FHLBank has determined that all mortgage loans in the MPF Program are considered collateral dependent and has elected to measure individual loan impairment based on collateral value less estimated cost to sell. Collateral value is based on appraisals, if available, or estimated property values using housing pricing indices. If the collateral value less cost to sell is less than the recorded investment in the loan, the loan is considered impaired. The excess of the recorded investment in the loan over the loan’s collateral value less cost to sell is recorded as the loan’s estimate of allowance for loan loss. If a loan has an individual impairment recorded, it is excluded from the pool assessment.
Once the pool level and individual loan level assessments are completed, the total estimates of loan losses are accumulated to the master commitment level to determine how the expected future losses would be shared between the FHLBank and the PFIs, based on the loss allocation rules for each MPF product (see Item 1 - “Business - Mortgage Loans Held for Portfolio” for more details). The estimated losses that will be allocated to the FHLBank are recorded as the balance in the allowance for loan loss with the resulting offset being presented as the provision for credit losses on mortgage loans.
The process of determining the allowance for loan losses requires a high degree of judgment. It is possible that others, given the same information, may at any point in time reach different reasonable conclusions. Because of variability in the data underlying the assumptions made in the process of determining the allowance for loan losses, estimates of the portfolio’s inherent risks will change as warranted by changes in the economy, particularly the residential mortgage loan market and changes in house prices. The degree to which any particular change would affect the allowance for loan losses would depend on the severity of the change.
As of December 31, 2009 and 2008, the allowance for loan losses on the conventional mortgage loan portfolio amounted to $1,897,000 and $884,000, respectively. The allowances reflect the FHLBank’s estimate of probable incurred losses inherent in its mortgage loan portfolio as of those dates. As of December 31, 2009 and 2008, the allowance for credit losses did not include any loans that were impaired based on an individual loan level assessment.
See Table 25 under this Item 7 for detail of the activity in the allowance for credit losses on mortgage loans.
Impact of Recently Issued Accounting Standards
See Note 2 of the Notes to the Financial Statements included under Item 8 - “Financial Statements and Supplementary Data” for a discussion of recently issued accounting standards.
Balance Sheet Analysis
Overall - Table 16 presents changes in the major components of the FHLBank’s Statements of Condition from December 31, 2008 to December 31, 2009 (in thousands):
Table 16
Investments also include interest-bearing deposits, Federal funds sold and securities purchased under agreements to resell.
Advances - Outstanding advances decreased by 37.9 percent from $35.8 billion as of December 31, 2008 to $22.3 billion as of December 31, 2009 (see Table 16). Total advances as a percentage of total assets decreased from 61.2 percent as of December 31, 2008 to 52.2 percent as of December 31, 2009. The number of members and non-members with outstanding advances was 687 as of December 31, 2008 and decreased to 640 as of December 31, 2009.
Reductions in advance balances from the FHLBank’s five largest borrowers as of December 31, 2008 (see Table 2 under Item 1 - “Business - Advances”) account for over half of the decrease in total advances in 2009. This includes U.S. Central Federal Credit Union, which paid down $5.4 billion during the first quarter of 2009, largely as a consequence of government assistance received by U.S. Central Federal Credit Union and its placement into conservatorship by the National Credit Union Administration on March 20, 2009. The remaining decrease is the result of a decline in the demand for FHLBank advances attributable to: (1) investors increasing bank deposits after retreating from the stock markets; (2) sluggish loan demand at our members; and (3) programs offered by the U.S. government and the Federal Reserve to infuse the financial markets with liquidity as a way to address the ongoing financial and liquidity crisis, which compete against advances. The final rule relating to FDIC deposit assessments as well as the possibility of ongoing special assessments on FDIC-insured financial institution deposit balances continues to improve the relative cost of advances for our member FDIC-insured financial institutions. However, these actions do not seem to have impacted the demand for advances at this time, and there is nothing to indicate to FHLBank management that the decline in outstanding FHLBank advances will cease until there is an increase in U.S. economic activity that results in increased loan demand at our member financial institutions. While we cannot predict how much more advances will decline, if any, we do not expect the rate of decline in 2010 to be anywhere near the decline experienced in 2009. We anticipate the percentage of total advances to total assets to remain near 50 percent during 2010. If advances continue to decline, we expect to: (1) repurchase excess capital stock, consistent with past practice, when and as requested; and (2) leverage capital in the range of 22:1 to 23:1 as conditions dictate. In addition, when member advance demand does begin to increase, a few larger members could have a significant impact on the amount of total outstanding advances.
Because of the significant decrease in advances, the dollar amount and percentage composition of several of the advance products listed in Table 1 under Item 1 - “Business - Advances” have changed materially during 2009. Line of credit advances (which re-price daily) represented 4.0 percent of outstanding advances as of December 31, 2009 and declined by $6.9 billion, or 89.0 percent, from December 31, 2008. Short-term, fixed rate advances (maturities of 93 days or less) decreased by $4.8 billion, or 87.9 percent, and represented 3.0 percent of advances as of December 31, 2009. Adjustable rate callable advances (re-pricing daily to every three months) increased by $1.0 billion, or 15.2 percent, and represented 33.4 percent of total advances at the end of 2009. Fixed rate convertible advances (swapped to three-month LIBOR, synthetically creating three-month advances) decreased by $0.7 billion, or 12.1 percent, and represented 23.2 percent of advances as of year-end 2009. Regular fixed rate advances were 30.2 percent of advances as of December 31, 2009 following a $1.3 billion, or 16.3 percent, decline from year-end 2008.
Table 17 summarizes the par amount of FHLBank advances by year of maturity, or next call date for callable advances, as of December 31, 2009 (in thousands):
Table 17
A significant portion of advances with longer maturities are swapped to short-term indices (one-month or three-month LIBOR) to synthetically create adjustable rate advances. Consequently, advances that effectively re-price at least every three months (swapped long-term advances, line of credit advances, short-term fixed rate advances, adjustable rate advances and convertible rate advances) represent 83.1 percent and 86.5 percent of the FHLBank’s total advance portfolio as of December 31, 2009 and December 31, 2008, respectively. See Table 1 under Item 1 - “Business - Advances” for a summary of the advance products outstanding as of December 31, 2009 and 2008.
Because of the relatively short nature of the FHLBank’s advance portfolio, including the impact of any interest rate swaps qualifying as fair value hedges (i.e., regular and convertible fixed rate advances swapped to three-month LIBOR utilizing interest rate swaps), the average yield in this portfolio typically responds quickly to changes in short-term interest rates. The average yield on advances was 1.34 percent for the year ended December 31, 2009 compared to 2.97 percent for 2008 and 5.26 percent for 2007. The decrease in average yields on advances is attributable to the decline in short-term rates, with the average short-term advance rate dropping approximately 400 bps from the end of 2007.
The level of short-term interest rates is primarily driven by FOMC decisions on the level of its overnight Federal funds target, but is also influenced by the expectations of capital market participants related to the strength of the economy, future inflationary pressures and other factors. Throughout 2009, the FOMC left the Federal funds target rate unchanged at zero to 0.25 percent; and given the ongoing recession and the current economic conditions in early 2010, the FOMC did not change the Federal funds target rate at its March 16, 2010 meeting. Therefore, we anticipate advance yields will remain relatively stable in 2010 unless there is a significant change in our advance mix. See Table 60, Spread and Yield Analysis, and Table 61, Rate and Volume Analysis, under Item 7 - “Financial Review - Results of Operations” for further information on 2007 through 2009 average balances and yields.
The FHLBank develops its advance programs, as authorized in the Bank Act and in regulations established by the Finance Agency, to meet the specific needs of its members. As a wholesale provider of funds, the FHLBank competes with brokered certificates of deposit, security repurchase agreements and U.S. government lending programs for short- and medium-term maturities. The FHLBank strives to price its advances relative to its marginal cost of funds while trying to remain competitive with these markets. While there is less competition in the long-term maturities, member advance demand for these maturities has historically been lower than the demand for short-term maturities. Nonetheless, long-term advances are also priced at relatively low spreads to the FHLBank’s cost of funds.
Prepayment Fees: The FHLBank prices advances based on the FHLBank’s marginal cost of issuing matched-maturity funding while considering its related administrative and operating costs, substitute pricing and desired profitability targets. Advances with a maturity or re-pricing period greater than three months generally incorporate a fee sufficient to make the FHLBank financially indifferent should the borrower decide to prepay the advance.
The FHLBank had no foreign advances as of December 31, 2009, 2008, 2007, 2006 and 2005. Table 18 presents the book value of total advances as of December 31, 2009, 2008, 2007, 2006 and 2005 (in thousands):
Table 18
Letters of Credit: The FHLBank also issues letters of credit for members. Members must collateralize letters of credit at the date of issuance and at all times thereafter. Letters of credit are secured in accordance with the same requirements as for advances. However, letters of credit issued or confirmed on behalf of a member to: (1) facilitate residential housing finance; or (2) facilitate community lending that is eligible for any of the FHLBank’s CICA programs may also be secured by state and local government securities. Table 19 presents outstanding letters of credit balances as of December 31, 2009, 2008, 2007, 2006 and 2005 (in thousands):
Table 19
Standby Credit Facility: In December 2007, the FHLBank began offering a standby credit facility (SCF) product, which is a commitment to issue an advance. SCF commitments are for terms of one year; and any draws on the SCF must be fully collateralized prior to any disbursement of funds and at all times thereafter. Outstanding SCF commitments totaled $1.0 billion and $2.0 billion as of December 31, 2008 and 2007, respectively. As of December 31, 2009, the FHLBank had no outstanding SCF commitments.
Housing Associates: The FHLBank is permitted under the Bank Act to make advances to housing associates, which are non-members that are approved mortgagees under Title II of the National Housing Act. Outstanding advances to housing associates totaled $73.3 million and $149.0 million as of December 31, 2009 and 2008, respectively, representing less than one percent of total advances for each period presented. All outstanding housing associates advances as of December 31, 2009 and 2008 were to state housing finance authorities; and therefore, the restrictive collateral provisions indicated in Item 1 - “Business - Advances” do not apply.
MPF Program - The FHLBank participates in the MPF Program through the MPF Provider, a division of the FHLBank of Chicago. Under this program, participating members of an FHLBank can sell fixed rate, size-conforming, single-family mortgage loans to the FHLBank (closed loans) and/or originate loans on behalf of the FHLBank (table funded loans). As of December 31, 2009 and 2008, agreements were in place with 169 and 161 PFIs, respectively, and the number of those PFIs that have delivered loans under the program in the same time period was 155 and 147, respectively. During 2009, the volume of new loans originated by or acquired from in-district PFIs was $1.2 billion. New loans issued or purchased, net of loan payments received, increased the outstanding balance of the MPF portfolio by 10.3 percent, or $310.0 million. Although there is no guarantee, we anticipate that the number of PFIs delivering loans to the FHLBank will increase during 2010 and beyond as we strive to increase the number of active PFIs.
Toward the end of 2008, the U.S. Treasury and Federal Reserve Banks began direct purchases of MBS backed by Fannie Mae, Freddie Mac and Ginnie Mae. These purchases continued throughout 2009 and resulted in lower interest rates on residential mortgages. Because the FHLBank’s funding costs are generally higher than those of the U.S. Treasury, the MPF pricing formula was adjusted to take into account the cost of FHLBank debt, resulting in lower prices than those offered by Fannie Mae or Freddie Mac. Despite the government intervention into the residential mortgage market, volumes sold under the MPF Program during 2009 outpaced the program’s repayments. The program for direct purchases of MBS backed by Fannie Mae, Freddie Mac and Ginnie Mae is currently scheduled to expire on March 31, 2010.
Future volume growth for mortgage loans held in portfolio will depend on a number of factors, including: (1) the number of new and delivering PFIs; (2) the mortgage loan origination volume of PFIs in 2010; (3) refinancing activity; (4) the level of interest rates and the shape of the yield curve; and (5) the relative competitiveness of MPF pricing to the prices offered by other buyers of mortgage loans. In September 2008, the MPF Provider announced the addition of an MPF product (MPF Xtra) that provides PFIs with access to the secondary mortgage market without adding to the interest rate risk on an FHLBank’s balance sheet. An agreement was executed with Fannie Mae as the first non-FHLBank investor in MPF assets. The MPF Xtra product is being offered by the FHLBanks of Boston, Chicago, Des Moines and Pittsburgh. Although FHLBank Topeka has not yet offered the product, it is prepared to do so if future market conditions deem it undesirable to hold MPF assets in portfolio. The MPF Program has been a very attractive option for smaller institutions compared to their other (non-GSE) secondary mortgage market options.
Table 20 presents the FHLBank’s top five PFIs, the outstanding balances (in thousands) of mortgage loans acquired from them as of December 31, 2009 and 2008, and the percentage of those loans to total MPF loans outstanding on those dates. If a PFI was not one of the top five for one of the years presented, the applicable column is left blank. The larger PFIs have generally had decreasing balances as most of their new loan production is being sold directly to Fannie Mae or Freddie Mac due to government actions that have made their pricing more competitive than pricing on MPF loans. As a result, most of the FHLBank’s MPF portfolio growth is primarily coming from smaller PFIs that are not set up to sell directly to Fannie Mae or Freddie Mac.
Table 20
La Salle National Bank, N.A. is an out-of-district PFI in which we previously participated in mortgage loans with the FHLBank of Chicago.
Formerly Commercial Federal Bank, FSB headquartered in Omaha, NE. Bank of the West acquired Commercial Federal Bank, FSB on December 2, 2005. Bank of the West is a member of the Federal Home Loan Bank of San Francisco.
The average yields on mortgage loans were 5.01 percent, 5.16 percent and 5.21 percent during 2009, 2008 and 2007, respectively. The average yield on mortgage loans decreased in 2009 and 2008. This decrease is primarily attributable to the falling mortgage interest rate environment late in 2008 and throughout 2009. The average yield on mortgage loans is expected to decrease in response to anticipated decreases in market interest rates on mortgage loans during 2010. See Table 60, Spread and Yield Analysis, and Table 61, Rate and Volume Analysis, under Item 7 for further information.
Asset Quality: The FHLBank classifies conventional real estate mortgage loans as “non-performing” when they are contractually past due 90 days or more and interest is no longer accrued. Interest continues to accrue on government-insured real estate mortgage loans (e.g., FHA, VA, HUD and RHS loans) that are contractually past due 90 days or more. The weighted average FICO® score and LTV ratio recorded at origination for conventional mortgage loans held in portfolio as of December 31, 2009 was 746 FICO and 72.9 percent LTV (see Table 27). The percentage of loans 90 days or more past due has increased from 0.3 percent as of December 31, 2008 to 0.8 percent as of December 31, 2009 (see Table 22). Although the percentage change in non-performing loans has more than doubled, in comparison to national data, the current percentage is still extremely low. According to the December 31, 2009 Mortgage Bankers Association National Delinquency survey, 4.0 percent of all conventional mortgage loans are 90 days or more past due. This is more than four times the level of non-performing loans in the MPF portfolio.
On July 15, 2009, the MPF Provider issued a PFI Notice announcing a Temporary Loan Payment Modification Plan (Modification Plan). The plan applies to conventional loans funded by the FHLBank prior to January 1, 2009 that are in default or in imminent danger of default. The Modification Plan was effective on the date of the PFI Notice and is effective through December 31, 2011. Under certain circumstances and if meeting specific criteria, the Modification Plan may be an appropriate loss mitigation option for certain borrowers, by temporarily reducing the monthly housing payments to a sustainable level. The FHLBank estimates the number of potential loans eligible for the Modification Plan to be minimal. However, the loans currently performing but facing imminent default are difficult to estimate.
Table 21 presents the unpaid principal for conventional and government-insured mortgage loans as of December 31, 2009, 2008, 2007, 2006 and 2005 (in thousands):
Table 21
Table 22 presents the unpaid principal for performing mortgage loans, non-performing mortgage loans and mortgage loans 90 or more days past due and accruing as of December 31, 2009, 2008, 2007, 2006 and 2005 (in thousands):
Table 22
Information regarding the interest income shortfall on the non-performing loans during the periods ending December 31, 2009 and 2008 is included in Table 23 (in thousands):
Table 23
MPF Allowance for Credit Losses on Mortgage Loans: As of December 31, 2009, 2008, 2007, 2006 and 2005, the FHLBank had recorded an allowance for credit losses of $1,897,000, $884,000, $844,000, $854,000 and $756,000, respectively. The FHLBank bases its allowance on management’s estimate of probable credit losses inherent in the FHLBank’s mortgage loan portfolio as of the Statement of Condition date. The estimate is based on an analysis of the FHLBank’s historical loss experience (see Item 7 - “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Critical Accounting Policies and Estimates” for further information). Management believes that policies and procedures are in place to effectively manage the credit risk on MPF mortgage loans.
The credit risk of MPF loans is managed by structuring potential credit losses into certain layers. As is customary for conventional mortgage loans, PMI is required for MPF loans with LTVs greater than 80 percent. Losses beyond the PMI layer are absorbed by an FLA established by the FHLBank for each pool of mortgage loans sold by a PFI up to the amount of the FLA. If losses beyond this layer are incurred, they are absorbed through a CE obligation (see Item 1 - “Business - Mortgage Loans Held for Portfolio” for additional information).
Table 24 presents a roll forward analysis of the FLA for the periods ended December 31, 2009 and 2008 (in thousands):
Table 24
There were de minimis reductions in CE fees paid for losses absorbed in the FLA during 2009 and 2008. Losses did not exceed the FLA balance at any time during 2009 or 2008.
Table 25 presents the allowance for mortgage loan losses as of December 31, 2009, 2008, 2007, 2006 and 2005 (in thousands):
Table 25
The provision for mortgage loan losses has increased with an increase in the number of delinquencies. However, the ratio of net charge-offs/recoveries to average loans outstanding was less than one basis point for the periods ending December 31, 2009, 2008, 2007, 2006 and 2005.
FHLBank Topeka’s mortgage loans held in portfolio are dispersed across all 50 states and the District of Columbia as of December 31, 2009, 2008, 2007, 2006 and 2005. The largest concentration of loans is in the states of Kansas (Southwest region) and Nebraska (Midwest region), which as a percent of total loans together represented 60 percent, 52 percent, 51 percent, 49 percent and 46 percent as of December 31, 2009, 2008, 2007, 2006 and 2005, respectively. For the years ended December 31, 2009, 2008, 2007, 2006 and 2005, no zip code represented more than 5 percent of total mortgage loans. The median size of a mortgage loan held in portfolio was approximately $75,000 as of December 31, 2009, $71,000 as of December 31, 2008, and $65,000 as of December 31, 2007, 2006 and 2005. Table 26 is a summary of the percentage geographic concentration by region as of December 31, 2009, 2008, 2007, 2006 and 2005:
Table 26
Percentages are calculated based on the unpaid principal balance at the end of each year.
Midwest includes: IA, IL, IN, MI, MN, ND, NE, OH, SD and WI
Northeast includes: CT, DE, MA, ME, NH, NJ, NY, PA, RI and VT
Southeast includes: AL, DC, FL, GA, KY, MD, MS, NC, SC, TN, VA and WV
Southwest includes: AR, AZ, CO, KS, LA, MO, NM, OK, TX and UT
West includes: AK, CA, HI, ID, MT, NV, OR, WA and WY
Table 27 provides the weighted average FICO® scores and weighted average LTV at origination for conventional mortgage loans outstanding as of December 31, 2009, 2008, 2007, 2006 and 2005:
Table 27
FICO® is a widely used credit industry model developed by Fair Isaac Corporation to assess borrower credit quality with scores typically ranging from 300 to 850 with the low end of the scale indicating a poor credit risk. A credit score of 620 is frequently cited as a cutoff point, with credit scores below that typically considered “sub-prime.”
LTV is a primary variable in credit performance. Generally speaking, higher loan-to-value means greater risk of loss in the event of a default and also means higher loss severity.
Investments - Investments decreased 15.9 percent from December 31, 2008 to December 31, 2009, while the FHLBank’s assets decreased by 27.2 percent for the same period (see Table 16). Investments are generally used by the FHLBank for liquidity purposes as well as to leverage capital during periods when advances decline and capital stock is not reduced proportional to the decline in advances. The average yield on investments was 1.66 percent in 2009 compared to 3.49 percent during 2008 and 5.29 percent during 2007. Average yields on investments declined from 2007 to 2009 due primarily to declining interest rates. The FOMC began reducing its Federal funds target rate in September 2007 in response to weakening economic conditions related to deterioration in the nation’s housing market. The overnight Federal funds target rate was decreased from 5.25 percent in September 2007 to a range of zero to 0.25 percent by December 31, 2008 where it remained throughout 2009. The average rate on FHLBank investments rises and falls in conjunction with the level of short-term interest rates primarily because of the short-term nature of the FHLBank’s investment portfolio and a large position in variable-rate MBS. Because the FOMC decreased its target rate by 100 basis points during 2007 and by 400 basis points in 2008, the average rate earned on FHLBank investments declined during 2008 and 2009. See Table 60, Spread and Yield Analysis, and Table 61, Rate and Volume Analysis, under this Item 7 for further information on yield and balance fluctuations.
Short-term investments used for liquidity purposes consisted primarily of deposits in banks, overnight and term Federal funds, certificates of deposit, bank notes and commercial paper. Short-term investments, which include investments with remaining maturities of one year or less, were $6.7 billion and $7.5 billion as of December 31, 2009 and 2008, respectively. This decrease in short-term investments from 2008 to 2009 is primarily attributable to a decrease in the FHLBank’s capital related to declining advance balances. The FHLBank also decreased its average leverage of capital over this time period to maintain the flexibility to meet member requests for repurchases of excess capital stock. In the fourth quarter of 2008, the FHLBank began holding its short-term investment securities as trading in order to enhance its liquidity position. The FHLBank’s long-term investment portfolio, consisting of GSE debentures, MBS and taxable state or local housing finance agency securities, was $9.6 billion and $11.9 billion as of December 31, 2009 and 2008, respectively. This decrease in the long-term investment portfolio can be primarily attributed to decreasing balances in the FHLBank’s MBS/CMO portfolio where the investment authority limit is directly related to the decreasing amount of capital stock outstanding as discussed previously. The GSE debentures that the FHLBank holds in its long-term investment portfolio provide attractive returns, can serve as excellent collateral (e.g., repos and net derivatives exposure) and qualify for regulatory liquidity once their remaining term to maturity decreases to 36 months or less. All of the FHLBank’s unsecured Agency and GSE debentures are fixed rate bonds, which are swapped from fixed to variable rates. All swapped Agency debentures are classified as trading securities.
On March 24, 2008, the Finance Board issued Resolution 2008-08, “Temporary Authorization to Invest in Additional Agency Mortgage Securities.” In the Resolution, the Finance Board stated that the FHLBanks “can address difficulties and liquidity constraints in the housing finance market if the current investment limit in the FMP is increased so the FHLBanks may invest in MBS issued by, or backed by pools of mortgages guaranteed by, Freddie Mac or Fannie Mae.” Consequently, in the Resolution the Finance Board waived the restrictions in the FMP that limit an FHLBank’s investment in Mortgage Securities to 300 percent of its capital and restrict quarterly increases in holdings of Mortgage Securities to no more than 50 percent of capital so that an FHLBank can temporarily invest in Agency Mortgage Securities up to an additional 300 percent of its capital, subject to specified conditions. By allowing the FHLBanks to purchase additional Agency MBS, the Finance Board intended to further its statutory housing finance mission. To the extent the Resolution can increase the demand for Agency MBS, the added liquidity could help to restore the market for these securities and could, in turn, lead to lower liquidity premiums, lower mortgage rates, and increased home purchases. On March 27, 2008, the FHLBank submitted to the Finance Board a notice and information required by Resolution 2008-08 to increase its MBS/CMO holdings from 300 percent to 400 percent of capital. The Finance Board approved the FHLBank’s strategy for increasing its MBS/CMO holdings under the temporary authority on April 10, 2008. The FHLBank acquired $2.7 billion of variable rate Agency MBS/CMOs under this expanded MBS investment authority during 2008. In December 2009, $97.7 million of variable rate Agency MBS/CMOs were purchased under the 300 percent investment authority. On December 18, 2009, the FHLBank submitted to the Finance Agency a notice required by Resolution 2008-08 to increase its MBS/CMO holdings by an additional 100 percent to a total of 500 percent of capital. The FHLBank began purchasing additional MBS in January 2010 under the expansion of this limit to 500 percent of capital and anticipates utilizing this expanded investment authority through March 31, 2010, when the expanded authority ends.
The FHLBank’s RMP restricts the acquisition of investments to high-quality, short-term money market instruments and highly rated long-term securities. The FHLBank uses the short-term portfolio to sustain the liquidity necessary to meet member credit needs, to provide a reasonable return on member deposits and to manage the FHLBank’s leverage ratio. Long-term securities are used to provide a reliable income flow and to achieve a desired maturity structure. The majority of these long-term securities are MBS, which provide an alternative means to promote liquidity in the mortgage finance markets while providing attractive returns to the FHLBank. As of December 31, 2009, the FHLBank held $0.6 billion in MBS/CMOs in its trading portfolio for liquidity purposes and to provide additional balance sheet flexibility. All of the MBS in the trading portfolio are variable rate U.S. Agency or GSE issues, which were acquired and classified as such with the intent of minimizing the volatility of price changes over time. Note, however, that even variable rate Agency MBS have been subject to a significant amount of price volatility during the financial market credit crisis with the widening of the option-adjusted spreads of these instruments during 2007 and 2008, followed by a tightening of the option-adjusted spreads of these instruments during 2009.
The FHLBank has reduced its participation in the market for taxable state HFA securities outside its four-state area, but remains a supporter of the state HFA market within the FHLBank’s Tenth District. State or local HFAs provide funds for low-income housing and other similar initiatives. By purchasing state or local HFA securities in the primary market, the FHLBank not only receives competitive returns but also provides necessary liquidity to traditionally underserved segments of the housing market. The FHLBank also provides standby bond purchase agreements (SBPA) to two state HFAs within the Tenth District. For a predetermined fee, the FHLBank accepts an obligation to purchase the authorities’ bonds if the remarketing agent is unable to resell the bonds to suitable investors, and to hold the bonds until the designated marketing agent can find a suitable investor or the HFA repurchases the bonds according to a schedule established by the SBPA. The FHLBank increased its participation in this market in 2009 as the financial crisis took its toll on other liquidity providers of SBPAs supporting bonds issued by the Colorado Housing and Finance Authority (CHFA). Currently, the standby bond purchase commitments executed by the FHLBank expire no later than 2015, though some are renewable upon request of the HFA and at the option of the FHLBank. Total commitments for bond purchases under the SBPAs were $1.6 billion and $1.3 billion as of December 31, 2009 and 2008, respectively. The FHLBank was not required to purchase any bonds under these agreements during 2009 or 2007. However, during the third quarter of 2008, the FHLBank was required to purchase several of the bonds issued by the CHFA and covered under SBPAs because the remarketing agent, Lehman Brothers Holdings, Inc., was liquidated after the bankruptcy of its parent and was unable to adequately remarket all of CHFA’s bonds. All of the bonds purchased during the third quarter under the SBPAs were held in the FHLBank’s available-for-sale portfolio, remarketed and repurchased from the FHLBank prior to the end of the third quarter 2008. In accordance with the SBPAs, the FHLBank purchased and resold the bonds at par value; therefore no gains (losses) were recorded in other comprehensive income on the purchase and subsequent sale of these bonds. During the fourth quarter of 2008, the FHLBank continued to purchase and resell at par small amounts of these securities periodically for short periods of time until they were successfully remarketed by the new remarketing agent but there were none that had not been resold by the end of 2008. The HFA securities backed by FHLBank SBPAs have continued to perform well even in the face of failed auctions of auction rate notes and other similar instruments during 2008 and early 2009. The FHLBank plans to continue to support the state HFAs in its district by continuing to execute SBPAs where appropriate and when allowed by policy.
Major Security Types: Securities for which the FHLBank has the ability and intent to hold to maturity are classified as held-to-maturity securities and recorded at carrying value, which is the net total of par, premiums, discounts and credit and non-credit OTTI. The FHLBank classifies certain investments as trading securities and carries them at fair value. The FHLBank records changes in the fair values of these investments through other income and original premiums/discounts on these investments are not amortized. The FHLBank does not practice active trading, but holds trading securities for asset/liability management purposes, including liquidity. The FHLBank also classifies certain investments that it may sell before maturity as available-for-sale and carries them at fair value. If fixed rate securities are hedged with interest rate swaps, the FHLBank classifies the securities as trading securities so that the changes in fair values of both the derivatives hedging the securities and the trading securities are recorded in other income. Securities acquired to hedge against duration risk, which are likely to be sold when the duration risk is no longer present, are also classified as available-for-sale securities. See Notes 4 through 6 in the Notes to Financial Statements included in Item 8 to this report for additional information on the FHLBank’s different investment classifications including what types of securities are held under each classification. The carrying value and contractual maturity of the FHLBank’s investments as of December 31, 2009, 2008 and 2007 are summarized by security type in Tables 28 through 30 (in thousands). Expected maturities of certain securities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment fees.
Table 28
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Fannie Mae and Freddie Mac are GSEs. Both entities were placed into conservatorship by the Finance Agency on September 7, 2008.
Ginnie Mae securities are guaranteed by the U.S. government.
At December 31, 2009, carrying value has been adjusted by the credit and non-credit components of OTTI charges on private-label MBS.
Primarily consists of private-label MBS backed by residential loans.
Table 29
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Fannie Mae and Freddie Mac are GSEs. Both entities were placed into conservatorship by the Finance Agency on September 7, 2008.
Ginnie Mae securities are guaranteed by the U.S. government.
As of December 31, 2008, carrying value is equivalent to amortized cost.
Primarily consists of private-label MBS backed by residential loans.
Table 30
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Fannie Mae and Freddie Mac are GSEs. Both entities were placed into conservatorship by the Finance Agency on September 7, 2008.
Ginnie Mae securities are guaranteed by the U.S. government.
As of December 31, 2007, carrying value is equivalent to amortized cost.
Primarily consists of private-label MBS backed by residential loans.
Table 31 presents the FHLBank’s MBS investment portfolio by categories of securities as of December 31, 2009, 2008 and 2007 (in thousands):
Table 31
Yield Characteristics: Table 32 presents the yield characteristics of the FHLBank’s non-MBS investments, classified as held-to-maturity securities and trading securities, as of December 31, 2009:
Table 32
Table 33 presents the yield characteristics of the FHLBank’s MBS investments, classified as held-to-maturity securities and trading securities, as of December 31, 2009:
Table 33
Table 34 presents securities held by the FHLBank from issuers, excluding U.S. government agencies, with book values greater than ten percent of FHLBank capital as of December 31, 2009 (in thousands):
Table 34
Note: None of the issuers of these securities are FHLBank Topeka members or subsidiaries of FHLBank Topeka members.
Securities Ratings: Table 35 presents the percentage of FHLBank investments classified as held-to-maturity or trading securities by rating as of December 31, 2009 and 2008:
Table 35
Private-label mortgage-backed securities. The FHLBank has not purchased a private-label MBS since early 2006. All of the FHLBank’s acquisitions of private-label MBS investments carried the highest ratings from Moody’s, Fitch or S&P when acquired. The FHLBank has only purchased private-label MBS investments with weighted average FICO scores of 700 or above and weighted average LTVs of 80 percent or lower at the time of acquisition. The FHLBank classifies private-label MBS as prime, Alt-A and subprime based on the originator’s classification at the time of origination or based on classification by an NRSRO upon issuance of the MBS.
Table 36 presents a summary of the par value of private-label MBS by interest rate type and by type of collateral as of December 31, 2009 and 2008 (in thousands):
Table 36
During 2008, the FHLBank experienced a significant decline in the estimated fair values of its private-label MBS due to interest rate volatility, illiquidity in the marketplace and credit deterioration in the U.S. mortgage markets. This decline continued into the first quarter of 2009; however, during the second quarter of 2009, the pace of the decline slowed appreciably and the fair value of many of the FHLBank’s prime, early vintage private-label MBS actually improved from year-end 2008. Fair values continued to improve, although only slightly, into the third and fourth quarters of 2009. Significant declines in fair values experienced during 2008 were particularly evident across the market for private-label MBS securitized in 2006 and 2007 primarily because of less stringent underwriting standards used by mortgage originators during those years. More than 95 percent of the FHLBank’s private-label MBS were securitized prior to 2006, and there are no 2007 vintage securities in the portfolio. While some of the most significant declines in fair values have been in the 2006 and 2007 vintage MBS, the earlier vintages owned by the FHLBank have not been immune to the declines in fair value. Table 37 presents the fair value as a percentage of par value of the FHLBank’s private-label MBS by year of securitization as of December 31, 2009, 2008 and 2007:
Table 37
Table 38 presents the par value of the FHLBank’s private-label MBS by rating and by year of collateralization as of December 31, 2009 (in thousands):
Table 38
Table 39 presents the underlying collateral performance and credit enhancement statistics of the FHLBank’s private-label MBS as of December 31, 2009 (in thousands):
Table 39
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Determined based on underlying loans that are 60 days or more past due, including bankruptcies, foreclosures and REO. Collateral delinquency percentages are calculated based on information available from third-party financial data providers.
Under the FHLBank’s RMP, acquisitions of private-label MBS are limited to securities where the geographic concentration of loans collateralizing the security are such that no single state represents more than 50 percent of the total by dollar amount. As the structure of the underlying collateral shifts because of prepayments, the concentration shifts. Thus, FHLBank management continues to monitor concentration of the underlying collateral for its private-label MBS portfolio for risk management purposes. Table 40 presents the FHLBank’s geographic concentration of collateral securing private-label MBS (excluding commercial MBS) as of December 31, 2009 for those states with concentrations of five percent or greater of total private-label MBS (excluding commercial MBS):
Table 40
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Calculated based upon weighted average geographic concentrations as available from third-party servicers.
As of December 31, 2009, the FHLBank held private-label MBS covered by monoline insurance companies, which provide credit support for these securities. Credit support is defined as the percentage of subordinate tranches and over-collateralization, if any, in a security structure that will absorb losses before the holders of the security will incur losses. Table 41 presents coverage amounts and unrecognized losses on the private-label MBS covered by monoline bond insurance as of December 31, 2009 (in thousands):
Table 41
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As noted previously, the FHLBank only acquired private-label MBS investments that carried the highest ratings from Moody’s, Fitch or S&P on the acquisition dates, and the FHLBank has not purchased a private-label MBS since 2006. With the current disruption in the financial markets, over 45 percent of the par value of the FHLBank’s private-label MBS has been downgraded below triple-A. Table 42 presents a summary of private-label MBS by credit rating as of December 31, 2009 (in thousands):
Table 42
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Determined based on underlying loans that are 60 days or more past due, including bankruptcies, foreclosures and REO. Collateral delinquency percentages are calculated based on information available from third-party financial data providers.
As of December 31, 2009, the FHLBank had amortized cost of $1.7 billion of private-label securities with unrecognized losses. (See Note 6 of the Notes to the Financial Statements included under Item 8 - “Financial Statements and Supplementary Data” for a summary of held-to-maturity securities with unrecognized losses aggregated by major security type and length of time that the individual securities have been in a continuous unrecognized loss position.) Table 43 presents characteristics of the FHLBank’s private-label MBS in a gross unrecognized loss position (in thousands). The underlying collateral for all prime loans was first lien mortgages.
Table 43
Table 44 presents the amortized cost and fair values of the FHLBank’s private-label MBS by credit rating as of December 31, 2009 and March 15, 2010 for securities that have been downgraded during that period (in thousands). There were no downgrades on the FHLBank’s private-label MBS backed by manufactured housing loans, home equity loans or commercial loans.
Table 44
Table 45 presents the amortized cost and credit rating (as of March 15, 2010) of the FHLBank’s private-label MBS portfolio for securities on negative watch with the lowest rated NRSRO as of March 15, 2010 (in thousands):
Table 45
Other-than-temporary Impairment. As mentioned previously, the FHLBank experienced a significant decline in the estimated fair values of its private-label MBS due to interest rate volatility, illiquidity in the marketplace and credit deterioration in the U.S. mortgage markets during 2008, which continued to some extent into the first quarter of 2009 but improved throughout the remainder of 2009. Despite the improvement in the fair value of its private-label MBS over the last nine months of 2009, the fair values of the majority of the FHLBank’s private-label MBS in its held-to-maturity portfolio remain below amortized cost as of December 31, 2009. However, based upon the FHLBank’s OTTI evaluation process that results in a conclusion as to whether a credit loss exists (present value of the FHLBank’s best estimate of the cash flows expected to be collected is less than the amortized cost basis of each individual security), we have concluded that, except for eight private-label MBS upon which we have recognized OTTI, there is no evidence of a likely credit loss; there is no intent to sell, nor is there any requirement to sell; and, thus no OTTI for the remaining private-label MBS that have declined in value.
See “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Critical Accounting Policies and Estimates” under this Item 7 and Note 6 of the Notes to Financial Statements under Item 8 - “Financial Statements and Supplementary Data” for additional information on the FHLBank’s OTTI evaluation process. The FHLBank implemented a process for the determination of OTTI under an approach that is consistent with the other 11 FHLBanks in accordance with guidance issued by the Finance Agency. Each FHLBank performs its OTTI analysis primarily using key modeling assumptions provided and approved by the FHLBanks’ OTTI Governance Committee, of which FHLBank Topeka is an active member, for the majority of its private-label residential MBS and home equity loan investments. Certain private-label MBS backed by multi-family and commercial real estate loans, home equity lines of credit, manufactured housing loans and other securities that were not able to be cash flow tested were outside of the scope of the OTTI Governance Committee and were analyzed for OTTI by the FHLBank.
During the first and second quarters of 2009, for private-label MBS with fair values below amortized cost, the FHLBank performed an analysis to determine if any of these securities were at risk for OTTI. To determine which individual securities were at risk for OTTI and should be quantitatively evaluated utilizing a detailed cash flow analysis, the FHLBank used indicators, or “screens,” which consider various characteristics of each security. At-risk securities were evaluated by estimating projected cash flows using models that incorporated projections and assumptions typically based on the structure of the security and certain economic environment assumptions such as delinquency and default rates, loss severity, home price appreciation/depreciation, interest rates and securities prepayment speeds while factoring in the underlying collateral and credit enhancement. The FHLBank contracted with the FHLBank of San Francisco in the first quarter of 2009 to provide expected cash flows utilizing key modeling assumptions provided by the FHLBank of San Francisco that were reviewed by the FHLBank. The FHLBank contracted with the FHLBank of Dallas in the second quarter of 2009 to provide the expected cash flows utilizing key modeling assumptions developed by the FHLBanks’ OTTI Governance Committee for private-label MBS with fair values below amortized cost and considered at-risk. However, the FHLBank of San Francisco continued to provide the expected cash flows for all private-label MBS that were commonly held among the FHLBanks (owned by two or more FHLBanks) with fair values below amortized cost and considered at-risk, which included private-label MBS held by us.
Beginning in the third quarter of 2009, the process involved selecting 100 percent of the FHLBank’s private-label MBS portfolio, excluding Agency MBS and private-label commercial MBS, for purposes of OTTI cash flow analysis to be run using the FHLBanks’ common platform and approved assumptions. The FHLBank of San Francisco provided the expected cash flows for FHLBank Topeka utilizing the key modeling assumptions developed and approved by the FHLBank Topeka, which included the information provided by FHLBanks’ OTTI Governance Committee, for the third and fourth quarters of 2009. For certain private-label MBS where underlying collateral data was not available, alternative procedures were performed by the FHLBank to assess these securities for OTTI. The risk models and loan information data sources used were the same as in the prior three quarters.
The eight securities upon which we recognized OTTI included five private-label MBS that were identified as other-than-temporarily impaired in 2008, one private-label MBS that was first identified as other-than-temporarily impaired in the first quarter 2009 and experienced slight additional credit deterioration in the second quarter 2009 (additional impairment recorded in the second quarter of 2009) and two private-label MBS that were first identified as other-than-temporarily impaired in the third quarter 2009 (additional credit impairment was recorded on one security in the fourth quarter of 2009). While the remainder of the FHLBank’s held-to-maturity securities portfolio has also seen a decline in fair value, the decline is considered temporary because: (1) the FHLBank does not have the intent to sell the securities; (2) it is not likely that the FHLBank will be required to sell the securities before anticipated recovery; and (3) the expected cash flows are likely to be collected. Table 46 presents OTTI recorded as of December 31, 2009 and 2008 by security type (in thousands).
Table 46
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In addition to evaluating all of our private-label MBS under a base case (or best estimate) scenario for generating expected cash flows, a cash flow analysis was also performed for each security under a more stressful housing price scenario. The more stressful scenario was designed to provide an indication of the sensitivity of the FHLBank’s private-label MBS to the deterioration in housing prices beyond our base case estimates. The more stressful housing price scenario assumes a housing price forecast that is 5 percentage points lower at the trough than the base case scenario followed by a flatter recovery path. Home prices were projected to increase zero percent in the first year, one percent in the second year, two percent in the third and fourth years, and three percent in each subsequent year. (See Note 6 of the Notes to the Financial Statements included under Item 8 - “Financial Statements and Supplementary Data” for a description of the assumptions used to determine actual credit-related OTTI.) Table 47 represents the impact on credit-related OTTI in the more stressful housing price scenario compared to actual credit-related OTTI recorded using base-case housing price index (HPI) assumptions by collateral type, which is based on the originator’s classification at the time of origination or based on classification by an NRSRO upon issuance of the MBS (dollar amounts in thousands). The stress test scenario and associated results do not represent the FHLBank’s current expectations and therefore, should not be construed as a prediction of the FHLBank’s future results, market conditions or the actual performance of these securities. Rather, the results from the hypothetical stress test scenario provide a measure of the credit losses that the FHLBank might incur if home prices decline (and subsequent recoveries) are more adverse than those projected as our best estimate in our OTTI assessment.
Table 47
Deposits - The FHLBank offers deposit programs for the benefit of its members and certain other qualifying non-members. Deposit products offered include demand and overnight deposits, short-term certificates of deposit and a limited number of non-interest bearing products. The annualized average rate paid on all interest-bearing deposits was 0.29 percent, 1.92 percent and 4.93 percent for 2009, 2008 and 2007, respectively. The average rate paid on deposits fluctuated in tandem with the movement in short-term interest rates. The level of short-term interest rates is primarily driven by the FOMC decisions on the target rate for overnight Federal funds, but is also influenced by the expectations of capital market participants. Most deposits are very short-term, and the FHLBank, as a matter of prudence, holds short-term assets with maturities similar to the deposits (see Item 7 - “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Risk Management - Liquidity Risk Management”). The majority of the FHLBank’s deposits are in overnight or demand accounts that re-price daily based upon a market index such as overnight Federal funds. The level of deposits at the FHLBank is driven by member demand for FHLBank deposit products, which in turn is a function of the liquidity position of members. Factors that influence deposit levels include turnover in member investment and loan portfolios, changes in members’ customer deposit balances, changes in members’ demand for liquidity and the FHLBank’s deposit pricing as compared to other short-term market rates. Declines in the level of FHLBank deposits could occur during 2010 if demand for loans at member institutions increases, if members continue to de-lever their balance sheets or if decreases in the general level of liquidity of members should occur. Because of its ready access to the capital markets through consolidated obligations, however, the FHLBank expects to be able to replace any reduction in deposits with similarly priced borrowings.
As of December 31, 2009 and 2008, time deposits in denominations of $100,000 or more totaled $32.3 million and $570.3 million, respectively. Table 48 presents the maturities for these time deposits by remaining maturity as of December 31, 2009 and 2008 respectively (in thousands):
Table 48
Table 49 presents the average amount of and the annual rate paid on deposit types that exceed 10 percent of average deposits for 2009, 2008 and 2007 (in thousands). Deposit types are included if the 10 percent threshold is met in any year.
Table 49
Consolidated Obligations - Consolidated obligations are the joint and several debt obligations of the 12 FHLBanks and consist of bonds and discount notes. Consolidated obligations represent the primary source of liabilities used by the FHLBank to fund advances, mortgage loans and investments. As noted in the “Risk Management” section under Item 7A, the FHLBank uses debt with a variety of maturities and option characteristics to manage its DOE and interest rate risk profile. The FHLBank makes extensive use of derivative transactions, executed in conjunction with specific consolidated obligation debt issues, to synthetically structure funding terms and costs.
The FHLBank primarily uses consolidated obligation bonds to fund longer-term (one year or greater) advances, mortgage loans and investments. To the extent that the bond is funding variable rate assets or assets swapped to synthetically create variable rate assets, the FHLBank typically either issues a consolidated obligation bond that has variable rates matching the asset index or it swaps a fixed-rate or a complex consolidated obligation bond to match that index. Additionally, the FHLBank sometimes uses fixed-rate or complex consolidated obligation bonds that are swapped to LIBOR to fund short-term advances and money market investments. This occurred during the third and fourth quarters of 2009 as the FHLBank issued a significant amount of callable, fixed rate consolidated obligation bonds with step-up coupons swapped to one-month and three-month LIBOR. In many cases, because of the low absolute level of one- and three-month LIBOR experienced in 2009, the initial swapped funding cost for these structures was less than the funding cost of short-term discount notes.
The FHLBank primarily uses consolidated obligation discount notes to fund shorter-term advances and investments (maturities of three months or less). However, the FHLBank sometimes uses short-term, fixed rate consolidated obligations, including discount notes, to fund longer-term variable rate assets or assets swapped to synthetically create variable rate assets. Discount notes as a percentage of total consolidated obligations dropped from 49 percent as of the end of 2008 to 30 percent as of the end of 2009. This decrease was primarily a function of: (1) the shrinkage in short-term FHLBank advances and investments during 2009; and (2) the improvement in the financial markets during 2009 that has allowed the FHLBank issue swapped callable bonds during 2009 at lower sub-LIBOR costs than in late 2008 and early 2009.
During 2009, the FHLBank’s total consolidated obligation balances decreased significantly as funding needs for advances and investments decreased. While total consolidated obligations decreased 27.1 percent from December 31, 2008 to December 31, 2009, the mix between discount notes and bonds changed over the period. Discount notes decreased by $14.7 billion and bonds increased by $0.1 million from December 31, 2008 to December 31, 2009. The reasons for the change in the funding mix include: (1) short-term advances, which were primarily funded by discount notes, declined substantially in 2009; (2) financial markets stabilized in the last nine months of 2009, which resulted in improved investor demand for longer-term callable and non-callable fixed rate bonds that could be issued at a reasonable cost; (3) the FHLBank reduced its average regulatory capital leverage from 2008 to 2009 primarily by not replacing maturing discount notes; and (4) as discussed previously, the FHLBank was able to issue callable, fixed-rate or complex consolidated obligation bonds that are swapped to LIBOR as a replacement for discount notes to fund short-term advances and money market investments in late 2009.
The spread between one- and three-month LIBOR and the overnight Federal funds target rate exceeded 3.00 percent at times during October 2008. This spread between short-term LIBOR and overnight Federal funds target rate decreased throughout 2009 to negative 0.01906 percent for one-month LIBOR and positive 0.00063 percent for three-month LIBOR by December 31, 2009. The LIBOR/Federal funds target rate spread is of significance because: (1) the FHLBank has historically used consolidated obligation bonds swapped to LIBOR at favorable sub-LIBOR rates to fund a portion of its short-term fixed rate advance, short-term money market investment and variable rate MBS portfolios; (2) the cost of FHLBank short-term consolidated obligation discount notes has been favorable relative to LIBOR, especially when the LIBOR/Federal funds target rate spread was at its widest levels; and (3) the FHLBank generally prices its short-term fixed rate advances at a spread over its marginal cost of short-term consolidated obligation discount notes.
The decreases in the FOMC Federal funds target rate during 2008, together with the significant steepening of the U.S. Treasury curve from the 2-year to the 10-year maturities during 2009, resulted in the continued widening of spreads between the yield on investments and the FHLBank’s cost of funds throughout 2009. Much of this widening can be partially attributed to the low absolute borrowing costs enjoyed by the FHLBank in short-term consolidated obligation discount notes throughout 2009. FHLBank short-term discount notes are viewed favorably by market participants primarily because of the FHLBank’s GSE status relative to other short-term investment alternatives.
The average annualized effective rate paid on consolidated obligations was 1.29 percent during 2009, 2.99 percent during 2008 and 5.08 percent during 2007. The average effective rate paid on consolidated obligations decreased in response to: (1) decreasing short-term market interest rates in general, which remained relatively low throughout 2009; (2) improving swap and Treasury spreads relative to FHLBank consolidated obligations; (3) short-term funding costs for FHLBank consolidated obligations remaining relatively low throughout 2009; (4) funding costs for longer-term FHLBank consolidated obligations that improved relative to U.S. Treasury obligations and LIBOR throughout much of 2009; and (5) the issuance of unswapped long-term consolidated obligation bonds to replace higher rate bonds that were called during 2009. While the FOMC’s target rate for overnight Federal funds remained unchanged in 2009, short-term LIBOR rates declined significantly in 2009 primarily because of improvements in liquidity in the financial markets as financial institutions saw less risk in lending short-term funds to other financial institutions. The significant decline in short-term LIBOR rates in 2009 resulted in lower funding costs for the FHLBank because a significant portion of our funding is LIBOR-based (i.e., floating rate bonds and callable bonds swapped to one- and three-month LIBOR). In fact, because of the low absolute LIBOR levels and the swap spreads relative to certain FHLBank consolidated obligations, a portion of the FHLBank’s swapped consolidated obligations actually had interest rates at, near or below zero percent as of December 31, 2009. While the interest rate swap market conditions were highly favorable relative to swapped consolidated obligations, especially callable complex consolidated obligation bonds, compared to short-term discount notes in late 2009, there is no assurance that these conditions will continue into 2010. If the conditions do not persist, the result will be an increase in the FHLBank’s cost of funds and a decrease in the FHLBank’s net income.
The FHLBank continued to increase the optionality in the liability portfolios used to fund assets with prepayment characteristics and some fixed rate advances by increasing the percentage of callable debt used to fund these assets. During 2009, the FHLBank called $3.2 billion of unswapped callable consolidated obligations but issued $4.0 billion of unswapped callable consolidated obligation bonds. While the issuances were primarily used to refinance debt that was called, they were also used to fund growth in the FHLBank’s MPF mortgage loan portfolio and to fund a certain portion of fixed rate advances. This portfolio refinancing has an impact on portfolio spreads by reducing funding costs due to the issuance of new debt at a lower cost. For a discussion on yields and spreads see Table 60, Spread and Yield Analysis, and Table 61, Rate and Volume Analysis, under Item 7 - “Financial Review - Results of Operations” for further information.
Several recent developments have the potential to impact the demand for FHLBank short-term consolidated obligations including discount notes, floating rate consolidated obligations and short-term consolidated obligation bonds in the coming months. For a discussion of the impact of these recent developments, U.S. government programs and the financial markets on the cost of FHLBank consolidated obligations, see “Financial Market Trends” under this Item 7.
Borrowings with original maturities of one year or less are classified as short-term. Table 50 summarizes short-term borrowings for the years ended December 31, 2009, 2008 and 2007 (in thousands):
Table 50
Derivatives - The FHLBank recorded derivative assets of $15.9 million and $34.5 million and derivative liabilities of $240.6 million and $404.4 million at December 31, 2009 and 2008, respectively. All derivatives are marked to fair values, netted by counterparty with any associated accrued interest, offset by the fair value of any cash collateral received or delivered and included on the Statements of Condition as an asset when there is a net fair value gain or as a liability when there is a net fair value loss. Fair values of the FHLBank’s derivatives primarily fluctuate as LIBOR fluctuates. The LIBOR curve generally reflects the demand for and supply of derivative products, but other factors such as market participant expectations can drive the market price for derivatives.
The FHLBank uses derivatives in three ways: (1) by designating them as either a fair value or cash flow hedge of an underlying financial instrument, firm commitment or a forecasted transaction; (2) by acting as an intermediary; and (3) in asset/liability management (i.e., economic hedge). Economic hedges are defined as derivatives hedging specific or non-specific underlying assets, liabilities or firm commitments that do not qualify for hedge accounting, but are acceptable hedging strategies under the FHLBank’s RMP. To meet the hedging needs of its members, the FHLBank enters into offsetting derivatives, acting as an intermediary between members and other counterparties. This intermediation allows smaller members indirect access to the derivatives market. The derivatives used in intermediary activities do not receive hedge accounting and are separately marked-to-market through earnings (classified as economic hedges).
The notional amount of total derivatives outstanding decreased from $35.2 billion at December 31, 2008 to $33.5 billion at December 31, 2009. Decreases occurred in interest rate swaps executed to hedge consolidated obligation discount notes (from $1.3 billion as of December 31, 2008 to $0.1 billion as of December 31, 2009) and interest rate swaps executed to hedge advances (from $10.0 billion as of December 31, 2008 to $9.0 billion as of December 31, 2009). These decreases were partially offset by an increase in interest rate swaps executed to hedge consolidated obligation bonds (from $15.1 billion as of December 31, 2008 to $15.8 billion as of December 31, 2009). Changes in the types of interest rate swaps hedging these items during 2009 were as follows:
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The decrease in interest rate swaps executed to hedge consolidated obligation discount notes was the result of improving market conditions, which allowed the FHLBank to use longer-term consolidated obligation bonds swapped to LIBOR for its LIBOR-based funding needs.
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The decline in interest rate swaps executed to hedge advances was primarily the result of a $1.2 billion decline in swaps hedging convertible advances resulting from the maturities or restructuring of the underlying advances.
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The overall increase in interest rate swaps executed to hedge consolidated obligation bonds was the result of improving market conditions that allowed the FHLBank to once again issue bonds swapped to LIBOR at attractive funding levels for its LIBOR-based funding needs instead of meeting those needs with floating rate consolidated obligations or by swapping discount notes. Interest rate swaps executed to hedge fixed rate callable step-up or step-down consolidated obligations increased from $1.0 billion as of December 31, 2008 to $3.7 billion as of December 31, 2009. During the second half of 2009, callable, step-up consolidated obligations attracted significant investor demand and the FHLBank used interest rate swaps to convert these bonds to variable rate LIBOR funding at very favorable funding levels. Interest rate swaps executed to hedge changes or increasing costs of funds also increased significantly from $0.9 billion as of December 31, 2008 to $3.4 billion as of December 31, 2009, as the FHLBank opportunistically issued variable rate consolidated obligation bonds that it was able to swap to attractive sub-LIBOR levels (pay variable/receive variable interest rate swaps classified as economic hedges). These increases were partially offset by a decrease in swaps executed to hedge complex fixed rate consolidated obligations (from $2.4 billion as of December 31, 2008 to $0.7 billion as of December 31, 2009) and a decrease in interest rate swaps executed to hedge fixed rate callable consolidated obligation bonds (from $4.3 billion as of December 31, 2008 to $1.1 billion as of December 31, 2009). This decline was primarily the result of counterparties executing their option to call these swaps. When a counterparty calls the swap used to hedge consolidated obligation bonds, including complex fixed rate bonds, the FHLBank typically exercises its right to call the associated bond.
For additional information regarding the types of derivative instruments and risks hedged, see Tables 78 through 81 under Item 7A
Item 7A: Quantitative and Qualitative Disclosures About Market Risk
Interest Rate Risk Management
The FHLBank measures interest rate risk exposure by various methods, including the calculation of DOE and MVE.
Duration of Equity: DOE aggregates the estimated sensitivity of market value for each of the FHLBank’s financial assets and liabilities to changes in interest rates. In essence, DOE indicates the sensitivity of theoretical MVE to changes in interest rates. However, MVE should not be considered indicative of the market value of the FHLBank as a going concern or the value of the FHLBank in a liquidation scenario. A positive DOE results when the duration of assets and designated derivatives is greater than the duration of liabilities and designated derivatives. A positive DOE generally indicates that the FHLBank has a degree of interest rate risk exposure in a rising interest rate environment, and a negative DOE indicates a degree of interest rate risk exposure in a declining interest rate environment. Higher DOE numbers, whether positive or negative, indicate greater volatility of MVE in response to changing interest rates. That is, if the FHLBank has a DOE of 3.0, a 100-basis-point (one percent) increase in interest rates will cause the FHLBank’s MVE to decline by approximately 3 percent. However, it should be noted that a decline in MVE does not translate directly into a decline in near-term income, especially for entities that do not trade financial instruments. Changes in market value may indicate trends in income over longer periods, and knowing the sensitivity of market value to changes in interest rates gives a measure of the risks being taken by the FHLBank.
Under the RMP approved by its Board of Directors, the FHLBank’s DOE is generally limited to a range of ±5.0 assuming current interest rates. The FHLBank’s DOE is generally limited to a range of ±7.0 assuming an instantaneous parallel increase or decrease in interest rates of 200 bps. During periods of extremely low interest rates, such as those experienced over the past several years, the Finance Agency requires that FHLBanks employ a constrained down shock analysis to limit the evolution of forward interest rates to positive non-zero values.
The DOE parameters established by the FHLBank’s Board of Directors represent one way to establish general limits on the amount of interest rate risk that the FHLBank can accept. If the FHLBank’s DOE exceeds the policy limits established by the Board of Directors, management either: (1) takes asset/liability actions to bring the DOE back within the range established in the FHLBank’s RMP; or (2) reviews and discusses potential asset/liability management actions with the Board of Directors at the next regularly scheduled meeting that could bring the DOE back within the ranges established in the RMP and ascertains a course of action, which can include a determination that no asset/liability management actions are necessary.
The FHLBank typically maintains DOE within the above ranges through management of the durations of its assets, liabilities and derivatives. Significant resources in terms of staffing, software and equipment are continuously devoted to assuring that the level of interest rate risk existing in the FHLBank’s balance sheet is properly measured and limited to prudent and reasonable levels. The DOE that FHLBank management considers prudent and reasonable is somewhat lower than the RMP limits mentioned above and can change depending upon market conditions and other factors. The FHLBank typically manages the current base DOE to remain in the range of ±2.5. When the FHLBank’s DOE exceeds either the limits established by the RMP or the more narrowly-defined limits to which the FHLBank manages duration, corrective actions taken may include: (1) the purchase of interest rate caps, interest rate floors, swaptions or other derivatives; (2) the sale of assets; and/or (3) the addition to the balance sheet of assets or liabilities having characteristics that are such that they counterbalance the excessive duration observed. For example, if DOE has become more positive than desired due to variable rate MBS that have reached cap limits, the FHLBank may purchase interest rate caps that have the effect of removing those MBS cap limits. The FHLBank would be short caps in the MBS investments and long caps in the offsetting derivative positions, thus reducing the FHLBank’s DOE. Further, if an increase in DOE were due to the extension of mortgage loans, MBS or advance maturities by the FHLBank’s members, the more appropriate action would be to add new long-term liabilities to the balance sheet to offset the lengthening asset position.
Table 76 presents the DOE in the base case and the up and down 100 and 200 bps interest rate shock scenarios for 2009 and 2008:
Table 76
The DOE as of December 31, 2009 has declined significantly from December 31, 2008 and is now inside management’s operating range of ±2.5. Several factors contributed to the decrease, including: (1) asset/liability actions taken by management; and (2) a significant improvement in market prices of MBS investments held by the FHLBank.
The primary factor contributing to the decrease in duration in all scenarios was the action taken by management through the continued issuance of longer term, short lock-out, fixed rate callable consolidated obligations to replace callable debt that was in-the-money. This debt replacement of in-the-money debt with longer term callable debt effectively replaced liabilities with duration profiles at or near zero with liabilities having duration profiles sufficient to produce an increase in liability duration. The longer duration of these consolidated obligations helps offset the extension in the duration of the FHLBank’s assets and provides a managed boundary for the DOE measurement, especially in the up shock scenario. The short lock-out period reduces the holding period for the ability to exercise the embedded option and provides a level of protection against an asset duration shortening event precipitated by an increase in prepayment speeds of the fixed rate MBS/CMO and mortgage loan portfolios. Since this course of asset/liability action generates an increase in the duration of liabilities, the impact on DOE was a net decrease as the FHLBank’s balance sheet became increasingly positioned to be less asset sensitive.
An additional contributing factor to the decrease in duration was the improvement in MBS prices that reversed the trend of price declines during most of 2008, especially the significant drop in the fourth quarter of 2008. The increasing MBS prices during 2009 reversed the upward pressure on the FHLBank’s DOE profile of the severely depressed MBS prices from the end of 2008. This is because improved MBS prices lead to a larger denominator in the duration calculation, producing a decrease in duration. Just as MBS price behavior became uncoupled from traditional market pricing forces (market prices declined even though long-term interest rates declined dramatically) during 2008 primarily because a lack of liquidity in the mortgage markets, a converse relationship developed during 2009, producing improving market prices of mortgage securities even though long-term interest rates were rising. This pricing relationship is further demonstrated by considering with increasing rates, the expectation would be for prepayments to slow, thus extending or lengthening the duration profile of the mortgage portfolio. However, when factoring the impact of the improved prices, the prepayment impact became less of a contributing factor as the impact was muted from slowing prepayments.
In addition, the interest rate cap portfolio that provides a hedge of the embedded caps in the variable rate MBS investment portfolio experienced a duration lengthening as long-term interest rates rose during 2009. This direct relationship was anticipated as the yield curve steepened (higher long-term rates, stable/lower short-term rates), resulting in increasing market value gains in the cap portfolio as the effective caps trended towards a higher probability of becoming in-the-money. This yield curve steepening is clearly demonstrated by observing that the spread relationship between the 2-year and 10-year U.S. Treasury levels increased from 144 bps as of December 31, 2008 to 269 bps as of December 31, 2009. This steepened yield curve environment generates increasing market value fluctuations that produce an increasing duration profile since duration essentially measures changes in market value. Therefore, as the MBS portfolios experienced an atypical decrease in duration as prices improved with rising rates, the typical offsetting arrangement from the interest rate cap portfolio placed downward pressure on duration as rates rose, producing an effective factored DOE decline.
The FHLBank’s current and past purchases of interest rate caps and floors tend to partially offset the negative convexity of the FHLBank’s mortgage assets and the effects of the interest rate caps embedded in the adjustable rate MBS/CMOs. Convexity is the measure of the exponential change in prices for a given change in interest rates; or more simply stated, it measures the rate of change in duration as interest rates change. When an instrument is negatively convex, price increases as interest rates decline. When an instrument’s convexity profile decreases, it simply demonstrates that the duration profile is flattening or that the duration is changing at an increasingly slower rate. When an instrument’s convexity profile increases, the duration profile is steepening and is decreasing in price at an increasingly faster rate. Duration is a measure of the relative risk of a financial instrument, and the more rapidly duration changes as interest rates change, the riskier the instrument. MBS/CMOs have negative convexity as a result of the embedded caps and prepayment options. All of the FHLBank’s mortgage loans are fixed rate, so they have negative convexity only as a result of the prepayment options. The FHLBank seeks to mitigate this negative convexity with purchased options that have positive convexity and callable liabilities that have negative convexity, which offset some or all of the negative convexity risk in its assets. While changes in current capital market conditions make it challenging to manage the FHLBank’s market risk position, we continue to take measured asset/liability actions to stay within established policy.
While the FHLBank typically monitors and manages to the DOE in the base and ±200 basis point instantaneous shock scenarios for asset/liability and risk management purposes, duration measurements are also computed and reported for the ±100 basis point instantaneous shock scenarios as an additional indication of the FHLBank’s risk profile. The atypical long DOE results in the down 100 basis point instantaneous shock scenario as of December 31, 2008, March 31, 2009 and June 30, 2009 were isolated to a model assumption within the mortgage valuation model utilized by the FHLBank. As noted in Table 76, the DOE measurements experienced a fairly dramatic movement beginning on December 31, 2008. During the fourth quarter of 2008, the interest rate environment experienced a significant decline where three-month LIBOR declined 262 bps between September 30, 2008 and December 31, 2008. This market shift caused the interest rate model to generate interest rate scenarios that were considerably different from interest rate scenarios generated when rates were more normalized. When deriving valuations using these low market rate driven interest rate paths, the pricing and risk profiles revealed inconsistencies not only in the base scenarios, but also in the downward shock scenarios. This low rate environment is considered a qualifying event that required a modeling assumption change to the speed at which the various interest rate paths generated in the model revert to the mean. This mean reversion adjustment serves to temper the large variations in the derived rate paths and produces a price and risk measurement profile that is considered more reasonable and conforms more consistently with management’s expectations of the overall risk profile of the balance sheet. The mean reversion adjustment was implemented by the FHLBank beginning with the September 30, 2009 DOE calculation process.
The items noted above were also partly influenced by a significant decline in assets and associated capital levels during 2009 (see Table 16 under Item 7 - “Management’s Discussion and Analysis of Financial condition and Results of Operations”) that magnified the respective duration and DOE contribution components of each portfolio, including the investment and funding portfolios. These declines cause the respective portfolio equity-based weightings to shift, leading to an equity compositional reallocation. For instance, the base case callable consolidated obligations duration increased just over 50 percent during this period (based on the preceding discussion) and the balance sheet liability weighting increased over 60 percent as the callable consolidated obligations became a larger percentage of the FHLBank’s overall balance sheet composition. This weighting shift in turn caused a magnification of just over 80 percent in duration increase when factored into the overall balance sheet equity duration measurement. This DOE magnification changes the context regarding the respective portfolio duration impact of the DOE results, and each is thoroughly reviewed and considered when hedging activities are proposed and evaluated.
The down 200 basis point instantaneous shock scenario continued to decline from December 31, 2008 to December 31, 2009. As the yield curve continued to steepen during 2009, the short-end remained at historically low levels, causing short-term instrument valuations to be derived using a valuation curve that is technically floored at zero. Under low rate environments, the model effectively floors interest rates at zero through the implementation of a zero boundary constraint. With this zero boundary implementation, the duration of short-term instruments approach zero. Reviewing the duration calculation, the larger the value change between interest rate scenarios, the larger the duration since the measurement is capturing the sensitivity of valuations to changes in rates. The inverse then would conclude that with small or no change in value, the duration result would approach zero. With the low absolute level of the short-term interest rates, shocking the curve down 200 bps would trigger the zero boundary constraint. This scenario would introduce minimal or no value change in the short-term instruments since no change in the valuation curve occurs. Reviewing the composition of liabilities on the balance sheet, a large portion was short-term discount notes that under the zero boundary regime would have a duration of zero. Further, reviewing the interest rate cap portfolio indicates that as of December 31, 2008, several caps were sufficiently out-of-the-money at this rate level such that no valuation amounts were generated. With the steepened yield curve and volatility impact, the December 31, 2009 cap valuations resulted in an increase of over 90 percent in the number of caps with values greater than zero in the down 200 basis point instantaneous shock scenario. This increase in valuation results translates to a larger duration impact since more valuation change occurred for more interest rate cap derivatives at that rate level. The net impact of the contributing factors was a decrease in DOE in all interest rate scenarios.
As reflected in Table 76, the FHLBank’s DOE at December 31, 2008 was outside of its RMP base case range of ±5.0.The FHLBank typically manages a DOE measurement that exceeds the established limits with various asset/liability management actions. Whenever an established limit is exceeded, the Board of Directors is advised by management and the issue is discussed at the next regularly scheduled Board of Directors’ meeting. If after discussion, the Board of Directors determines that asset/liability management action is required, the Board-approved approach is implemented by management to address the situation. Even though all DOE measurements are inside management’s operating range as of December 31, 2009, active monitoring of portfolio relationships and overall DOE dynamics continues as do evaluation processes for acceptable future asset/liability management actions.
In calculating DOE, the FHLBank also calculates its duration gap, which is the difference between the duration of its assets and the duration of its liabilities. The FHLBank’s base duration gap was less than 0.1 month, 2.9 months and 1.4 months as of December 31, 2009, 2008 and 2007, respectively. All 12 FHLBanks are required to submit this base duration gap number to the Office of Finance as part of the quarterly reporting process created by the Finance Agency.
Matching the duration of assets with the duration of liabilities funding those assets is accomplished through the use of different debt maturities and embedded option characteristics, as well as the use of derivatives, primarily interest rate swaps, caps, floors and swaptions as discussed above. Interest rate swaps increase the flexibility of the FHLBank’s funding alternatives by providing desirable cash flows or characteristics that might not be as readily available or cost-effective if obtained in the standard GSE debt market. Finance Agency regulation prohibits the speculative use of derivatives, and the FHLBank does not engage in derivatives trading for short-term profit. Because the FHLBank does not engage in the speculative use of derivatives through trading or other activities, the primary risk posed to the FHLBank by derivative transactions is credit risk in that a counterparty may fail to meet its contractual obligations on a transaction and thereby force the FHLBank to replace the derivative at market price (see Item 7 - “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Risk Management - Credit Risk Management” for additional information).
Another element of interest rate risk management is the funding of mortgage loans and prepayable assets with liabilities that have similar duration or average cash flow patterns over time. To achieve the desired liability durations, the FHLBank issues debt across a broad spectrum of final maturities. Because the durations of mortgage loans and other prepayable assets change as interest rates change, callable debt with similar duration characteristics is frequently issued. The duration of callable debt shortens when interest rates decrease and lengthens when interest rates increase, allowing the duration of the debt to better match the typical duration of mortgage loans and other prepayable assets as interest rates change. As discussed above, this normal funding and hedging relationship became significantly distorted during 2008 with the uncoupling of MBS pricing mechanisms. In addition to actively monitoring this relationship, the funding and hedging profile and process are continually measured and reevaluated. The FHLBank also uses interest rate caps, floors and swaptions to manage the duration of its assets and liabilities. For example, in rising interest rate environments, out-of-the-money caps are purchased to help manage the duration extension of mortgage assets, especially variable rate MBS with periodic and lifetime embedded interest rate caps. The FHLBank may also purchase receive-fixed or pay-fixed swaptions (options to enter into receive-fixed rate or pay-fixed rate interest rate swaps) to manage its overall DOE in falling or rising interest rate environments, respectively. During times of falling interest rates, when mortgage assets are prepaying quickly and shortening in duration, the FHLBank may synthetically convert fixed rate debt to variable rate using interest rate swaps in order to shorten the duration of its liabilities to more closely match the shortening duration of its mortgage assets. As the FHLBank needs to lengthen its liability duration, it terminates selected interest rate swaps to effectively extend the duration of the previously swapped debt.
Market Value of Equity: MVE is the net value of the FHLBank’s assets and liabilities. Estimating sensitivity of the FHLBank’s MVE to changes in interest rates is another measure of interest rate risk. The FHLBank generally maintains a MVE within limits specified by the Board of Directors in the RMP. As of September 18, 2009, the Board of Directors amended the RMP to measure the FHLBank’s market value risk in terms of the MVE in relation to the FHLBank’s total regulatory capital stock outstanding (TRCS). The RMP previously calculated this metric relative to the book value of equity (BVE) and stipulated that the ratio of MVE to BVE be not less than 85 percent in the base scenario or 80 percent under a ±200 basis point instantaneous shock in interest rates. TRCS includes all capital stock outstanding, including stock subject to mandatory redemption. As a cooperative, using the TRCS is a more reasonable measure because it reflects the market value of the FHLBank relative to the book value of its capital stock. As of December 17, 2009, the Board of Directors amended the RMP to revise the stipulation that MVE shall not be less than 85 percent of the FHLBank’s TRCS under the base case scenario to a 90 percent threshold, and to revise the stipulation that the MVE/TRCS ratio shall not be less than 80 percent under a ±200 basis point instantaneous parallel shock in interest rates to an 85 percent threshold. Table 77 presents MVE as a percent of TRCS as of December 31, 2009 as well as information for previous periods for comparability. As of December 31, 2009, all scenarios are well within the specified limits as described above and much of the improvement in the ratio can be attributed to the continued increase in MBS market values and the FHLBank’s retained earnings.
Table 77
Detail of Derivative Instruments by Type of Instrument by Type of Risk: Various types of derivative instruments are utilized by the FHLBank to mitigate the interest rate risks described in the preceding sections. The FHLBank currently employs derivative instruments by designating them as either a fair value or cash flow hedge of an underlying financial instrument or a forecasted transaction; by acting as an intermediary; or in asset/liability management (i.e., an economic hedge). An economic hedge is defined as a derivative hedging specific or non-specific underlying assets, liabilities or firm commitments that either does not qualify for hedge accounting, or for which the FHLBank has not elected hedge accounting, but is an acceptable hedging strategy under the FHLBank’s RMP. For hedging relationships that are not designated for shortcut hedge accounting (see additional details in Note 1 - Summary of Significant Accounting Policies under Item 8), the FHLBank formally assesses (both at the hedge’s inception and monthly on an ongoing basis) whether the derivatives used have been highly effective in offsetting changes in the fair values or cash flows of hedged items and whether those derivatives may be expected to remain highly effective in future periods. The FHLBank typically uses regression analyses or similar statistical analyses to assess the effectiveness of its long haul hedges. See Note 9 - Derivatives and Hedging Activities in the Notes to Financial Statements under Item 8
Item 8: Financial Statements and Supplementary Data
The following financial statements and accompanying notes, including the Report of Independent Registered Public Accounting Firm, are set forth on pages to of this Form 10-K.
Audited Financial Statements
Description
Page Number
Management's Report on Internal Control Over Financial Reporting
Report of Independent Registered Public Accounting Firm - PricewaterhouseCoopers LLP
Statements of Condition as of December 31, 2009 and 2008
Statements of Income for the Years Ended December 31, 2009, 2008, and 2007
Statements of Capital for the Years Ended December 31, 2009, 2008, and 2007
Statements of Cash Flows for the Years Ended December 31, 2009, 2008 and 2007
Notes to Financial Statements
Tables 82 and 83 present supplementary quarterly financial information (unaudited) for the years ended December 31, 2009 and 2008 (in thousands):
Table 82
Table 83
The FHLBank’s interest income and expense decreased throughout 2008 and 2009 in response to decreasing short-term market interest rates. During the fourth quarter of 2008, the FHLBank experienced a significant contraction in net interest spreads as it extended its consolidated obligations in the midst of rapidly falling interest rates. As a result of this extension of funding, the FHLBank’s assets re-priced faster than liabilities during the fourth quarter and its net interest income decreased significantly. The extension of the terms of borrowings was to increase liquidity in order to ensure it could meet member advance demand over the end of the year. The impact of the cost of this extension of liabilities was reversed during the first and second quarters of 2009 as those liabilities, primarily short-term discount notes, matured and were replaced with lower costing liabilities. The significant fluctuations that have occurred in non-interest income are primarily the result of the recognition of net gains/losses on derivatives and hedging activities as well as the mark-to-market revaluations of trading securities. See Item 7 - “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Results of Operations” for additional information.
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. The FHLBank’s senior management is responsible for establishing and maintaining a system of disclosure controls and procedures designed to ensure that information required to be disclosed by the FHLBank in the reports filed or submitted under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the SEC. The FHLBank’s disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by the FHLBank in the reports that it files or submits under the Exchange Act is accumulated and communicated to the FHLBank’s management, including its principal executive officer or officers and principal financial officer or officers, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure. In designing and evaluating the FHLBank’s disclosure controls and procedures, the FHLBank’s management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives.
Management of the FHLBank evaluated the effectiveness of the design and operation of its disclosure controls and procedures with the participation of the President and Chief Executive Officer (CEO) and Chief Financial Officer (CFO) as of December 31, 2009. Based upon that evaluation, the CEO and CFO have concluded that the FHLBank’s disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-(e) under the Securities Exchange Act of 1934, as amended) were effective at a reasonable assurance level as of December 31, 2009.
Management’s Report on Internal Control Over Financial Reporting. Management of the FHLBank is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rule 13a-15(f) under the Exchange Act. The FHLBank’s internal control over financial reporting is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of the financial statements in accordance with GAAP.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements and even when determined to be effective, can only provide reasonable assurance with respect to financial statement preparation and presentation. 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.
Management of the FHLBank assessed the effectiveness of the FHLBank’s internal control over financial reporting using the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control-Integrated Framework. Based on this evaluation under the COSO framework, management has concluded that the FHLBank’s internal control over financial reporting was effective as of December 31, 2009.
The effectiveness of the FHLBank’s internal control over financial reporting as of December 31, 2009 has been audited by PricewaterhouseCoopers LLP, the FHLBank’s independent registered public accounting firm, as stated in their report which is included under Item 8 - “Financial Statements and Supplementary Data.”
Changes in Internal Control Over Financial Reporting. There has been no change in the FHLBank’s internal control over financial reporting that occurred during the last fiscal quarter of the fiscal year for which this annual report on Form 10-K is filed that has materially affected, or is reasonably likely to materially affect, the FHLBank’s internal control over financial reporting.
Item 9B:
Item 9B: Other Information
None.
PART III
Item 10:
Item 10: Directors, Executive Officers and Corporate Governance
Table 84 sets forth certain information regarding each of the executive officers of the FHLBank as of the date of this annual report on Form 10-K.
Table 84
Executive Officer
Age
Position Held
Employee of the
FHLBank Since
Andrew J. Jetter
President/Chief Executive Officer
May 18, 1987
David S. Fisher
SEVP/Chief Operating Officer
January 1, 2006
Mark E. Yardley
EVP/Chief Financial Officer
October 1, 1984
Patrick C. Doran
SVP/General Counsel/Corporate Secretary
May 1, 2004
Sonia R. Betsworth
SVP/Director of Credit
January 10, 1983
Denise L. Cauthon
First VP/Controller
August 9, 1989
Thomas E. Millburn
First VP/Director of Internal Audit
September 26, 1994
No executive officer has any family relationship with any other executive officer or director. All executive officers, other than the Director of Internal Audit, may be removed from office or discharged by the Board of Directors or the President and CEO with or without cause. The Audit Committee of the Board of Directors may remove the Director of Internal Audit from office, with or without cause.
There are no arrangements or understandings between any executive officer and any other person pursuant to which the executive officer was or is to be selected as an officer of the FHLBank, including no employment agreement between any executive officer and the FHLBank.
No executive officer serves as a director of any public company.
Except as otherwise indicated below, each officer has been engaged in the principal occupation listed above for at least five years:
Andrew J. Jetter became President and CEO of the FHLBank in September 2002. He served as Executive Vice President and Chief Operating Officer from January 1998 to September 2002. Mr. Jetter joined the FHLBank in 1987 as an attorney and was promoted to General Counsel in 1989, Vice President in 1993, and Senior Vice President in 1996.
David S. Fisher became Senior Executive Vice President and Chief Operating Officer (COO) of the FHLBank in April 2008. He served as Executive Vice President and COO from January 2006 through March 2008. From June 2000 until joining the FHLBank in January 2006, Mr. Fisher was EVP and CFO of Commercial Federal Bank, FSB in Omaha, Nebraska. He was responsible for Treasury, Capital Markets, Accounting, Finance, Real Estate, Strategic Planning, Information Technology, Operations, Human Resources and Investor Relations departments. He also served as chairman of the FHLBank Risk Management Advisory Board from April 2004 until December 2005.
Mark E. Yardley became Executive Vice President and CFO of the FHLBank in February 2005. He served as First Senior Vice President and CFO from December 1999 through February 2005 and as First Senior Vice President, Director of Finance, from January 1999 to December 1999. Mr. Yardley joined the FHLBank in 1984 as Director of Internal Audit and was promoted to Assistant Vice President in 1990 and Vice President in 1991.
Patrick C. Doran became Senior Vice President, General Counsel and Corporate Secretary of the FHLBank in May 2004. Prior to joining the FHLBank in May 2004, he served as Senior Counsel and Vice President of Corporate and Community Affairs for 1st Source Bank, South Bend, Indiana.
Sonia R. Betsworth became Senior Vice President, Director of Credit in July 2009. She served as Senior Vice President, Director of Member Products from April 2006 through June 2009, Director of Sales, Lending and Collateral from 2002 to April 2006 and Director of Credit and Collateral from 1999 to 2002. She joined the FHLBank in 1983. Ms. Betsworth was named Assistant Vice President in 1994 and Vice President in 1998.
Denise L. Cauthon became First Vice President and Controller in March 2007. She served as Vice President and Controller from January 2005 to March 2007. Ms. Cauthon joined the FHLBank in 1989 as a staff internal auditor and was promoted to Assistant Liability Manager and then Financial Reporting Accountant in 1998. Ms. Cauthon was promoted to Financial Reporting and Operations Manager in 1999 and was named Assistant Vice President in 2000. She was promoted to Assistant Controller-Financial Reporting in 2002 and became Vice President in 2004.
Thomas E. Millburn became First Vice President, Director of Internal Audit in March 2004. Mr. Millburn joined the FHLBank in 1994 as a staff internal auditor and was promoted to Assistant Vice President, Director of Internal Audit in 1999 and then to Vice President in 2000.
Directors
As of the date of this annual report on Form 10-K, the FHLBank has 14 directors, eight of whom are serving directorships as “member directors” (as such term is defined under the Bank Act) and six of whom are serving directorships as “independent directors” (as such term is also defined under the Bank Act). On October 2, 2009, James R. Hamby and Bruce A. Schriefer were deemed elected to new terms as member directors beginning on January 1, 2010. These member directorships were filled without an election because Mr. Hamby and Mr. Schriefer were the only nominees who accepted nomination for the open member directorships in Oklahoma and Kansas, respectively, as reported in our current report on Form 8-K filed with the SEC on December 23, 2009. On November 25, 2009, Steven D. Hogan was re-elected as a member director to fill a Colorado directorship beginning on January 1, 2010, as reported in our current report on Form 8-K filed with the SEC on December 23, 2009. Also on that date, Andrew C. Hove, Jr. was elected as a public interest independent director and Richard S. Masinton was elected as an independent director, each with terms beginning on January 1, 2010, as reported in our current report on Form 8-K filed with the SEC on December 23, 2009.
The Bank Act (as amended by the Recovery Act) and Finance Agency regulations mandate that the FHLBank’s Board of Directors consist of 13 directors or such other number as may be provided by the Bank Act and Finance Agency regulations, a majority of whom are to be member directors and at least two-fifths of whom are to be independent directors. Due to the interplay of the “method of equal proportions,” which the Finance Agency uses to allocate member directorships to each state in the FHLBank’s four-state district, the requirement that at least two-fifths of the directorate must be comprised of independent directors and the requirement that the number of member directorships allocated to each of those four states must be at least equal to the number allocated to each state on December 31, 1960, the Finance Agency may be required from time to time to allocate additional member director seats. For 2010, the Finance Agency has authorized the FHLBank’s Board of Directors to consist of 14 directors, eight of whom are to be member directors and six of whom are to be independent directors. Under the Finance Agency regulations, new and re-elected directors serve four-year terms, subject to adjustment by the Finance Agency to establish staggering of the board. Directors cannot serve more than three consecutive full terms, except that a director may be re-elected to a directorship for a term that commences no earlier than two years after the expiration of the third full term. Each director must be: (1) a citizen of the United States; (2) either be a resident in the FHLBank’s district or serve as an officer or director of a member located in the FHLBank’s district; and (3) elected by a vote of the members, in accordance with the Bank Act and Finance Agency regulations. Additionally, at least two of the independent directors must qualify as public interest directors. To qualify as a public interest director, an individual must have more than four years of experience in representing consumer or community interests on banking services, credit needs, housing, or financial consumer protections.
Member directorships are designated to each of the four states in the FHLBank’s district and each of our members are entitled to nominate and vote for candidates representing the state in which the member’s principal place of business is located. To qualify as a nominee for a member directorship, a nominee must be an officer or director of a member located in the state the nominating member is located. Member directors are nominated by members located in the state to which the member directorship is assigned, based on a determination by the nominating institution that the nominee possesses the applicable experience, qualifications, attributes and skills to qualify the nominee to serve as an FHLBank director, without any participation from the FHLBank’s Board of Directors. An FHLBank director, acting in his or her personal capacity, may support the nomination or election of any individual for a member directorship, provided that no such individual shall purport to represent the views of the FHLBank or its Board of Directors in doing so. Following the nomination process, a member is entitled to cast, for each applicable member directorship, one vote for each share of capital stock that the member is required to hold, subject to a statutory limitation. Under this limitation, the total number of votes that each member may cast is limited to the average number of shares of each class 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.
Each of the FHLBank’s member directors meets the required qualifications and, as such, each is an officer or director of a member in the respective state from which they were nominated and elected.
Independent directors are elected by ballot from among those eligible persons nominated by the Board of Directors after consultation with the Affordable Housing Advisory Council and after the nominee has been submitted to the Finance Agency for review. In nominating independent directors, the FHLBank’s Board of Directors may consider an individual’s current and prior experience on the Board of Directors, the qualifications of nominees, and the skills and experience most likely to add strength to the Board of Directors. If the FHLBank’s Board of Directors nominates only one individual for each independent directorship, then each nominee must receive at least 20 percent of the number of votes eligible to be cast in the election to be elected. If the FHLBank’s Board of Directors nominates more persons for the type of independent directorship to be filled than there are directorships of that type to be filled in the election, then the nominee receiving the highest number of votes will be elected. Each member voting in the independent director election is entitled to cast one vote for each share of capital stock that the member is required to hold, subject to the statutory limitation discussed above. The FHLBank’s Board of Directors has adopted procedures for the nomination and election of independent directors, which are set forth in the FHLBank’s Amended and Restated Bylaws, attached as Exhibit 3.2 to the FHLBank’s Form 8-K filed with the SEC on December 18, 2009, and incorporated herein by this reference.
There are no arrangements or understandings between any director and any other person pursuant to which the director was or is to be selected as a director or nominee. No director has any family relationship with any other director or executive officer. No director or person nominated to become a director or executive officer of the FHLBank has been involved in any legal proceeding during the past ten years that would affect the integrity or ability of such director or nominee to serve in such capacity.
Table 85 sets forth certain information regarding each of the directors of the FHLBank as of the date of this annual report on Form 10-K.
Table 85
Director
Age
Type of
Directorship
Director Since
Current Term
Expiration
Board Committee
Membership1
Michael M. Berryhill
Member
January 2003
December 2012
(a) Chair, (b), (c)
Robert E. Caldwell, II
Independent
January 2004
December 2010
(c), (e) Chair, (f)
James R. Hamby
Member
January 2007
December 2013
(a), (c), (f) Chair
Thomas E. Henning
Independent
April 2007
December 2011
(b), (c), (d) Chair
Steven D. Hogan
Member
January 2004
December 2013
(d), (e)
Andrew C. Hove, Jr.
Independent
April 2007
December 2013
(a), (f)
Jane C. Knight
Independent
January 2004
December 2010
(e), (f)
Richard S. Masinton
Independent
April 2007
December 2013
(b) Chair, (c), (d)
Lawrence L. McCants
Member
January 2005
December 2010
(a), (b), (f)
Neil F. M. McKay
Independent
April 2007
December 2012
(a), (d)
Thomas H. Olson
Member
January 2002
December 2010
(d), (e)
Lindel E. Pettigrew
Member
January 2002
December 2010
(b), (c) Vice Chair, (e), (f)
Bruce A. Schriefer
Member
January 2007
December 2011
(d), (e)
Ronald K. Wente
Member
January 1996
December 2012
(a), (b), (c) Chair
__________
Board of Directors committees are as follows: (a) Audit; (b) Compensation; (c) Executive; (d) Finance; (e) Housing and Governance; and (f) Operations.
The following describes the principal occupation, business experience, qualifications and skills, among other matters, of the 14 directors who currently serve on the Board of Directors. Except as otherwise indicated, each director has been engaged in the principal occupation described below for at least five years:
Michael M. Berryhill,has been President and CEO of Morgan Federal Bank, Fort Morgan, Colorado, since 1988 and Chairman of its board of directors since 1993. Although as a member director the Board of Directors did not participate in Mr. Berryhill’s nomination, Mr. Berryhill possesses a B.S. in accounting, nine years audit and tax experience as a CPA with an international accounting firm, 24 years of experience managing a community bank, including 22 years as CEO and 17 years as Chairman of the board of directors, and prior experience as an FHLBank director, that assist in his service as a director.
Robert E. Caldwell, II has been President and CEO of Hampton Enterprises, Inc., a commercial real estate development, general contracting, construction management and property management firm, since 2006. He previously served as General Counsel for Linweld, Inc., a large independent manufacturer and distributor of industrial/medical gases and welding supplies. The Board of Directors considered Mr. Caldwell’s qualifications, skills and attributes, including his B.S. in business administration, his J.D. and MBA, his experience as General Counsel for Linweld, Inc., a subsidiary of a Japanese Public Company, his service as President and CEO of a commercial real estate and construction company, and his prior service as an FHLBank director, when making his nomination. Mr. Caldwell served as Vice Chairman of the FHLBank’s Board of Directors from January 2004 through December 2006.
James R. Hamby has been CEO of Vision Bank, Ada, Oklahoma, since 1990. Although as a member director the Board of Directors did not participate in Mr. Hamby’s nomination, Mr. Hamby possesses an MBA and is a graduate of the Graduate School of Banking at Southern Methodist University, over 30 years of banking experience, including 20 years as CEO of a bank, significant experience in bank investments, bank accounting and all other aspects of banking, and prior experience as an FHLBank director, that assist in his service as a director. Prior to his current term, Mr. Hamby served as a member director of the FHLBank from January 1995 through December 2000.
Thomas E. Henning has been the Chairman, President and CEO of the Assurity Security Group, Inc. (ASGI) in Lincoln, Nebraska, since 2005 and was employed by Security Financial Life Insurance Co., a predecessor to ASGI, from 1990 to 2006. He is also the Chairman, President and CEO of ASGI’s wholly owned subsidiary, Assurity Life Insurance Company. Mr. Henning has served on the board of Nelnet, Inc., a public company and provider of education finance and services, headquartered in Lincoln, Nebraska, since 2003. The Board of Directors considered Mr. Henning’s qualifications, skills and attributes, including his past experience as President and CEO of a community bank and President and COO of a regional banking group, his current experience as Chairman, President and CEO of a medium sized life and health insurance company, his 30 years of financial services experience, his extensive background in financial analysis and accounting, strategic planning and business plan execution, and his prior service as an FHLBank director, when making his nomination.
Steven D. Hogan has been an officer of Yampa Valley Bank, Steamboat Springs, Colorado, since April 2007. Mr. Hogan is also currently President of Capital West National Bank, Fort Collins, Colorado. Prior to that, he was President of Centennial Bank of the West where he was employed since 2001. From 2000 to 2001 he was a Senior Credit Officer for Vista Bank, Colorado Springs, Colorado. Mr. Hogan was employed with the Federal Home Loan Bank System, serving in the Dallas district from 1993 to 1996 and the Topeka district from 1996 to 2000. He began his career with the First National Bank of Grapevine where he was employed from 1981 to 1993. Although as a member director the Board of Directors did not participate in Mr. Hogan’s nomination, Mr. Hogan possesses a BBA in Finance, an MBA, is a graduate from the Graduate School of Banking at the University of Colorado, 29 years of banking experience, including experience as an executive officer since 1996, seven years of experience as an officer within the FHLBank system, and prior experience as an FHLBank director, that assist in his service as a director.
Andrew C. Hove, Jr., now retired, previously served as Vice Chairman and Acting Chairman of the Federal Deposit Insurance Corporation from 1991 to 2001, and prior to that he served as the Chairman and CEO of Minden Exchange Bank and Trust, Minden, Nebraska. Mr. Hove currently serves on the boards of directors of NeighborWorks Lincoln in Lincoln, Nebraska and Great Western Bank, Sioux Falls, South Dakota. Mr. Hove also previously served on the board of directors of Sovereign Bank, Wyomissing, Pennsylvania, a public company, until 2009. The Board of Directors considered Mr. Hove’s qualifications, skills and attributes, including his experience as Chairman and CEO of a community bank, his experience as Vice Chairman and Acting Chairman of the Federal Deposit Insurance Corporation, his activities and affiliation with NeighborWorks Lincoln, and his prior service as an FHLBank director, when making his nomination.
Jane C. Knight, now retired, served as Vice President of Site-based Strategies for Kansas Big Brothers Big Sisters from 2002 through 2005. Prior to that, she directed the Wichita office for Kansas Governor Bill Graves and was in charge of addressing constituent concerns, including housing issues. The Board of Directors considered Ms. Knight’s qualifications, skills and attributes, including her ability to provide the Board of Directors with gender diversity, her prior management skills, including her service as Director of the Kansas Governor’s regional office, her experience with housing issues through the Governor’s office and Habitat for Humanity, her experience with not-for-profit organizations, and her prior service as an FHLBank director, when making her nomination.
Richard S. Masinton has been Executive Vice President of Quinn Capital, LLC in Leawood, Kansas since January 2009. Mr. Masinton previously served as Chief Financial Officer and Executive Vice President of Russell Stover Candies in Kansas City, Missouri, from 1996 until 2008. In January 2009, Mr. Masinton was elected to the board of directors of No More Homeless Pets Kansas City, an animal welfare charity. He also sits on the boards of directors of Eco-Choice Springwater, LLC and CRB Biosoft, LLC. Mr. Masinton previously retired from the boards of directors of OneNeck IT Services Corp and Enterprise Financial Services Corporation, a publicly owned bank holding company. He has also served on the board of advisors of the University of Kansas School of Business and presently sits on an advisory board at the University of Oklahoma School of Business. The Board of Directors considered Mr. Masinton’s qualifications, skills and attributes, including his Masters Degree in Accounting, Finance and Economics, his certification as a CPA, his experience on the board of a publicly owned bank holding company, including his seven years of experience as Chairman of the audit committee, his 40 years of experience as a corporate executive, and his prior service as an FHLBank director, when making his nomination.
Lawrence L. McCants has been Chairman of the Board and President of First National Bank in Goodland, Kansas, since 1983. Mr. McCants was previously employed by the Comptroller of the Currency for 11 years. Although as a member director the Board of Directors did not participate in Mr. McCants’ nomination, Mr. McCants possesses 38 years of experience in banking, both as a regulator and a banker, knowledge of both large and small financial institutions, experience in strategic planning, investments, risk management and operations, and prior experience as an FHLBank director, that assist in his service as a director.
Neil F. M. McKay was Chief Financial Officer and Treasurer of Capital Federal Savings in Topeka, Kansas from 1994 through March 2006. Mr. McKay, now retired, has held significant executive positions in various financial institutions including Heartland Federal Savings in Ponca City, Oklahoma, and First Nationwide Bank (now part of Citibank) in San Francisco, California. He was also a CPA in public practice for 12 years. The Board of Directors considered Mr. McKay’s qualifications, skills and attributes, including his certification as a CPA, his 12 years of service as an audit manager of large, publicly traded banks, his experience as Controller of a $30 billion publicly traded bank, his experience as CFO of an $8 billion publicly traded bank, and his prior service as an FHLBank director, when making his nomination.
Thomas H. Olson has been Chairman of the Board of Lisco State Bank, Lisco, Nebraska, since 1976. Mr. Olson has served as Chairman of the Board or a director of five other banks located in Nebraska, Colorado and Wyoming. Although as a member director the Board of Directors did not participate in Mr. Olson’s nomination, Mr. Olson possesses extensive experience serving as Chairman of the Board of numerous banking institutions, experience serving as President of the Independent Community Bankers Association and the Nebraska Bankers Association, experience in working with members of Congress and the state legislature, and prior experience as an FHLBank director, that assist in his service as a director.
Lindel E. Pettigrew has served as the Vice Chairman of the FHLBank’s Board of Directors since January 2007. Mr. Pettigrew has been President and CEO of Chickasha Bank and Trust Company, Chickasha, Oklahoma, since 1974. Although as a member director the Board of Directors did not participate in Mr. Pettigrew’s nomination, Mr. Pettigrew possesses 49 years of experience in commercial banking, including 37 years as President and CEO of Chickasha Bank and Trust Company, broad experience in commercial, real estate and agriculture lending, experience serving as Chair and Vice-Chair of economic development efforts in his community, and prior experience as an FHLBank director, that assist in his service as a director.
Bruce A. Schriefer joined Bankers’ Bank of Kansas, Wichita, Kansas, in 1996 and has served as President, CEO and director since that time. Although as a member director the Board of Directors did not participate in Mr. Schriefer’s nomination, Mr. Schriefer possesses 39 years of experience at various levels of commercial banking, experience as a former director of the Federal Reserve Bank of Kansas City, experience on the boards of directors of various national and state trade associations, current experience as a member of the FDIC Advisory Committee on Community Banking, and prior experience as an FHLBank director, that assist in his service as a director.
Ronald K. Wente has served as Chairman of the FHLBank Board of Directors since 2000. Mr. Wente has been President and CEO of Golden Belt Bank, Ellis, Kansas, since 1974. Although as a member director the Board of Directors did not participate in Mr. Wente’s nomination, Mr. Wente possesses 37 years of banking experience, experience with the products and services provided by the FHLBank, including knowledge of operations, regulatory compliance and legislative issues, extensive experience with banking trade groups both on the regional and national level, and prior experience as an FHLBank director, that assist in his service as a director. Mr. Wente is an ex officio member of all FHLBank committees.
Code of Ethics
The FHLBank has adopted a Code of Ethics that applies to the FHLBank’s directors, officers (including the FHLBank’s principal executive officer, principal financial officer, principal accounting officer or controller and persons performing similar functions) and employees. The FHLBank has posted its Code of Ethics on its Web site at www.fhlbtopeka.com. The FHLBank will also post on its Web site any amendments to, or waivers from, a provision of its Code of Ethics that applies to the principal executive officer, principal financial officer, principal accounting officer, or persons performing similar functions as required by applicable rules and regulations. The Code of Ethics is available, in print, free of charge, upon request. Written requests may be made to the General Counsel of the FHLBank at One Security Benefit Place, Suite 100, Topeka, Kansas, 66606.
Audit Committee Financial Expert
The FHLBank has a separately-designated audit committee, which consists of Michael M. Berryhill, the chairman of the Audit Committee, Neil F.M. McKay, James R. Hamby, Andrew C. Hove, Jr., Lawrence L. McCants and Ronald K. Wente.
The Board of Directors has determined that Neil F.M. McKay qualifies as an “audit committee financial expert” as that term is defined under SEC regulations. Mr. McKay is “independent” in accordance with the Nasdaq Independence Standards for audit committee members, as those standards apply to the FHLBank.
The Compensation Committee Report is included following the Compensation Discussion and Analysis in Item 11
Item 11. Executive Compensation
Compensation Discussion and Analysis
Overview
Our overall compensation philosophy is to establish and provide a total compensation program for our executive officers, including the President and CEO (CEO), the Senior Executive Vice President and COO (COO), the Executive Vice President and CFO (CFO), the Senior Vice President and General Counsel (General Counsel), the Senior Vice President and Director of Credit (Director of Credit) (collectively, the Named Executive Officers) and other executive officers identified by the Board of Directors, that assists and supports us in achieving our mission to make a difference by helping our members build their communities. In determining the appropriate total compensation package for our Named Executive Officers, we consider the principal objectives of our compensation program are: (1) attracting and retaining highly-qualified and talented individuals; and (2) motivating these individuals to achieve individual and FHLBank-wide performance goals through incentive awards that reward such performance.
The Compensation Committee of the Board of Directors (Compensation Committee) oversees the compensation of the Named Executive Officers. The Compensation Committee’s responsibilities include:
§
Advising the Board of Directors on the establishment of appropriate compensation, incentive and benefits programs, including recommending performance goals for the Executive Short Term Incentive Plan (ESTIP) and the 2009-2011 Long Term Incentive Plan (LTIP);
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Overseeing the base salaries, merit raises and salary adjustments of the COO, the CFO, and the General Counsel; and
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Recommending to the Board of Directors the base salary, merit raises and salary adjustments of the CEO.
The CEO is responsible for recommending to the Compensation Committee the base salary, merit raises and salary adjustments of the COO, CFO and General Counsel and approving the base salary, merit raises and salary adjustments of the Director of Credit as recommended by the CFO.
Elements of Executive Compensation
To implement our compensation objectives, the elements of our 2009 compensation program for the Named Executive Officers included: (1) annual base salary; (2) annual cash incentive awards; (3) award opportunities under our long term incentive plan (4) retirement and other benefits; and (5) limited perquisites.
Annual Base Salary
A significant element of each Named Executive Officer’s total compensation is annual base salary. The Compensation Committee has determined that appropriate annual base salaries for each Named Executive Officer should be competitive at the 50th percentile level of the salaries of comparable executive positions within labor markets that it has defined as peer groups of ours for purposes of competitive compensation analysis, as discussed below under “Use of Benchmarks.” Adjustments to annual base salaries for the Named Executive Officers are considered annually and may be made in April following an analysis of our compensation practices in the previous year. Adjustments to annual base salaries of the Named Executive Officers are based on: (1) each Named Executive Officer’s scope of responsibility and accountability; (2) analysis of our comparator labor markets (as described below); (3) performance as measured in terms of FHLBank-wide goals; (4) the perceived performance of each Named Executive Officer subjectively; and (5) other factors such as experience, time in position, general economic conditions, and labor supply and demand conditions. In February 2009, based upon a recommendation from management and consideration of the Compensation Committee, the Compensation Committee determined not to increase base salaries for the CEO, COO, CFO, and General Counsel. The CEO and Executive management also decided not to increase base salaries for most other employees, including the Director of Credit. This decision was made primarily due to the unpredictability and volatility anticipated in economic and business conditions for financial institutions for 2009.
Annual Cash Incentive Awards
The ESTIP governs the eligibility and payout of annual cash incentive awards for the Named Executive Officers. The purpose of the ESTIP is to motivate our Named Executive Officers to achieve annual goals that are aligned with our mission and business objectives and to reward them for attaining such goals. The Board of Directors adopted performance objectives in February 2009 for award opportunities under the ESTIP in 2009. A detailed discussion related to the analysis undertaken in establishing the performance goals for the ESTIP is provided below under “Establishment of Performance Goals for Incentive Opportunities.”
Long Term Cash Incentive Awards
The LTIP became effective on January 1, 2009. The LTIP serves to promote consistency of high-value creation for our members by promoting our long-term growth and profitability in accordance with the achievement of long-term strategic objectives and our mission. The LTIP also promotes the loyalty and dedication of our Named Executive Officers to us and to our strategic objectives by rewarding performance that facilitates our growth, financial stability, and success over the long term. In addition, the LTIP serves to increase our capacity to attract, retain and motivate key employees by enhancing our ability to offer competitive total compensation to our Named Executive Officers by providing deferred incentives to them that will further motivate them to facilitate our longer term strategic objectives and that will reward performance that results in our growth and financial stability over a three-year performance period.
Retirement and Other Benefits
We maintain a comprehensive retirement program for our eligible officers comprised of two qualified retirement plans: (1) the Pentegra Defined Benefit Plan for Financial Institutions, a tax-qualified multiple-employer defined-benefit plan (DB Plan) and (2) the Pentegra Financial Institutions Thrift Plan, a retirement savings plan qualified under the Internal Revenue Code (IRC) for employees of the FHLBank (DC Plan).
In 2009, each of the Named Executive Officers participated in the DB Plan, which required no contribution from any Named Executive Officer. Effective January 1, 2009, the DB Plan was amended closing it to employees hired on or after January 1, 2009, by making such persons ineligible to participate in the DB Plan. Employees, including the Named Executive Officers that were hired prior to January 1, 2009 may continue to participate in the DB Plan.
All employees who have met the eligibility requirements can choose to participate in the DC Plan. We match employee contributions based on the length of service and the amount of an employee’s contribution. These employer contributions are immediately 100 percent vested. Matching ratios for all employees, including the Named Executive Officers, under the DC Plan are as follows:
Year 1
No match
Years 2 through 3
100 percent match up to 3 percent of employee’s eligible compensation
Years 4 through 5
150 percent match up to 3 percent of employee’s eligible compensation
After 5 years
200 percent match up to 3 percent of employee’s eligible compensation
Due to the closure of the DB Plan to employees hired on or after January 1, 2009, the DC Plan was amended, effective January 1, 2009 to make employees hired on or after that date eligible to receive a basic contribution from the FHLBank equal to 2 percent of salary after one year of employment.
In response to federal legislation, which imposed restrictions on the pension benefits payable to our executives, we subsequently established a third retirement plan, the Benefit Equalization Plan (BEP). The BEP is a non-qualified plan that restores the pension benefits an eligible employee is restricted from receiving because of the limitations imposed by the IRC on the benefits received from or contributions made to our two qualified pension plans. Generally, the BEP is characterized as a non-qualified “excess benefit” plan, which restores those retirement benefits that exceed the IRC limits applicable to the qualified DB Plan and DC Plan. In this respect, the BEP is an extension of our retirement commitment to our Named Executive Officers and other highly compensated employees that preserves and restores the full pension benefits that, due to IRC limitations, are not payable from the qualified pension plans. As of December 31, 2009, each of the Named Executive Officers would be entitled to receive their respective balance of compensation deferred through participation under the BEP within ninety days of any such Named Executive Officer’s termination of employment due to death, disability or retirement. For each Named Executive Officer, these amounts are listed in Table 97 under the column titled “Aggregate Balance at Last FYE.” The BEP also provides for a potential payment to the Named Executive Officers in such amounts upon a change in control as defined in the BEP and in accordance with IRC Section 409A and applicable regulations.
We are also committed to providing competitive, high-quality benefits designed to promote health, well-being, good will and income protection for all employees, including the Named Executive Officers. We offer all employees a core level of benefits and a variety of optional benefits including medical, dental, prescription drug, life insurance, long-term disability, flexible spending accounts, employee assistance program and travel accident insurance. The Named Executive Officers participate in these core benefit programs on the same basis as all other full-time employees.
Perquisites
The Board of Directors views the perquisites afforded to the Named Executive Officers as an element of the total compensation program. Any perquisites provided, however, are not intended to materially add to any Named Executive Officer’s compensation package and, as such, are provided to them primarily as a convenience associated with their respective duties and responsibilities.
Examples of perquisites that were provided to the Named Executive Officers in 2009 included the following:
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The personal use of an FHLBank-owned automobile for the President;
§
Financial and tax planning for the President; and
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Spousal travel.
Categorical types of perquisites provided to the Named Executive Officers in 2009 are presented and detailed in the Summary Compensation Table (see Table 92 under this Item 11) and accompanying narrative in the case that aggregate perquisites to any single Named Executive Officer exceeded $10,000.
Analysis of Compensation Decisions in 2009
Use of Benchmarks
A key to attracting and retaining highly-qualified executive officers is the identification of the appropriate labor markets within which we must compete for executive talent. We have historically recruited nationally in our efforts to attract highly-qualified candidates for the Named Executive Officer positions. To ensure that we are offering and paying competitive compensation, the Board of Directors (and/or Compensation Committee) has periodically retained compensation consultants to assist with comparative analyses of the Named Executive Officers’ total compensation with respect to compensation elements of annual base salary, annual incentive awards and benefits by providing benchmarks for competitive levels of such compensation.
Our Compensation Committee typically performs this comprehensive comparative analysis annually. In 2009, the Compensation Committee performed a more limited comparative analysis related to total compensation since the Named Executive Officers and Compensation Committee recommended, and the Board of Directors approved, no increases to the Named Executive Officers base salary for 2009.
Typically, our benchmark analysis consists of defining peer group(s), benchmark jobs and determining pay positioning (e.g., low quartile, median or high quartile) to better understand our Named Executive Officers’ competitive positioning in terms of total compensation. The Compensation Committee has defined two peer groups for comparative purposes by looking at organizations that we compete with for business and/or talent. These are primarily the other FHLBanks and, secondarily, other financial services institutions (together, the Peer Group). The decision to remain competitive with the other FHLBanks and, at the same time, consider the broader labor market of financial services institutions reflects our belief that the knowledge and skills necessary to effectively perform our Named Executive Officers’ duties may be developed as a result of experience not only at other FHLBanks, but also at a variety of other financial services institutions. We also recognize that Topeka’s geographic location may be a positive or a negative factor in attracting executives, but generally is a positive factor in retaining executives.
Within the Peer Group, the Compensation Committee analyzes data at the 25th percentile, 50th percentile and 75th percentile compensation ranges for comparing executive positions similar to those of our Named Executive Officers to benchmark the competitiveness of our total compensation for the Named Executive Officers. We generally strive to compensate our Named Executive Officers at the 50th percentile; however, the ultimate percentile determined appropriate in any given year will depend on the scope of a Named Executive Officer’s responsibility as compared to a benchmark job, the experience and performance of the individual Named Executive Officer, and our overall performance. Generally, the Compensation Committee operates to utilize below median pay for poor performance and above median pay for superior performance. While survey information may be a factor in setting executive compensation, we believe that surveys should not override the need for independent decisions that are consistent with our financial condition and future prospects.
In 2009, the Compensation Committee considered the competitive position of our Named Executive Officers total compensation by reviewing comparative data obtained from the compensation consultants, McLagan Partners, which included: (1) McLagan’s FHLBank Custom Compensation and pay data; and (2) McLagan’s proprietary survey database for financial services institutions. It was determined by the Compensation Committee that with respect to competitive pay positioning and for purposes of retaining our Named Executive Officers that the maintenance of 2008 levels of base salary, in addition to the opportunities for annual and long term incentive awards discussed below, represented appropriate compensation for the Named Executive Officers in 2009.
Consideration of Individual Performance
In addition to using benchmarking, as described above, the performance of each Named Executive Officer is considered by the Compensation Committee, by the CEO, and by the CFO in the case of the Director of Credit, in determining whether it is appropriate to increase annual base salaries based on a subjective determination of the perceived merit of each Named Executive Officer. In 2009, these individual performance appraisals were conducted; however, the Compensation Committee determined that base salaries would not be increased in 2009 upon the recommendation of the Named Executive Officers and the agreement of the Compensation Committee (as discussed above), notwithstanding the perceived merit of any particular Named Executive Officer warranting an increase.
Consideration of Internal Pay Equity
A final factor that the Compensation Committee generally considers in determining base salary increases in its effort to retain our Named Executive Officers is the relative difference in compensation between the executive officers as well as the pay relationship between executive officers and other employees at the FHLBank. The Compensation Committee believes that internal pay equity provides an additional perspective to that of benchmarked compensation information. While comparisons to compensation levels of executive positions within our Peer Group are the primary basis used to assess the overall competitiveness of our compensation program, we also believe that our executive compensation practices should be internally consistent and equitable.
Because no adjustments were made to base salaries in 2009, the internal pay equity of our Named Executive Officers remained unchanged from the previous year and therefore no adjustments were made to any Named Executive Officer’s base salary on this basis.
Establishment of Performance Goals for Incentive Award Opportunities in 2009
ESTIP
Motivating our Named Executive Officers to accomplish business and financial short-term goals that promote a high level of performance for our members is another key objective of our total compensation program. Consequently, our compensation and benefits programs are designed to motivate our Named Executive Officers to engage in the behaviors and performance necessary to deliver our desired results of operations in a highly competitive environment. We also recognize that well-designed incentive compensation plans provide important opportunities to motivate our Named Executive Officers to accomplish financial and operational goals that promote our mission.
To effectively motivate the Named Executive Officers to accomplish short-term goals that promote our performance, we believe that incentive awards must represent pay at risk. In other words, the administration of our incentive compensation plans must be such that awards are distributed only in exchange for accomplishing pre-established, Board of Directors-approved goals, and are not distributed if such goals are not met. In 2009, we achieved this compensation objective through attainment of annual performance objectives under our ESTIP.
Beginning in November 2008, management and designated members of the Compensation Committee met to develop and propose performance objectives for executive compensation awards under the ESTIP for 2009 Named Executive Officer award opportunities. The proposed performance objectives reflect the drivers of our business and mission and were based upon the Compensation Committee’s and management’s discussions with respect to our primary mission and stockholder perceptions of success. Individual Compensation Committee members participated in the development of appropriate levels and thresholds for each goal and the Compensation Committee reviewed, analyzed and adjusted the proposed performance objectives, as appropriate, for 2009 before submitting the objectives to the Board of Directors for approval.
In February 2009, the Board of Directors approved the five FHLBank-wide performance objectives from which to measure potential awards to the Named Executive Officers under the ESTIP. The performance objectives against which the Named Executive Officers’ performance were evaluated in 2009 represented a mix of profit-oriented and service-oriented performance measures, and reflected the fact that our primary mission as a cooperatively-owned GSE is providing reliable and dependable overall benefits to our members in the form of products, services and dividends. The performance objectives for 2009 are described in Table 86:
Table 86
Performance Objective
Measure
Core Return Spread on Class B Common Stock1
Spread between pre-hedging, pre-AHP/REFCORP core return available for Class B Common Stock (weighted by the amount of Class B Common Stock outstanding each day) and the weighted average daily overnight Federal funds effective rate
Net Income After Capital Charge1
The dollar amount of pre-hedging core earnings that exceeds the cost of the required return on each component of capital (Class A Common Stock, Class B Common Stock and Retained Earnings)
Advance Penetration
The average member’s advance-to-asset ratio in relation to the prior year’s ratio adjusted for the national trend in the other borrowings-to-total asset ratio as reported by the Federal Reserve
Core Product Utilization
The weighted average member and housing associate usage of core banking (profit-oriented) products
Mission Product Utilization
Based on the member usage of mission-oriented products consisting of AHP, CHP, CDP, RFHP, TOP and JOBS programs
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As part of evaluating its financial performance and measuring ESTIP performance, FHLBank adjusts net income reported in accordance with GAAP for the impact of: (1) AHP and REFCorp assessments; (2) items related to derivative and hedging activities; and (3) other irregular or non-recurring items such as prepayment fees, gain/loss on retirement of debt and gain/loss on securities. The result is referred to as core income, which is not defined within GAAP. Core income is used to compute a core return on equity that is then compared to the average overnight Federal funds effective rate. Because we are basically a “hold-to-maturity” investor and do not trade derivatives or investments, we believe that core income and core return on equity are important to understanding our operating results and performance as measured under the ESTIP and provide a meaningful period-to-period comparison in contrast to GAAP income, which can vary significantly because of derivative and hedging activities and other items that may not recur. Hedge accounting affects the timing of income or expense from derivatives and their related assets and liabilities hedged, but not the economic income or expense from these derivatives. For example, gains on interest rate swaps offset prior losses or will be offset by losses in future periods because the value of the swaps will equal zero at maturity, and our intent is to hold these derivatives until maturity.
The profit-oriented objectives of “Core Return Spread on Class B Common Stock” and “Net Income After Capital Charge” (non-GAAP measures) were based on: (1) the belief that profitability is critical to the long-term viability of the organization; and (2) the understanding that the holders of Class B Common Stock represent the members constituting the primary users of our products and services. The “Advance Penetration” performance objective was established to address average advance usage by members as a percentage of each member’s balance sheet. Finally, the performance objectives for “Core Product Utilization” and “Mission Product Utilization” address the members’ usage of profit generating products and non-profit generating products, respectively. A key driver in the development of the objectives was the Board of Directors’ perspective that it is important for us to serve all members, regardless of asset size. Consequently, the product-oriented objectives represented an average of the ratios calculated across all members unweighted by asset size. The weighting for each performance objective is discussed in detail below.
Award levels were set at threshold, target and optimum percentages of annual base salary. All of the FHLBank’s performance objectives are annual goals, but quarterly progress payments are made under the ESTIP in accordance with interim goals established for each performance range and applied to the respective annual performance objective. So long as at least a threshold level of performance was achieved, payouts were made up to a maximum payout percentage set for each Named Executive Officer. In addition, the Compensation Committee established a holdback of twenty percent of the quarterly progress payments, which would only be paid after year-end if we achieved at least a threshold level of performance for the year against the Core Return on Class B Capital Stock performance objective. For 2009, we achieved the threshold level of performance for the Core Return on Class B Capital Stock objective and, therefore, the Compensation Committee approved distribution of the holdback amount of the ESTIP awards earned by the Named Executive Officers upon review and counsel of the Finance Agency (as discussed below). See Table 94 for the results of achievement of each objective for each Named Executive Officer.
Table 87 sets forth the specific interim and annual goal performance ranges for each of our established performance objectives in 2009:
Table 87
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The performance range for “Net Income After Capital Charge” is based on our cumulative net income per quarter.
Measures represent the percentage above the national average. Such national trend data was derived from the Federal Reserve’s Statistical Release H8 “Historical Data - Assets and Liabilities of Commercial Banks in the United States.” We used the data attributed to the subgroup Assets and Liabilities of Small Domestically Chartered Commercial Banks in the Unites States (not seasonally adjusted, adjusted for mergers, billions of dollars).
We have identified the following as our core banking products: line of credit advances, regular advances, letters of credit, mortgage loans acquired under the MPF Program, overnight deposits and safekeeping.
The performance range for “Mission Product Utilization” is based on the number of our members at the time of mission product usage that qualify as users of a product at any time during the calendar year. Program participation use is credited and remains credited for the entire calendar year irrespective of whether the participating member is subsequently acquired, merged or otherwise terminates its membership.
Under the ESTIP, the Compensation Committee has the discretion to reduce or eliminate the amount of an award otherwise payable to a Named Executive Officer if, due to extenuating circumstances, the Compensation Committee subjectively determines the reduction or elimination of an award is warranted. Such discretion has not been historically exercised by the Board of Directors under the ESTIP and was not exercised in 2009.
Table 88 provides the weighting for the various performance goals as a percent of the total ESTIP award opportunity for each Named Executive Officer.
Table 88
Performance Objective
Weight %
Core Return Spread on Class B Common Stock
Net Income After Capital Charge
Advance Penetration
Core Product Utilization
Mission Product Utilization
Award values as a percentage of annual base salary for performance goal achievement were assigned based on the Named Executive Officer’s position in the hierarchy of the FHLBank, which partially reflects the Named Executive Officer’s role in our strategic decisions as well as the Named Executive Officer’s influence over our overall operations and culture.
Table 89
Position
Target
CEO
55 percent
COO and CFO
45 percent
General Counsel and Director of Credit
35 percent
While markets were extremely volatile over the course of 2009, we had an outstanding year in terms of Net Income After Capital Charge and Core Return Spread on Class B Common Stock (non-GAAP measures) and a solid financial performance overall with member utilization of our products and services also performing well. This underscores the value we provide to our members. Due to our actual achievement of each of the five performance objectives each quarter and as of December 31, 2009, the Compensation Committee approved quarterly and annual payouts, including the holdback amount applicable to the Core Return Spread on Class B Capital Stock, under the ESTIP to the Named Executive Officers.
For 2010, the Compensation Committee recommended and the Board of Directors approved in December 2009, the addition of an annual Risk Management goal as an additional performance goal for the ESTIP and eliminated the performance measures based on Advance Penetration. The Advance Penetration goal was replaced in 2010 with the new Risk Management goal. The Compensation Committee chose to add Risk Management as a performance goal to be consistent with corporate best practices and to align compensation with sound risk management.
LTIP
Because the LTIP became effective as of January 1, 2009 and requires achievement of performance measures over a three-year period (through 2011), the Named Executive Officers did not earn awards under the LTIP in 2009, although the FHLBank accrued and expensed an amount consistent with target achievement under the LTIP through December 31, 2009.
Table 90 presents the Base Award Opportunity Percentage for each Named Executive Officer eligible to participate in the Performance Period (January 1, 2009 through December 31, 2011) under the LTIP:
Table 90
Named Executive Officer
Level
Base Award Opportunity Percentage
Andrew J. Jetter
Level I
David S. Fisher
Level II
Mark E. Yardley
Level II
Patrick C. Doran
Level III
Sonia Betsworth
Level III
In calculating base award amounts, performance is measured as demonstrated in Table 91:
Table 91
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Total Return equals total dividends, plus the change in retained earnings, divided by average capital. For FHLBank Topeka, total dividends is defined as the sum of the actual dividends paid on required Class A Common Stock and all Class B Common Stock during the three-year performance period, change in retained earnings is defined as the change in retained earnings from December 31, 2008 to December 31, 2011, and average capital is defined as the average daily ending balance of required Class A Common Stock and all Class B Common Stock. For the other FHLBanks, unless determined otherwise by the Compensation Committee, total dividends is defined as all dividends paid on all capital stock during the three-year period, change in retained earnings is defined as the change in retained earnings from December 31, 2008 to December 31, 2011, and average capital is defined as the average of all capital stock outstanding for the 12 quarter ending dates starting with March 31, 2009 and ending December 31, 2011. For performance comparison purposes, FHLBank Topeka will be ranked against the other FHLBanks, with the highest total return being the best performance, and ranking first out of the 12 FHLBanks.
Expense Growth is the dollar amount of the change in operating expenses (including salaries and benefits, costs of quarters and other operating expenses) at FHLBank Topeka from calendar year 2008 to calendar year 2011. For performance comparison purposes, FHLBank Topeka will be ranked against the other FHLBanks, with the lowest increase (or greatest decrease) being the best performance, and a first out of the 12 FHLBanks being the highest ranking.
Why We Choose to Pay these Elements
We believe the Compensation Committee’s analyses described above provides an appropriate process to determine compensation levels for each Named Executive Officer that reasonably positions us to competitively manage our operations for success and to accomplish our mission.
The mix of compensation elements that comprised the total compensation of our Named Executive Officers in 2009, including annual base salary, short-term incentive awards, a long-term incentive plan, and retirement-related benefits, particularly allowed us to provide total compensation that we believe appropriately balanced reasonable guaranteed pay through carefully considered base salary determinations with additional cash compensation opportunities at risk to the Named Executive Officers. This means that while we strived to match an appropriate level of compensation comparable to that reflected by our defined labor markets and internal pay analysis through annual base salary and retirement benefits components, we also strived to provide a component of compensation that is at risk in both the short term and the long term, but represents an opportunity for reward based on the achievement of both our annual and long-term performance goals. The Committee believes that the Supplemental Thrift Plan, as defined under “Deferred Compensation” in this Item 11, and the defined benefit portion of the BEP provide additional retirement benefits that are necessary for the FHLBank’s total rewards package to remain competitive, particularly compared with competitors who may offer equity-based compensation and/or long-term incentives. Additional information regarding these plans can be found in the narratives to the Pension Benefits and Nonqualified Deferred Compensation tables in this Item 11.
Therefore, where we achieved performance goals in 2009, the Named Executive Officers received awards that were determined to correspond to the respective Named Executive Officer’s contribution to our success.
Severance Benefits
We provide severance benefits to the Named Executive Officers pursuant to our Officer Severance Policy. The policy’s primary objective is to provide a level of protection to officers, including the Named Executive Officers, from loss of income during a period of unemployment. Our officers are eligible to receive severance pay under the policy if we terminate the officer’s employment with or without cause, subject to certain limitations. These limitations include: (1) the officer voluntarily terminates employment; (2) the officer’s employment is terminated by us for misconduct; or (3) the officer accepts employment or refuses other employment offered by us at or before the time of termination.
Provided the requirements of the policy are met and the Named Executive Officer provides us an enforceable release, the Named Executive Officer will receive severance pay equal to the following amount of the Named Executive Officer’s final annual base salary indicated for the officer’s title.
President
52 weeks
Executive Vice President (COO and CFO)
39 weeks
Senior Vice President (General Counsel and Director of Credit)
26 weeks
See “Potential Payments Upon Termination or Change in Control” in this Item 11 for more information related to potential payouts on termination or change in control attributable to each Named Executive Officers as of December 31, 2009.
Finance Agency Oversight
Section 1113 of the Recovery Act 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. On June 5, 2009, the Finance Agency published a proposed regulation designed to implement these statutory requirements covering compensation payable to members of an FHLBank’s senior executive team and defines “reasonable” and “comparable” compensation. In addition, under the proposed regulation, the Finance Agency Director would have authority to approve certain compensation and termination benefits.
On October 27, 2009, the Finance Agency issued an advisory bulletin establishing certain principles for executive compensation at the FHLBanks and the Office of Finance that include: (1) such compensation must be reasonable and comparable to that offered to executives in similar positions at comparable financial institutions; (2) such compensation should be consistent with sound risk management and preservation of the par value of FHLBank stock; (3) a significant percentage of an executive’s incentive based compensation should be tied to longer-term performance and outcome-indicators and be deferred and made contingent upon performance over several years; and (4) the Board of Directors should promote accountability and transparency in the process of setting compensation. The FHLBanks have been directed to provide all compensation actions affecting their five most highly compensated officers to the Finance Agency for review. Accordingly, in January 2010, we submitted to the Finance Agency proposed payouts to the Named Executive Officers under the ESTIP for 2009.
Compensation Committee Report
The Compensation Committee of the FHLBank’s Board of Directors has reviewed and discussed the Compensation Discussion and Analysis with management. Based on its review and discussions with management, the Compensation Committee has recommended to the Board of Directors that the Compensation Discussion and Analysis be included in our annual report on Form 10-K.
The Compensation Committee
of the Board of Directors
Richard S. Masinton, Chairman
Lindel E. Pettigrew
Michael M. Berryhill
Ronald K. Wente
Thomas E. Henning
Lawrence L. McCants
Table 92 presents the Summary Compensation Table for the Named Executive Officers.
Table 92
Table 93 presents the components of “All Other Compensation” as summarized in Table 92.
Table 93
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Mr. Jetter’s perquisites and personal benefits consist of an FHLBank-provided automobile, financial and tax planning services and expenses for spousal travel.
Table 94 presents the Grants of Plan Based Awards Table for the Named Executive Officers.
Table 94
Amounts reflected for the ESTIP and LTIP represent the applicable range of possible payouts and do not represent amounts actually earned or awarded for the fiscal year ended December 31, 2009. LTIP amounts are calculated using the base salaries in effect on January 1 at the beginning of the performance period. Awards, if any, under the LTIP are payable in the year following the end of the three-year performance period. See discussion under 2009-2011 Long Term Incentive Plan under this Item 11 for a description of the material term of the LTIP and future payouts.
Dates under the ESTIP represent the date a cash award was granted to each Named Executive Officer. All awards were payable at a later date.
2009 Executive Short Term Incentive Plan
Under the ESTIP, Named Executive Officers may earn quarterly progress payments for year-to date performance against their annual goal metrics upon achieving performance objectives established by the Board of Directors. As discussed previously, for 2009, these performance objectives included: (1) core return on Class B Stock as a spread over the weighted average daily overnight Federal funds effective rate; (2) net income after capital charge; (3) advance penetration; (4) core product utilization; and (5) mission product utilization.
Performance Ranges
Awards under the ESTIP may be granted for achievement corresponding to performance ranges, from threshold, to target, to optimum performance for each goal metric. Within a performance range, threshold represents the lowest level of annual performance eligible for an award; target represents the expected level of annual performance; and optimum represents the best attainable level of annual performance required to obtain the maximum award payment. Awards may be earned for performance anywhere within these performance ranges at a percentage of base salary that corresponds to actual performance. For performance that falls between any two levels of performance, linear interpolation is used to ensure that the annual award is consistent with the level of performance achieved. Named Executive Officers may earn annual awards expressed as a percent of their earned base salary as follows:
Table 95
Calculation of Quarterly Progress payments and Final Awards
Named Executive Officers may receive quarterly progress payments for year-to-date performance against their performance objectives when performance exceeds the interim quarterly performance levels for the goal metric against which quarterly progress payments are computed. In aggregate, any quarterly progress payment received for such performance may not exceed the value of the annual awards. Twenty percent of the calculated quarterly progress payments are retained by the FHLBank and paid after the end of the ESTIP plan period if: (1) the Named Executive Officer was employed by the FHLBank on the last day of the plan year; and (2) no pro-ration or forfeiture provisions in the ESTIP applied. The formulas for determining quarterly progress payments (QP) and the final award (FA) earned for performance against a single performance objective are:
QP = [(Earned Base) (Award percent) (Metric Weight) (100 percent - Holdback percent)] - Previous Payments
FA = [(Earned Base) (Award percent) (Metric Weight)] - Previous Payments
Forfeiture Provisions
A Named Executive Officer, in the discretion of the Compensation Committee, may be required to forfeit an award earned under the ESTIP if the Named Executive Officer is: (1) discharged from employment with the FHLBank for Good Cause as defined under the ESTIP; (2) engages in competition with the FHLBank or interferes with the business relationships of the FHLBank during his employment or following his termination; (3) discloses confidential information of the FHLBank; or (4) refuses to report to the FHLBank any discoveries or improvements conceived by the Named Executive Officer during the course of employment that relate to the business of the FHLBank. A Named Executive Officer is not eligible to receive progress payments toward annual awards or holdbacks arising out of an annual award for any quarter during which employment ceases for any reason other than death or for subsequent quarters of such Plan period.
2009-2011 Long Term Incentive Plan
The LTIP provides eligible executive officers the opportunity to earn long-term incentive compensation based on the FHLBank’s attainment of certain financial goals determined by the Compensation Committee of the Board of Directors. The purpose of the LTIP is to promote loyalty and dedication of key employees to the FHLBank and reward performance that facilitates the strategic objectives and resulting growth and financial stability of the FHLBank. The Compensation Committee, in consultation with the CEO, is responsible for administering the LTIP and has the full authority to construe, interpret, implement, and administer the LTIP in such capacity.
The identities of the individual employees eligible for participation under the LTIP will be recommended by the CEO to the Compensation Committee for approval for a given Performance Period. “Performance Period” is defined under the LTIP as a three-year period, with the first Performance Period extending from January 1, 2009 to December 31, 2011. Eligibility under the LTIP is limited to a select group of management or other highly compensated employees, but normally will be further limited to the CEO and senior officers who are members of the Strategic Planning Group (as such term is defined in the LTIP) (collectively, the “Executive Group”). Other key employees may be recommended as participants on a limited basis to address extraordinary performance and/or other criteria and considerations as determined by the Compensation Committee. The LTIP provides for four levels of participation, which have been established to take into consideration that certain key employees have a greater and more direct impact than others on the annual and cumulative success of the FHLBank. See Compensation Discussion and Analysis under this Item 11 for details about eligibility for participation and the opportunity percentages for each Named Executive Officer.
The LTIP uses a formula based on the FHLBank’s Performance Measures for a given Performance Period, which are set by the Compensation Committee and described under the Compensation Discussion and Analysis for the 2009-2011 Performance Period. Under the LTIP, the Performance Measures are more than just points of annual performance; rather, they may vary within a range from “Threshold,” defined as the minimum achievement level acceptable for the Performance Measure, to “Target,” defined as the expected achievement level for the Performance Measure, to “Maximum,” defined as the achievement level for the Performance Measure that substantially exceeds the Target level of achievement. For performance that falls between any two levels of performance (e.g., between Threshold and Target or Target and Maximum), linear interpolation is used to ensure that the award is consistent with the level of performance achieved.
A participant’s award under the LTIP equals the Base Award Opportunity, which means the total award that may be earned during a Performance Period for achieving Target performance levels under each Performance Measure, plus any discretionary awards that may be recommended by the CEO to the Compensation Committee for any Level II, Level III and/or Level IV participant for extraordinary performance (the “Final Award”). The Final Award earned by a member of the Executive Group will be paid out in cash at the end of a Performance Period.
A Final Award will not be payable for any Performance Period where the FHLBank fails to achieve performance at or above the Performance Measure(s) set by the Compensation Committee or under any of the following circumstances: (1) the FHLBank receives a cumulative “4” rating in its FHFA examination, or other equivalent “operating in an unsafe or unsound condition, or with unsafe or unsound practices” rating from applicable regulatory authorities during any year within the Performance Period; (2) the FHLBank has negative net income, as defined and in accordance with GAAP, for the cumulative Performance Period; or (3) a given participant does not achieve “satisfactory” individual achievement levels during the applicable Performance Period. The determination of whether performance is deemed “satisfactory” is in the sole discretion of the Compensation Committee. Additionally, the Final Award shall be reduced by one-third for each year during the Performance Period in which the FHLBank has negative net income, as defined and in accordance with GAAP.
Pension Benefits
Table 96 presents the Pension Benefits Table for the Named Executive Officers.
Table 96
The FHLBank’s DB Plan covers all full time employees of the FHLBank as of January 1, 2009 who have met the eligibility requirements of: (1) attainment of age 21; (2) completion of twelve months of employment; and (3) employed by the FHLBank as of December 31, 2008, including the Named Executive Officers. Employees are not fully vested until they have completed five years of employment. The regular form of retirement benefits provides a single life annuity; a lump-sum payment or other additional payment options are also available to a limited degree for those Named Executive Officers who were employed prior to the plan change in 2003. The benefits are not subject to offset for social security or any other retirement benefits received.
The DB Plan provides a normal retirement benefit at or after age 65 where a Named Executive Officer has met the vesting requirement of completing five years of employment equal to 2.0 percent of his/her highest three-year average salary multiplied by his/her years of benefit service, up to 30 years. Three Named Executive Officer participants (Mr. Jetter, Mr. Yardley and Ms. Betsworth) are eligible to receive benefits in excess of 2.0 percent because of a plan change in 2003. The amount in excess of 2.0 percent is a calculated “frozen add-on,” determined at the time of the plan change. The formula for this “frozen add-on” is [old benefit formula as of August 31, 2003 minus new benefit formula as of September 1, 2003 equals the frozen add-on]. Earnings are defined as base salary plus overtime and bonuses, subject to an annual IRC Section 401(a)17 limit of $245,000 on earnings for 2009. Annual benefits provided under the DB Plan also are subject to IRC limits, which vary by age and benefit option selected. The annual IRC Section 415 benefit limit is $195,000 for 2009. Benefits are payable in the event of retirement, death, disability, or termination of employment if vested. Only the portion of the benefit accrued before September 1, 2003 is payable as a lump sum to employees who have attained age 50, otherwise benefits are paid in installments.
Early retirement benefits are payable at a reduced rate. Upon termination of employment prior to age 65, Named Executive Officers meeting the five year vesting and age 45 early retirement eligibility criteria are entitled to an early retirement benefit. The early retirement benefit amount is calculated by taking the normal retirement benefit amount and reducing it by 3.0 percent times the difference between the age of the early retiree and age 65. If the Named Executive Officer was employed prior to September 1, 2003 and his/her age and benefit service added together totaled 70 (Rule of 70), the normal retirement benefit amount would be reduced by 1.5 percent for each year between the age of the early retiree and age 65 for the portion of the normal retirement benefit accrued prior to September 1, 2003.
The FHLBank’s BEP is, in part, a non-qualified defined benefit plan. The defined benefit portion of the BEP provides benefits under the same terms and conditions as the DB Plan. However, the BEP does not limit the annual earnings or benefits of the Named Executive Officers. Benefits that would otherwise be provided under the BEP are reduced by benefits provided under the DB Plan.
The FHLBank’s contributions to the DB Plan through June 30, 1987, represented the normal cost of the plan. Funding and administrative costs of the DB Plan charged to compensation and benefits expense were $2,917,000 in 2009. The DB Plan is a multiple-employer plan and therefore is not required to disclose the accumulated benefit obligations, plan assets and the components of annual pension expense.
The measurement date used to determine the current year’s benefit obligation was December 31, 2009. The present value of the accrued benefit of the DB Plan, calculated through September 1, 2003, was valued at 50 percent of benefit value using the 2000 RP Mortality table (generational table for annuities) and 50 percent of benefit value using the 2000 RP Mortality table (statistical mortality table for lump sums), discounted to the current age of each Named Executive Officer at 5.96 percent interest. The present value of benefits accrued after September 1, 2003 are multiplied by a present value factor which uses the 2000 RP Mortality table (generational table for annuities) discounted to the current age of each Named Executive Officer at 5.96 percent interest. As of December 31, 2009, the actuary’s calculations utilized: (1) the projected unit credit valuation method; (2) the 2000 RP Mortality table (generational mortality table); (3) a 5.07 percent average salary increase adjustment; and (4) a 5.75 percent discount rate as the primary assumptions attributable to valuation of benefits under the DB portion of the BEP.
Deferred Compensation
Table 97 presents the Nonqualified Deferred Compensation Table for the Named Executive Officers. The FHLBank’s fiscal year (FY) is 2009, with a fiscal year end (FYE) of December 31, 2009.
Table 97
All amounts are also included in the salary column of the Summary Compensation Table.
The BEP is also, in part, an unfunded, nonqualified deferred compensation plan (the Supplemental Thrift Plan). The Supplemental Thrift Plan allows the Named Executive Officers, who so choose, to receive a credit for elective contributions in excess of the maximum permitted by the IRC limitations in the FHLBank’s DC Plan in which they participate. If portions of the Named Executive Officer’s regular DC Plan account contributions are returned after the end of the preceding year because of IRC limitations, the Named Executive Officer is credited with make-up contributions under the Supplemental Thrift Plan equal to the Named Executive Officer’s returned portions.
Named Executive Officers also receive matching contributions from the FHLBank equal to the matching contribution, if any, that would be credited under the qualified DC Plan. Patrick C. Doran and David S. Fisher negotiated higher matches in the Supplemental Thrift Plan until May 2009 and January 2011, respectively upon hire because of the one year waiting requirement before the FHLBank match begins under the DC Plan. In 2009, if Mr. Doran’s matching contribution under the FHLBank’s qualified 401(k) plan was less than 5.0 percent, then he received a matching contribution equal to the difference between 5.0 percent and the percentage received. In 2009, if Mr. Fisher’s matching contribution under the FHLBank’s qualified 401(k) plan was less than 6.0 percent, then he received a matching contribution equal to the difference between 6.0 percent and the percentage received.
The Supplemental Thrift Plan allows Named Executive Officers to receive a rate of return based on the FHLBank’s return on equity for 2009.
Named Executive Officers are at all times 100 percent vested in their Supplemental Thrift Plan accounts. In the event of unforeseen emergencies, they may request withdrawals equal to the lesser of the amounts necessary to meet their financial hardships or the amount of their account balances. Upon retirement or termination of employment with the FHLBank, the Named Executive Officer’s account balance would be paid in a lump sum, as soon as practicable.
Potential Payments Upon Termination/Change In Control
Table 98 represents the amount that would be payable to the Named Executive Officers as of December 31, 2009 had their employment been terminated unless on or prior to that date: (1) the Named Executive Officer voluntarily terminated employment; (2) the Named Executive Officer’s employment was terminated by the FHLBank for misconduct; or (3) the Named Executive Officer accepted employment elsewhere or refused other employment offered by the FHLBank at or before the time of termination.
Table 98
__________
Severance amount equals the number of weeks of base salary as described under Severance Benefits under the Compensation Discussion and Analysis under this Item 11 and any earned but unpaid incentive awards as of December 31, 2009.
As of December 31, 2009, the Named Executive Officers would be additionally entitled to the amount listed in Table 97 under the column titled “Aggregate Balance at Last FYE” within ninety days of any such Named Executive Officer’s termination of employment due to death, disability or retirement. While there was no provision for payout under the BEP upon a change in control event on or prior to December 31, 2009, the amended BEP as described under Pension Benefits under this Item 11 provides for a potential payment to each Named Executive Officer upon a change in control as defined under the amended BEP, effective January 1, 2009.
Director Compensation
Table 99 presents the Director Compensation Table for the FHLBank’s 2009 Board of Directors.
Table 99
All other compensation consists exclusively of charitable matching contributions made by the FHLBank on behalf of the respective director pursuant to the FHLBank’s Matching Gift Program. Contributions made to eligible nonprofit organizations in Colorado, Kansas, Nebraska or Oklahoma were matched on a dollar-for-dollar basis up to an aggregate maximum of $5,000 per calendar year. Due to timing differences between submission of invoices and payment, the actual expenditures listed could exceed $5,000 for the year. The FHLBank’s Matching Gift Program for directors was discontinued during 2009.
In accordance with Finance Agency regulations and the Bank Act, the FHLBank compensated its directors in 2009 in accordance with its Board of Directors Compensation Policy adopted effective January 1, 2009. The Board of Directors Compensation Policy provides that directors shall be paid a meeting fee for each day in attendance at a regular or special meeting of the Board of Directors up to a maximum annual compensation amount as set forth in the Board of Directors Compensation Policy.
The Directors’ Nonqualified Deferred Compensation Program (the Directors’ Plan) allowed directors to defer all or a portion of their fees, and elect annually a rate of return based on the FHLBank’s return on equity. On November 25, 2009, the Board of Directors, through its Executive Committee, voted to terminate the Directors’ Plan and submitted the action to the Finance Agency for approval. On December 23, 2009, the Finance Agency approved the termination of the Directors’ Plan. The Directors’ Plan will terminate effective December 30, 2009, and the FHLBank will distribute all the associated account balances to the beneficiaries in a lump sum payment on December 30, 2010 or such date as required in accordance with IRC Section 409A and other applicable laws.
Directors are also reimbursed for all necessary and reasonable travel, subsistence and other related expenses incurred in connection with the performance of their duties. Total travel expenses in the amount of $196,000 were paid for the FHLBank’s directors in 2009 for travel integrally and directly related to the performance of the directors’ duties.
Item 12:
Item 12: Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
The FHLBank is a cooperative. Its members or former members own all of the outstanding capital stock of the FHLBank. A majority of the directors of the FHLBank are elected from its membership. One of the voting rights of members is for the election of all of the FHLBank’s directors. Each member is eligible to vote for those open member director seats in the state in which its principal place of business is located and for all open independent director seats, which are elected by members of the entire FHLBank district. Membership is voluntary; however, members must give notice of their intent to withdraw from membership. A member that withdraws from membership may not be readmitted to membership for five years after the date upon which its required membership stock (Class A Common Stock) is redeemed by the FHLBank.
Management of the FHLBank cannot legally and, therefore, does not, own capital stock of the FHLBank. The FHLBank does not offer any compensation plan to its employees under which equity securities of the FHLBank are authorized for issuance.
Table 100 presents information on member institutions holding five percent or more of the total outstanding capital stock, which includes mandatorily redeemable capital stock, of the FHLBank as of December 31, 2009. Of these stockholders, no officer or director currently serves on the FHLBank’s Board of Directors.
Table 100
Additionally, because of the fact that a majority of the Board of Directors of the FHLBank is nominated and elected from the membership of the FHLBank (“member directors”), these member directors are officers or directors of member institutions that own the FHLBank’s capital stock. Table 101 presents total outstanding capital stock, which includes mandatorily redeemable capital stock, held as of December 31, 2009, for member institutions whose officers or directors served as directors of the FHLBank in 2009:
Table 101
Item 13:
Item 13: Certain Relationships and Related Transactions, and Director Independence
Certain Relationships and Related Transactions
Since the FHLBank is a cooperative, ownership of our capital stock is a prerequisite for our members to transact business with us. In recognition of this organizational structure, the SEC granted us an accommodation pursuant to a “no action letter,” dated May 23, 2006, which relieves us from the requirement to make disclosures under Item 404(a) of Regulation S-K for transactions with related persons, such as our members and directors, which occur in the ordinary course of business. Further, the Recovery Act codified this accommodation.
Members with beneficial ownership of more than five percent of the total outstanding capital stock of the FHLBank and all of our directors are classified as related persons under SEC regulations. Transactions with members deemed related persons of the FHLBank occur in the ordinary course of our business since we conduct our advance and mortgage loan business almost exclusively with our members. Our member directors are officers or directors of members that own FHLBank capital stock and conduct business with us.
Information with respect to the directors who are officers or directors of our members is set forth under Item 10 - “Directors and Executive Officers of the FHLBank and Corporate Governance - Directors.” Additional information regarding members that are beneficial owners of more than five percent of our total outstanding capital stock is provided in Item 12 - “Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.”
See Item 11 for a discussion of the compensation of the FHLBank’s Named Executive Officers and directors.
The FHLBank has a written “Related Person Transactions Policy” (Policy) that provides for the review and approval or ratification by our Audit Committee of any transaction with a related person that is outside the ordinary course of business. Under the Policy, transactions with related persons that are in the ordinary course of business are deemed pre-approved.
A “Related Person” under the Policy is:
§
Any person who is, or at any time since the beginning of the FHLBank’s last fiscal year was, a director, member of the Affordable Housing Advisory Council, or an executive officer of the FHLBank;
§
Any immediate family member of any of the foregoing persons;
§
Any firm, corporation, or other entity in which any of the foregoing persons is an executive officer, a general partner or principal or in a similar position; or
§
Any member institution (or successor) of the FHLBank who is known to be the beneficial owner of more than five percent of FHLBank voting securities.
“Ordinary course of business” is defined in the Policy as activities conducted with members, including but not limited to providing the FHLBank’s products and services listed in the Member Products and Services Guide to the extent such product and service transactions are conducted on terms no more favorable than the terms of comparable transactions with similarly situated members or housing associates, as applicable, or situations where the FHLBank obtains products or services from a Related Person where the rates and charges involved in the transactions are subject to competitive bidding.
Transactions outside the ordinary course of business, with Related Persons that have a direct or indirect material interest, and exceed $120,000 are subject to Audit Committee review and approval under the Policy and include situations in which: (1) the FHLBank obtains products or services from a Related Party of a nature, quantity or quality, or on terms, that are not readily available from alternative sources; or (2) the FHLBank provides products or services to a Related Party on terms not comparable to those provided to unrelated parties.
In 2009, there were no Related Party transactions outside the ordinary course of business that necessitated review or approval by the Audit Committee.
Director Independence
Board Operating Guidelines and Nasdaq Standards
The Board Operating Guidelines of the FHLBank (Guidelines), available at www.fhlbtopeka.com, require that the Board of Directors make an affirmative determination as to the independence of each director, as that term is defined by Rule 5605(a)(2) of the Nasdaq Marketplace Rules (the “Nasdaq Independence Standards”).
The Board of Directors has affirmatively determined that each one of its directors, both independent and member directors (each of whom is listed in Item 10 of this Form 10-K), is independent in accordance with the Nasdaq Independence Standards.
In order to assist the Board of Directors in making an affirmative determination of each director’s independence under the Nasdaq Independence Standards, the Board of Directors: (1) applied categorical standards for independence contained in the Guidelines and under the Nasdaq Independence Standards; (2) determined subjectively the independence of each director; and (3) considered the recommendation of the Audit Committee following its assessment of the independence of each director. The Board of Directors’ determination of independence under the Nasdaq Independence Standards rested upon a finding that each director has no relationship which, in the opinion of the Board of Directors, would interfere with that director’s exercise of independent judgment in carrying out the responsibilities of the director. Since under Finance Agency regulations, each independent director must be a bona fide resident of our district, and each member director must be an officer or director of one of our members, the Board of Directors included in its consideration whether any of these relationships would interfere with the exercise of independent judgment of a particular director.
Committee Independence
Audit Committee
In addition to the Nasdaq Independence Standards for committee members, the FHLBank’s Audit Committee members are subject to the independence standards of the Finance Agency. Finance Agency regulations state that a director will be considered sufficiently independent to serve as an Audit Committee member if that director does not have a disqualifying relationship with the FHLBank or its management that would interfere with the exercise of that director’s independent judgment. Disqualifying relationships include but are not limited to:
§
Being employed by the FHLBank in the current year or any of the past five years;
§
Accepting compensation from the FHLBank other than compensation for service as a director;
§
Serving or having served in any of the past five years as a consultant, advisor, promoter, underwriter, or legal counsel of or to the FHLBank; or
§
Being an immediate family member of an individual who is, or has been in any of the past five years, employed by the FHLBank as an executive officer.
In addition to the independence standards for Audit Committee members required under the Finance Agency regulations, Section 10A(m) of the Exchange Act sets forth the independence requirements of directors serving on the Audit Committee of a reporting company. Under Section 10A(m), in order to be considered independent, a member of the Audit Committee may not, other than in his or her capacity as a member of the Board of Directors or any other Board Committee: (1) accept any consulting, advisory, or other compensation from the FHLBank; or (2) be an affiliated person of the FHLBank.
As of March 25, 2010, all members of the FHLBank’s Audit Committee were independent under the Finance Agency’s audit committee independence criteria and under the independence criteria of Section 10A(m) of the Exchange Act.
The Finance Agency’s criteria for audit committee independence are posted on the corporate governance page of the FHLBank’s Web site at www.fhlbtopeka.com.
Item 14:
Item 14: Principal Accounting Fees and Services
The Audit Committee’s policy is to pre-approve all audit, audit-related and permissible non-audit services provided by the FHLBank’s independent accountants. The Audit Committee pre-approved all such services provided by the independent accountants during 2008 and 2009. These services have included audit services and audit-related services. Pre-approval is generally provided for up to one year and any pre-approval is detailed as to the particular service or category of services and is generally subject to a specific budget. The independent accountants and management are required to periodically report to the Audit Committee regarding the extent of services provided by the independent accountants in accordance with its pre-approval and the fees for the services performed to date. The Audit Committee may also pre-approve particular services on a case-by-case basis.
Table 102 sets forth the aggregate fees billed to the FHLBank for the years ended December 31, 2009 and 2008 by its external accounting firm, PricewaterhouseCoopers LLP (in thousands):
Table 102
Audit fees during the years ended December 31, 2009 and 2008, respectively, were for professional services rendered for the audits of the FHLBank’s annual financial statements and review of financial statements included in the FHLBank’s annual reports on Form 10-K and quarterly reports on Form 10-Q. The increase in audit-related fees during the year ended December 31, 2009 was primarily related to the FHLBank’s independent registered public accounting firm, PricewaterhouseCoopers LLP, performing an attestation on management’s assessment of the effectiveness of internal controls over financial reporting. During the year ended December 31, 2008, the FHLBank was permitted to furnish, rather than file, management’s report on internal control over financial reporting as the FHLBank is a non-accelerated filer as defined in Rule 12b-2 of the Exchange Act, and therefore, was not subject to attestation pursuant to SEC Release No. 34-58028. While the FHLBank was again permitted to furnish, rather than file, management’s report on internal control over financial reporting for the year ended December 31, 2009 pursuant to SEC Release No. 34-60813, the FHLBank’s Board of Directors and senior management made the decision not to exercise the SEC deferral in 2009 and instead elected to file the FHLBank’s internal control over financial reporting as of December 31, 2009 and obtain an attestation report from the FHLBank’s independent registered public accounting firm, PricewaterhouseCoopers, LLP.
Audit-related fees for the year ended December 31, 2008 were for assurance and related services primarily related to accounting consultations at both the FHLBank and FHLBank System level.
The FHLBank is exempt from all federal, state and local taxation, with the exception of real property tax. Therefore, no tax consultation fees were paid during the years ended December 31, 2009 and 2008.
Prior to approving PricewaterhouseCoopers LLP as the FHLBank’s independent accountants for 2009, the Audit Committee considered whether PricewaterhouseCoopers LLP’s provision of services other than audit services is compatible with maintaining the accountants’ independence.
PART IV
Item 15:
Item 15: Exhibits, Financial Statement Schedules
a)
The financial statements included as part of this Form 10-K are identified in the index to Audited Financial Statements appearing in Item 8 of this Form 10-K and which index is incorporated in this Item 15 by reference.
b)
Exhibits.
The FHLBank has incorporated by reference certain exhibits as specified below pursuant to Rule 12b-32 under the Exchange Act.
Exhibit
No.
Description
3.1
Exhibit 3.1 to the FHLBank’s registration statement on Form 10, filed May 15, 2006, and made effective on July 14, 2006 (File No. 000-52004) (the “Form 10 Registration Statement”), Federal Home Loan Bank of Topeka Articles and Organization Certificate, is incorporated herein by reference as Exhibit 3.1.
3.2
Exhibit 3.2 to the Current Report on Form 8-K, filed December 18, 2009, Amended and Restated Bylaws, is incorporated herein by reference as Exhibit 3.2.
4.1
Exhibit 4.1 to the quarterly report on Form 10-Q, filed August 12, 2009, Federal Home Loan Bank of Topeka Capital Plan, is incorporated herein by reference as Exhibit 4.1.
10.1*
Exhibit 10.2 to the Current Report on Form 8-K, filed December 24, 2008, Federal Home Loan Bank of Topeka Benefit Equalization Plan, is incorporated herein by reference as Exhibit 10.1.
10.2*
Exhibit 10.3 to the Current Report on Form 8-K, filed December 24, 2008, Federal Home Loan Bank of Topeka Directors’ Nonqualified Deferred Compensation Program, is incorporated herein by reference as Exhibit 10.2.
10.4
Exhibit 10.4 to the Form 10 Registration Statement, Federal Home Loan Bank of Topeka Office Complex Lease Agreement, is incorporated herein by reference as Exhibit 10.4.
10.4.1
Exhibit 10.4.1 to the Form 10 Registration Statement, Federal Home Loan Bank of Topeka Office Complex Lease Amendment, is incorporated herein by reference as Exhibit 10.4.1.
10.4.2
Exhibit 10.4.2 to the Form 10 Registration Statement, Federal Home Loan Bank of Topeka Office Second Complex Lease Amendment, is incorporated herein by reference as Exhibit 10.4.2.
10.5
Exhibit 10.5 to the Form 10 Registration Statement, Federal Home Loan Bank of Topeka Lease Agreement, is incorporated herein by reference as Exhibit 10.5.
10.6
Federal Home Loan Bank of Topeka Form of Advance, Pledge and Security Agreement (Specific Pledge), revised by FHLBank’s Board of Directors on March 26, 2009.
10.7
Federal Home Loan Bank of Topeka Form of Advance, Pledge and Security Agreement (Blanket Pledge), revised by FHLBank’s Board of Directors on March 26, 2009.
10.8
Federal Home Loan Bank of Topeka Form of Confirmation of Advance, as amended July 1, 2009.
10.9*
Exhibit 10.1 to the Current Report on Form 8-K, filed February 10, 2009, Federal Home Loan Bank of Topeka Executive Short Term Incentive Plan, is incorporated herein by reference as Exhibit 10.9.
10.10*
Exhibit 10.1 to the Current Report on Form 8-K, filed December 24, 2008, Federal Home Loan Bank of Topeka Long-Term Incentive Plan, is incorporated herein by reference as Exhibit 10.10.
10.11*
2010 Federal Home Loan Bank of Topeka Board of Directors Compensation Policy.
12.1
Federal Home Loan Bank of Topeka Statements of Computation of Ratios.
31.1
Certification of President and Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2
Certification of Executive Vice President and Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
Certification of President and Chief Executive Officer and Executive Vice President and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
99.1
Federal Home Loan Bank of Topeka Audit Committee Charter, as amended December 17, 2009.
99.2
Federal Home Loan Bank of Topeka Audit Committee Report.
* Represents a management contract or a compensatory plan or arrangement.
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.
Federal Home Loan Bank of Topeka
Date: March 25, 2010
By: /s/Andrew J. Jetter
Andrew J. Jetter
President and Chief 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 on the dates indicated.
Signature
Title
Date
/s/Andrew J. Jetter
President and Chief Executive Officer
March 25, 2010
Andrew J. Jetter
(Principal Executive Officer)
/s/Mark E. Yardley
Executive Vice President and Chief Financial Officer
March 25, 2010
Mark E. Yardley
(Principal Financial Officer)
/s/Denise L. Cauthon
First Vice President and Controller
March 25, 2010
Denise L. Cauthon
(Principal Accounting Officer)
/s/Ronald K. Wente
Chairman of the Board of Directors
March 25, 2010
Ronald K. Wente
/s/Lindel E. Pettigrew
Vice Chairman of the Board of Directors
March 25, 2010
Lindel E. Pettigrew
/s/Robert E. Caldwell, II
Director
March 25, 2010
Robert E. Caldwell, II
/s/James R. Hamby Director March 25, 2010
James R. Hamby
/s/Thomas E. Henning
Director
March 25, 2010
Thomas E. Henning
/s/Andrew C. Hove, Jr.
Director
March 25, 2010
Andrew C. Hove, Jr.
/s/Jane C. Knight
Director
March 25, 2010
Jane C. Knight
/s/Richard S. Masinton
Director
March 25, 2010
Richard S. Masinton
/s/Lawrence L. McCants
Director
March 25, 2010
Lawrence L. McCants
/s/Neil F. M. McKay
Director
March 25, 2010
Neil F. M. McKay
/s/Thomas H. Olson Director March 25, 2010
Thomas H. Olson
/s/Bruce A. Schriefer
Director
March 25, 2010
Bruce A. Schriefer
Management’s Report on Internal Control over Financial Reporting
Management of the Federal Home Loan Bank of Topeka (FHLBank) is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rule 13a-15(f) under the Exchange Act. The FHLBank’s internal control over financial reporting is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of the financial statements in accordance with generally accepted accounting principles. 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 FHLBank’s assets; (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 FHLBank are being made only in accordance with authorizations of the FHLBank’s management and board of directors; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the FHLBank’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 and even when determined to be effective, can only provide reasonable assurance with respect to financial statement preparation and presentation. 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.
Management of the FHLBank assessed the effectiveness of the FHLBank’s internal control over financial reporting using the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control - Integrated Framework. Based on this evaluation under the COSO framework, management has concluded that the FHLBank’s internal control over financial reporting was effective as of December 31, 2009.
The effectiveness of the FHLBank’s internal control over financial reporting as of December 31, 2009 has been audited by PricewaterhouseCoopers LLP, the FHLBank’s independent registered public accounting firm, as stated in their accompanying report.
/s/Andrew J. Jetter
Andrew J. Jetter
President and Chief Executive Officer
/s/Mark E. Yardley
Mark E. Yardley
Executive Vice President and Chief Financial Officer
Report of Independent Registered Public Accounting Firm
To the Board of Directors and Shareholders of the Federal Home Loan Bank of Topeka:
In our opinion, the accompanying statements of condition and the related statements of income, of capital and of cash flows present fairly, in all material respects, the financial position of the Federal Home Loan Bank of Topeka (the “Bank”) at December 31, 2009 and 2008, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2009 in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, the Bank maintained, in all material respects, effective internal control over financial reporting as of December 31, 2009, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Bank’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 Bank’s internal control over financial reporting based on our audits (which was an integrated audit in 2009). 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.
As discussed in Note 1, effective January 1 2009, the Bank adopted guidance that revises the recognition and reporting requirements for other-than-temporary impairments of debt securities classified as held-to-maturity.
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.
/s/ PricewaterhouseCoopers LLP
Dallas, Texas
March 25, 2010
FEDERAL HOME LOAN BANK OF TOPEKA
STATEMENTS OF CONDITION
(In thousands, except par value)
Fair value: $7,192,957 and $10,454,592 at December 31, 2009 and 2008, respectively.
The accompanying notes are an integral part of these financial statements.
FEDERAL HOME LOAN BANK OF TOPEKA
STATEMENTS OF INCOME
(In thousands)
The accompanying notes are an integral part of these financial statements.
FEDERAL HOME LOAN BANK OF TOPEKA
STATEMENTS OF CAPITAL FOR YEARS ENDED DECEMBER 31, 2009, 2008 AND 2007
(In thousands)
Putable
The accompanying notes are an integral part of these financial statements.
FEDERAL HOME LOAN BANK OF TOPEKA
STATEMENTS OF CAPITAL FOR YEARS ENDED DECEMBER 31, 2009, 2008 AND 2007 (continued)
(In thousands)
Putable
The accompanying notes are an integral part of these financial statements.
FEDERAL HOME LOAN BANK OF TOPEKA
STATEMENTS OF CAPITAL FOR YEARS ENDED DECEMBER 31, 2009, 2008 AND 2007 (continued)
(In thousands)
Putable
The accompanying notes are an integral part of these financial statements.
FEDERAL HOME LOAN BANK OF TOPEKA
STATEMENTS OF CASH FLOWS
(In thousands)
The accompanying notes are an integral part of these financial statements.
FEDERAL HOME LOAN BANK OF TOPEKA
STATEMENTS OF CASH FLOWS (continued)
(In thousands)
The accompanying notes are an integral part of these financial statements.
FEDERAL HOME LOAN BANK OF TOPEKA
Notes to Financial Statements
For the years ended December 31, 2009, 2008 and 2007
BACKGROUND INFORMATION
The Federal Home Loan Bank of Topeka (FHLBank or FHLBank Topeka), a federally chartered corporation, is one of 12 district Federal Home Loan Banks (FHLBanks). The FHLBanks serve the public by enhancing the availability of residential mortgage and targeted community development credit and provide a readily available, low-cost source of funds to their members. The FHLBank is a cooperative whose member institutions own nearly all of the outstanding capital stock of the FHLBank and generally receive dividends on their stock investments. Regulated financial depositories and insurance companies engaged in residential housing finance are eligible to apply for membership. State and local housing authorities that meet certain statutory requirements may become housing associates of the FHLBank and also be eligible to borrow from the FHLBank. While eligible to borrow, housing associates are not members of the FHLBank and, as such, are not permitted or required to hold capital stock.
All members are required to purchase stock in the FHLBank located in their district in accordance with the capital plan of that FHLBank. Under FHLBank Topeka’s capital plan, members must own capital stock in the FHLBank based on the amount of their total assets. Each member is also required to purchase activity-based capital stock as it engages in certain business activities with the FHLBank, including advances and Acquired Member Assets (AMA). Former members that still have outstanding business transactions with the FHLBank are also required to maintain their investments in FHLBank capital stock until the transactions mature or are paid off. As a result of these requirements, the FHLBank conducts business with members in the ordinary course of its business. For financial reporting purposes, the FHLBank defines related parties as those members: (1) with investments in excess of 10 percent of the FHLBank’s total capital stock outstanding, which includes mandatorily redeemable capital stock; or (2) with an officer or director serving on the FHLBank’s board of directors. See Note 18 for more information on related party transactions.
The Federal Housing Finance Board (Finance Board), an independent agency in the executive branch of the U.S. government, supervised and regulated the FHLBanks and the Office of Finance through July 29, 2008. With the passage of the Housing and Economic Recovery Act of 2008 (Recovery Act), the Federal Housing Finance Agency (Finance Agency) was established and became the new independent Federal regulator of the FHLBanks, effective July 30, 2008. The Finance Board was merged into the Finance Agency as of October 27, 2008. The Finance Agency’s 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 is operated as a separate entity and has its own management, employees and board of directors. The FHLBanks do 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 former Federal Home Loan Bank Board (predecessor to the Finance Board and Finance Agency) to facilitate the issuance and servicing of the consolidated obligations of the FHLBanks and to prepare the combined financial report of the 12 FHLBanks.
FHLBank debt instruments (consolidated obligations), which are the joint and several obligations of all FHLBanks, are the primary source of funds for the FHLBanks. Deposits, other borrowings and capital stock issued to members provide other sources of funds for the FHLBanks. The FHLBank primarily uses these funds to provide advances to members and to purchase loans from members through the Mortgage Partnership Finance® (MPF®) Program. In addition to credit services, the FHLBank also offers correspondent services such as wire transfer, security safekeeping and settlement.
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Use of Estimates: The preparation of financial statements under accounting standards generally accepted in the United States of America (GAAP) requires management to make estimates and assumptions as of the date of the financial statements in determining the reported amounts of assets, liabilities and estimated fair values and in determining the disclosure of any contingent assets or liabilities. Estimates and assumptions by management also affect the reported amounts of income and expense during the reporting period. Many of the estimates and assumptions, including those used in financial models, are based on financial market conditions as of the date of the financial statements. Because of the volatility of the financial markets, as well as other factors that affect management estimates, actual results may vary from these estimates.
Interest-Bearing Deposits and Federal Funds Sold: These investments provide short-term liquidity and are carried at cost.
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 held for liquidity purposes and carried at fair value. The FHLBank records changes in the fair value of these investments through other income (loss). While the FHLBank classifies certain securities as trading for financial reporting purposes, it does not actively trade any of these securities with the intent of realizing gains and holds these investments indefinitely as management periodically evaluates its asset/liability and liquidity needs. For asset/liability management purposes, all non-mortgage-backed securities issued by government-sponsored enterprises (GSE) that are currently classified as trading are matched to interest rate swaps that effectively convert the securities from fixed rate investments to variable rate instruments. Short-term money market investments with maturities of three months or less are acquired and classified as trading securities primarily for liquidity purposes. These short-term money market investments are periodically sold to meet the FHLBank’s cash flow needs.
The FHLBank also classifies investments that it may sell before maturity as available-for-sale and carries them at fair value. The change in fair value of available-for-sale securities is recorded in other comprehensive income (loss) (OCI) as a net unrealized gain or loss on available-for-sale securities.
The FHLBank carries, at cost, investments for which it has both the ability and intent to hold to maturity, adjusted for periodic principal repayments, amortization of premiums and accretion of discounts. Amortization of premiums and accretion of discounts are computed on the level-yield method. The FHLBank considers the following situations maturities for purposes of assessing ability and intent to hold to maturity: (1) the sale of the security is near enough to maturity (or call date if exercise of the call is probable) that interest rate risk is substantially eliminated as a pricing factor and the changes in market interest rates would not have a significant effect on the security’s fair value; or (2) the sale of a security occurs after the FHLBank has already collected a substantial portion (at least 85 percent) of the principal outstanding at acquisition either due to prepayments on the debt security or to scheduled payments on a debt security payable in equal installments (both principal and interest) over its term. The FHLBank may change its intent to hold to maturity a held-to-maturity investment without changing its intent to hold to maturity other held-to-maturity investments for the following circumstances: (1) evidence of a significant deterioration in the issuer’s creditworthiness; (2) a change in statutory or regulatory requirements significantly modifying either what constitutes a permissible investment or the maximum level of investments in certain kinds of investments, thereby causing the FHLBank to dispose of a held-to-maturity investment; (3) a significant increase by a regulator in the FHLBank’s capital requirements that causes the FHLBank to downsize by selling held-to-maturity investments; or (4) a significant increase in the risk weights of debt securities used for regulatory risk-based capital purposes.
The FHLBank computes the amortization of purchased premiums and accretion of purchased discounts on mortgage-backed securities (MBS) using the level-yield method over the estimated cash flows of the securities. This method requires a retrospective adjustment of the effective yield each time the FHLBank receives a principal repayment or changes the estimated remaining cash flows as if the actual principal repayments and new estimated cash flows had been known since the original acquisition dates of the securities. The FHLBank uses nationally recognized, market-based third-party prepayment models to estimate future cash flows. The FHLBank computes the amortization of premiums and accretion of discounts on other investments using the level-yield method to the contractual maturities of the securities.
Gains and losses on the sales of investment securities are computed using the specific identification method and are included in other income (loss). Sales of investment securities under agreements to repurchase the same, or substantially the same, instruments are treated as collateralized borrowings.
The FHLBank evaluates its individual held-to-maturity investment securities holdings in an unrealized loss position for other-than-temporary impairment (OTTI) at least quarterly, or more frequently if events or changes in circumstances indicate that these investments may be other-than-temporarily impaired. An investment is considered impaired when its fair value is less than its cost. The FHLBank considers an OTTI to have occurred under any of the following circumstances:
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If the FHLBank has the intent to sell the debt security;
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If, based on available evidence, the FHLBank believes it is more likely than not that it will be required to sell the debt security before the recovery of its amortized cost basis; or
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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 OTTI 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 a cash flow analysis to determine if it will recover the entire amortized cost basis of each of these securities. The present value of the cash flows expected to be collected is compared to the amortized cost basis of the security to determine if 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), the carrying value of the security is adjusted to its fair value. However, rather than recognizing the entire difference between the amortized cost basis and the 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 OCI, which is a component of capital. The total OTTI is presented in the income statement with an offset for the amount of the total OTTI that is recognized in OCI. Subsequent non-OTTI-related increases and decreases in the fair value of available-for-sale securities will be included in OCI. The OTTI recognized in OCI for debt securities classified as held-to-maturity will be 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 OTTI recognized).
For subsequent accounting of other-than-temporarily impaired securities, if the present value of cash flows expected to be collected is less than the amortized cost basis, the FHLBank would record an additional OTTI and adjust the yield of the security prospectively. The amount of total OTTI for an available-for-sale security that was previously impaired is determined as the difference between its: (1) amortized cost less the amount of OTTI recognized in OCI prior to the determination of OTTI; and (2) fair value. The amount of the total OTTI for a held-to-maturity security that was previously impaired subsequent to initial recognition is determined as the difference between its carrying amount prior to the determination of OTTI and its fair value. Additional credit losses related to previously other-than-temporarily impaired securities are reclassified out of Accumulated OCI into the Statement of Income.
The FHLBank recognizes subsequent interest income in accordance with the method described in accounting guidance for beneficial interests in securitized financial assets. As of the impairment measurement date, a new accretable yield is calculated for the impaired investment security. This is used to calculate the amount to be recognized into income over the remaining life of the security so as to match the amount and timing of future cash flows expected to be collected. Subsequent changes in estimated cash flows change the accretable yield on a prospective basis. The estimated cash flows and accretable yield are re-evaluated on a quarterly basis.
The FHLBank only acquires private-label MBS that are of high credit quality at acquisition, and thus, these investments are not initially subject to the incremental impairment guidance for certain beneficial interests in securitized financial assets, specifically those that are not of “high credit quality.” Authoritative GAAP does not specifically address whether impairments or credit downgrades subsequent to acquisition require the application of the incremental impairment guidance to a beneficial interest that was not in scope at the time of purchase. The FHLBank has historically elected to apply the incremental impairment guidance to securities not initially in scope, prospectively as of the date the security is determined to be other-than-temporarily impaired.
Advances: The FHLBank presents advances net of unearned commitment fees, premiums, discounts and fair value basis adjustments. The FHLBank amortizes the premiums and accretes the discounts on advances to interest income using the level-yield method. Interest on advances is credited to income as earned.
In accordance with the Federal Home Loan Bank Act of 1932 (Bank Act), as amended, and as more fully discussed in Note 7, the FHLBank obtains sufficient collateral on advances to protect it from losses. The Bank Act limits collateral on advances to certain investment securities, residential mortgage loans, deposits with the FHLBank and other real estate-related assets. However, community financial institutions (CFI) (the purposes of advances to which have been redefined by the Recovery Act to also include community development activities) are able to utilize expanded statutory collateral rules. The FHLBank evaluates the creditworthiness of its members and non-member borrowers on an ongoing basis and classifies as impaired any advance with respect to which management believes it is probable that all principal and interest due will not be collected according to its contractual terms. The FHLBank has not experienced any losses on advances since its inception, and no advances have been or are currently classified as impaired. As a result, the accrual of interest has not been discontinued on any advance. Because of the collateral pledged as security on the advances and prior repayment history, FHLBank management deems it unnecessary to establish an allowance for credit losses on advances.
Commitment Fees: Commitment fees for letters of credit are recorded as deferred credits when received and amortized over the terms of the letters of credit using a straight-line method. The FHLBank believes the likelihood of standby letters of credit being drawn upon is remote based upon past experience.
In 2007, the FHLBank began offering a standby credit facility (SCF) product. The structure of each SCF is reviewed to determine the proper accounting for the commitment fee. Depending on the likelihood of the commitment being exercised, the fee received is accounted for as follows:
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If remote, the commitment fee is recognized over the commitment period on a straight-line basis and reported as “Service fees” in other income (loss). If the commitment is later exercised and an advance issued, the remaining unamortized commitment fee is reclassified and treated as a basis adjustment of the advance and recognized over the life of the advance as an adjustment to yield.
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If other than remote, the commitment fee is deferred. If the commitment is subsequently exercised, the fee will be recognized over the life of the advance as an adjustment to yield. If the commitment expires unexercised, the commitment fee is recognized in service fee income upon expiration of the commitment.
Prepayment Fees: The FHLBank charges prepayment fees to its borrowers when certain advances are repaid before their original maturities. The FHLBank records prepayment fees net of hedging fair value basis adjustments included in the book basis of the advance, as “Prepayment fees on terminated advances” in the interest income section of its Statements of Income.
In cases where new advances are issued concurrent with advances terminating or within a short period after termination, the FHLBank evaluates whether new advances meet the accounting criteria to qualify as a modification of an existing advance or as a new advance. This is accomplished by comparing the advance terms and comparing present value calculations of the cash flows under the terms of the new advance and under the terms of the original advance. If the new advance qualifies as a modification, the net prepayment fee received on the prepaid advance is deferred as a discount and included in the basis of the modified advance. The basis adjustment is amortized over the life of the modified advance to advance interest income. If the modified advance is hedged, the fair value gain or loss on the advance and the prepayment fee are included in the carrying amount of the modified advance, and any prior gains or losses and prepayment fees are amortized to interest income over the life of the modified advance using the level-yield method. Modified hedged advances are marked to fair value after the modification, and subsequent fair value changes are recorded in “Net gain (loss) on derivatives and hedging activities” in other income (loss). The basis adjustment amortization amounted to a net increase (decrease) to net interest income of $295,000, $458,000 and $742,000 during 2009, 2008 and 2007, respectively. The net prepayment fees are recorded as “Prepayment fees on terminated advances” in the interest income section of the Statements of Income if it is determined the advance should be treated as a new advance and not a modification of the existing advance.
Mortgage Loans Held for Portfolio: The FHLBank participates in the MPF Program under which the FHLBank invests in government-insured or guaranteed (by the Federal Housing Administration, the Department of Veterans Affairs, the Rural Housing Service of the Department of Agriculture (RHS) and the Department of Housing and Urban Development (HUD)) loans and conventional residential mortgage loans, which are funded by the FHLBank through, or purchased from, its participating members, also referred to as Participating Financial Institutions (PFI). For one of the FHLBank’s MPF products, a member originates mortgage loans as an agent for the FHLBank and the loans are funded directly by the FHLBank. This process is commonly referred to as table funding. For all other MPF products, a member sells closed loans to the FHLBank. The FHLBank manages the liquidity, interest rate and options risks of the loans. Dependent upon the member’s product selection, the servicing rights can be retained or sold by the participating member. The FHLBank and the member share in the credit risk of the loans with the FHLBank assuming the first loss obligation limited by the First Loss Account (FLA) for each pool of mortgage loans sold by the member, and the member assuming mortgage loan losses in excess of the FLA up to the amount of the member’s credit enhancement obligation as specified in the master agreement for each pool of mortgage loans purchased from the member. Any losses in excess of the FLA and the credit enhancement obligation on each pool of mortgage loans purchased from or originated through a participating member are the responsibility of the FHLBank.
The FHLBank classifies MPF Program loans as held for investment and, accordingly, reports them at their principal amount outstanding, net of unamortized premiums, unaccreted discounts, deferred loan fees associated with table funded loans, hedging adjustments and unrealized gains and losses from mortgage purchase commitments. The FHLBank has the intent and ability to hold these mortgage loans to maturity.
The FHLBank defers and amortizes/accretes mortgage loan origination fees (agent fees) and premiums/discounts paid to and received from FHLBank members as interest income using the contractual method. The contractual method uses the cash flows required by the loan contracts, as adjusted for actual prepayments, to apply the interest method. The contractual method does not utilize estimates of future prepayments of principal.
The FHLBank records credit enhancement fees paid to PFIs as a reduction to mortgage loan interest income. The FHLBank also records non-origination fees received from FHLBank members, such as delivery commitment extension fees and pair off fees as part of the mark-to-market on derivatives to which they relate or as part of the loan basis, as applicable. Delivery commitment extension fees are received when the PFI requires an extension of the delivery commitment on an MPF loan beyond the original stated maturity date. These fees compensate the FHLBank for interest lost as a result of the late funding of the loan and represent the member purchasing a derivative from the FHLBank. Pair off fees are received from the PFI when the sum of the principal amount of the mortgages funded under a delivery commitment is less than 95 percent (i.e., under-delivery) or greater than 105 percent (i.e., over-delivery) of the delivery commitment amount. These fees compensate the FHLBank for hedge costs associated with the under-delivery or over-delivery, respectively. To the extent that pair off fees relate to under-deliveries of loans, they are included in the mark-to-market of the related delivery commitment derivative. If they relate to over-deliveries, they represent purchase price adjustments to the related loans acquired and are recorded as part of the loan basis.
The FHLBank places a conventional mortgage loan on non-accrual status when the collection of the contractual principal or interest from the borrower is 90 days or more past due. When a conventional mortgage loan is 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. A government-insured loan is not placed on non-accrual status when the collection of the contractual principal or interest is 90 days or more past due because of the U.S. government guarantee of the loan and the contractual obligation of the loan servicer.
Real estate owned (REO) includes assets that have been received in satisfaction of debt or as a result of actual foreclosures and in-substance foreclosures. REO is initially recorded (and subsequently carried at the lower of cost or fair value less estimated selling costs) as other assets in the Statements of Condition. Fair value is defined as the amount that a willing seller could expect from a willing buyer in an arm’s-length transaction. If the fair value of the real estate owned is less than the recorded investment in the MPF loan at the date of transfer, the FHLBank recognizes a charge-off to the allowance for loan losses. Subsequent realized gains and realized or unrealized losses on REO are included in other income (loss).
The FHLBank bases the allowance for credit losses on mortgage loans on management’s estimate of probable credit losses inherent within the FHLBank’s conventional mortgage loan portfolio as of the Statement of Condition date. Within the FHLBank’s calculation of its allowance for credit losses on mortgage loans, actual losses greater than the FLA for each pool of mortgage loans purchased from a member are offset by the member’s credit enhancement obligation for the pool of loans. The FHLBank performs periodic reviews of its portfolio to identify the inherent losses within the portfolio and to determine the likelihood of collection of the portfolio. The overall allowance is determined by an analysis that includes consideration of various data observations such as past and current performance, the amounts and timing of future cash flows, loan portfolio characteristics (e.g., loan-to-value ratios, debt-to-income ratios and FICO scores for individual loans), collateral valuations, industry data and prevailing economic conditions. The FHLBank has participated in the MPF Program since 2000 and utilizes the loss history of its own loan portfolio to determine its credit loss allowance. In the event the FHLBank generates a calculated loan loss in excess of the FLA for a master agreement, the FHLBank nets the PFI’s credit enhancement obligation against the calculated reserve to arrive at its share of the anticipated losses. All PFI credit enhancement obligations are fully collateralized with assets allowed by the FHLBank’s Member Products Policy. As a result of this analysis, the FHLBank recorded an allowance for credit losses of $1,897,000 and $884,000 as of December 31, 2009 and 2008, respectively. No specific allocation of the allowance for credit losses is assigned to loans considered impaired, because there were no impaired loans as of December 31, 2009 and 2008.
MPF Credit Enhancement: The credit enhancement is an obligation on the part of the participating member that ensures the retention of credit risk on loans it originates on behalf of or sells to the FHLBank. The amount of the credit enhancement is determined so that any losses in excess of the credit enhancement for each pool of mortgage loans purchased approximate those experienced by an investor in a AA-rated MBS. The FHLBank pays the participating member a credit enhancement fee for managing this portion of the credit risk in the pool of loans. These fees are paid monthly based upon the remaining unpaid principal balance for the pool of loans. The required credit enhancement obligation amount may vary depending on the various product alternatives selected by the participating member. The credit enhancement obligation of each member must be fully collateralized with assets allowed by FHLBank policy. If a loss exceeds the FLA under the performance-based credit enhancement (CE) fee for products (certain MPF products have guaranteed CEs) where the FHLBank could put back a loss incurred in the FLA to the PFI, the FHLBank would withhold future monthly CE fee payments to the PFI until the FLA loss amount is recovered. In such situations, however, the FHLBank is always at risk that future CE fee payments to the PFI on the applicable pool of loans could be insufficient to cover the amount of the FHLBank’s FLA loss. Credit enhancement fees paid by the FHLBank to participating members for assuming the credit enhancement obligation are netted against interest income when paid.
Premises, Software and Equipment: These assets are stated at cost less accumulated depreciation and amortization of $17,762,000 and $14,092,000 as of December 31, 2009 and 2008, respectively. Depreciation is computed on the straight-line method over the estimated useful lives of the assets ranging from three to 20 years. Leasehold improvements are amortized on the straight-line basis over the shorter of the estimated useful life of the improvement or the remaining term of the lease. Improvements and major renewals are capitalized and ordinary maintenance and repairs are expensed as incurred. Depreciation and amortization expense was $4,073,000, $3,629,000 and $3,519,000 for the years ended December 31, 2009, 2008 and 2007, respectively. Gains and losses on disposals are included in other income (loss). The net realized gain (loss) on disposal of premises, software and equipment was $(3,000), $15,000 and $(285,000) for the years ended December 31, 2009, 2008 and 2007, respectively.
The cost of purchased software and certain costs incurred in developing computer software for internal use is capitalized and amortized over future periods. As of December 31, 2009 and 2008, the FHLBank had $4,172,000 and $5,583,000, respectively, in unamortized computer software costs included in premises, software and equipment on its Statements of Condition. Amortization is computed on the straight-line method over three years for purchased software and five years for developed software. Amortization of computer software costs charged to expense was $2,625,000, $2,212,000 and $2,182,000 for the years ended December 31, 2009, 2008 and 2007, respectively.
Derivatives: All derivatives are recognized on the Statements of Condition at their fair value. Derivative assets and liabilities reported on the Statements of Condition include the net cash collateral and accrued interest from counterparties.
Each derivative is designated as one of the following:
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a hedge of the fair value of: (1) a recognized asset or liability or (2) an unrecognized firm commitment (a “fair value” hedge);
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a hedge of: (1) a forecasted transaction or (2) the variability of cash flows that are to be received or paid in connection with a recognized asset or liability (a “cash flow” hedge);
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a non-qualifying hedge of an asset or liability (an “economic” hedge) for asset/liability management purposes; or
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a non-qualifying hedge of another derivative (an “intermediary” hedge) that is offered as a product to members.
An economic hedge is defined as a derivative hedging specific or non-specific underlying assets, liabilities or firm commitments that does not qualify for hedge accounting but is an acceptable hedging strategy under the FHLBank’s Risk Management Policy (RMP). 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 changes in fair value on the derivative that are recorded in the FHLBank’s income but not offset by corresponding changes in the fair value of the economically hedged asset, liability or firm commitment being recorded simultaneously in income. As a result, the FHLBank recognizes only the change in fair value of these derivatives in other income (loss) as “Net gain (loss) on derivatives and hedging activities” with no offsetting fair value adjustments for the asset, liability or firm commitment.
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 (including changes that reflect losses or gains on firm commitments), are recorded in current-period earnings. Changes in the fair value of a derivative that is designated and qualifies as a cash flow hedge, to the extent that the hedge is effective, are recorded in OCI, a component of capital, until earnings are affected by the variability of the cash flows of the hedged transaction (i.e., until the recognition of interest on a variable rate asset or liability is recorded in earnings). For both fair value and cash flow hedges, any hedge ineffectiveness (which represents the amount by which the change in the fair value of the derivative differs from the change in fair value of the hedged item or the variability in the cash flows of the forecasted transaction) is recorded in current-period earnings.
The differentials between accruals of interest receivables and payables on derivatives designated as fair value or cash flow hedges are recognized as an adjustment to the interest income or expense of the designated underlying investment securities, advances, consolidated obligations or other financial instruments, thereby affecting the reported amount of net interest income on the Statements of Income. Changes in the fair value of an economic or intermediary hedge are recorded in current-period earnings. The differentials between accruals of interest receivables and payables on intermediated derivatives for members and other economic hedges are recognized as other income (loss). Therefore, both the net interest on the stand-alone derivatives and the fair value changes are recorded in other income (loss) as “Net gain (loss) on derivatives and hedging activities.” Cash flows associated with stand-alone derivatives are reflected as cash flows from operating activities in the Statements of Cash Flows unless the derivative meets the criteria to be a financing derivative.
The FHLBank evaluates any derivative that is issued with off-market terms, requires an upfront payment, or both to determine if the derivative contains a financing element. If the derivative contains an other than insignificant financing element, the FHLBank reports the cash flows associated with this derivative in the cash flows from financing activities section within the Statements of Cash Flows for the life of the derivative.
The FHLBank records derivatives on trade date, but records associated advances or consolidated obligation bonds on settlement date. The FHLBank considers hedges of committed advances and consolidated obligation bonds eligible for the shortcut method of hedge accounting so long as settlement of the committed advance or consolidated obligation occurs within the shortest period possible for that type of instrument, the fair value of the swap is zero on the date the FHLBank commits to issue the hedged item and the transaction meets all of the other criteria for shortcut hedge accounting. The impact of this accounting policy is that both changes in fair value of the derivative and the hedged item are recorded starting on the date that the FHLBank commits to enter into the transaction. The FHLBank has defined its market settlement conventions for hedged items to be five business days or less for advances and thirty calendar days or less, using a next business day convention, for consolidated obligation bonds. These market settlement conventions are the shortest period possible for each type of advance or consolidated obligation from the time the instruments are committed to the time they settle.
The FHLBank may acquire investments, issue debt and make advances 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 or debt (the host contract) and whether a separate, non-embedded instrument with the same terms as the embedded instrument would meet the definition of a derivative instrument. When it is determined that: (1) the embedded derivative 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. 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 earnings (such as an investment security classified as “trading” as well as hybrid financial instruments), 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 separately accounted for as a derivative.
Highly effective hedges that use interest rate swaps as the hedging instrument and that meet certain stringent criteria can qualify for “shortcut” fair value hedge accounting. Shortcut hedge accounting allows for the assumption of no ineffectiveness, which means that the change in fair value of the hedged item can be assumed to be equal to the change in fair value of the derivative. This is in contrast to fair value hedges designated under the “long haul” method, where the change in fair value of the hedged item must be measured separately from the derivative, and for which effectiveness testing must be performed regularly with results falling within established tolerances.
The FHLBank discontinues hedge accounting prospectively when: (1) it determines that the derivative is no longer effective in offsetting changes in the fair value or cash flows of a hedged item (including hedged items such as firm commitments or forecasted transactions); (2) the derivative and/or the hedged item expires or is sold, terminated or exercised; (3) it is no longer probable that the forecasted transaction will occur in the originally expected period; (4) a hedged firm commitment no longer meets the definition of a firm commitment; or (5) 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 its Statements of Condition at fair value, ceases to adjust the hedged asset or liability for changes in fair value, and begins amortizing the cumulative basis adjustment on the hedged item into earnings over the remaining life of the hedged item using the level-yield method. When hedge accounting is discontinued because the hedged item no longer meets the definition of a firm commitment, the FHLBank continues to carry the derivative on its Statements of Condition at fair value, removing any asset or liability that was recorded to recognize the firm commitment and recording it as a gain or loss in current-period earnings. When the FHLBank discontinues hedge accounting because it is probable that a forecasted transaction will not occur by the end of the originally specified time period or within an additional two-month period of time thereafter, the gains and losses that were accumulated in OCI will be recognized immediately in earnings. When hedge accounting is discontinued because the FHLBank determines that the derivative no longer qualifies as an effective cash flow hedge of an existing hedged item, the FHLBank continues to carry the derivative on its Statements of Condition at fair value and amortizes the cumulative OCI adjustment to earnings when earnings are affected by the original forecasted transaction. In all situations in which hedge accounting is discontinued and the derivative remains outstanding, the FHLBank carries the derivative at fair value on its Statements of Condition, recognizing changes in the fair value of the derivative in current-period earnings.
Premiums paid to acquire options, including caps and floors, are included in the initial basis of the derivative and reported in derivative assets or derivatives liabilities on the Statements of Condition. Fair values of derivatives are netted by counterparty where such legal right exists. If these netted amounts are positive, they are classified as a derivative asset and, if negative, a derivative liability. See Note 9 for more information.
Concessions on Consolidated Obligations: Amounts paid to dealers in connection with sales of consolidated obligations are deferred and amortized using the level-yield method over the contractual terms of the consolidated obligations. Concession amounts are prorated to the FHLBank by the Office of Finance based on the percentage of each consolidated obligation issued by the Office of Finance on behalf of the FHLBank. Unamortized concessions were $14,228,000 and $14,442,000 as of December 31, 2009 and 2008, respectively, and are included in other assets. Amortization of such concessions is included in consolidated obligation interest expense. Amortization of concessions on bonds totaled $13,765,000, $22,045,000 and $8,797,000 in 2009, 2008 and 2007, respectively. Concessions on discount notes totaled $2,310,000, $4,869,000 and $1,816,000 in 2009, 2008 and 2007, respectively.
Discounts and Premiums on Consolidated Obligations: The discounts on consolidated obligation discount notes are accreted to expense on the straight-line method throughout the terms of the related notes because of their short-term nature. During 2009, the average term of the FHLBank’s discount notes was less than one month. The discounts and premiums on consolidated obligation bonds, including zero coupon bonds, are accreted or amortized to expense over the contractual terms of the bond issues using the level-yield method.
Mandatorily Redeemable Capital Stock: The FHLBank reclassifies all stock subject to redemption from equity to liability once a member submits a written redemption request, gives notice of intent to withdraw from membership, or attains non-member status by merger or acquisition, charter termination or involuntary termination from membership, since the member shares will then meet the definition of a mandatorily redeemable financial instrument. There is no distinction as to treatment for reclassification from equity to liability between in-district redemption requests and those redemption requests triggered by out-of-district acquisitions. The FHLBank does not take into consideration its members’ right to cancel a redemption request in determining when shares of capital stock should be classified as a liability, because such cancellation would be subject to a substantial cancellation fee. Member and non-member shares meeting the definition of mandatorily redeemable capital stock are reclassified to a liability at fair value, which has been determined to be par value ($100) plus any estimated accrued but unpaid dividends. The FHLBank’s dividends are declared and paid at each quarter-end; therefore, the fair value reclassified equals par value. Dividends declared on member shares for the time after classification as a liability are accrued at the expected dividend rate and reflected as interest expense in the Statements of Income. The repurchase of these mandatorily redeemable financial instruments by the FHLBank will be reflected as financing cash outflows in the Statements of Cash Flows once settled. If a member submits a written request to cancel a previously submitted written redemption request, the capital stock covered by the written cancellation request is reclassified from a liability to capital at fair value. After the reclassification, dividends on the capital stock are no longer classified as interest expense.
Finance Agency/Finance Board Expenses: The FHLBank funded its share of the costs of operating the Finance Board and funds a portion of the costs of operating the Finance Agency since it was created on July 30, 2008. The Finance Board allocated its operating and capital expenditures to the FHLBanks based on each FHLBank’s percentage of total regulatory capital stock plus retained earnings for the 12 FHLBanks through July 29, 2008. The Finance Agency’s expenses and working capital fund are allocated among the FHLBanks based on the pro rata share of the annual assessments based on the ratio between each FHLBank’s minimum required regulatory capital and the aggregate minimum required regulatory capital of every FHLBank. Each FHLBank must pay an amount equal to one-half of its annual assessment twice each year.
Office of Finance Expenses: The Office of Finance allocates its operating and capital expenditures based on a formula that considers each FHLBank’s percentage of: (1) total capital stock for the 12 FHLBanks; (2) consolidated obligations issued; and (3) consolidated obligations outstanding. Certain expenses such as the cost of auditing the combined financial reports and specific rating agency expenses are allocated equally among the FHLBanks (each pays 1/12th).
Housing and Community Development (HCD) Programs: As more fully discussed in Note 12, the FHLBank is required to establish, fund and administer an Affordable Housing Program (AHP). The required annual AHP funding is charged to earnings, and an offsetting liability is established. 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.
Resolution Funding Corporation (REFCORP) Assessments: Although the FHLBank is exempt from all federal, state and local taxation except for real property taxes, it is required to make quarterly payments to REFCORP to be used to pay a portion of the interest on bonds issued by the 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. See Note 13 for more information.
Fair Values: Many of the FHLBank’s financial instruments lack an available trading market as characterized as the price that would be received to sell an asset, or paid to transfer a liability, in an orderly transaction between market participants at the measurement date. Therefore, the FHLBank has used significant estimates and present value calculations for the purpose of disclosing fair values. All fair values, regardless of re-pricing or maturity, were derived from pricing services or determined by calculating the present values of the expected future cash flows based on market observable inputs. The fair values of the FHLBank’s financial instruments and related assumptions are detailed in Note 16.
Cash Flows: For purposes of the Statements of Cash Flows, the FHLBank considers cash on hand and non-interest-bearing deposits in banks as cash and cash equivalents.
NOTE 2 - RECENTLY ISSUED ACCOUNTING STANDARDS AND INTERPRETATIONS AND CHANGES IN AND ADOPTIONS OF ACCOUNTING PRINCIPLES
Fair Value Measurements and Disclosures-Improving Disclosures about Fair Value Measurements. In January 2010, the Financial Accounting Standards Board (FASB) issued guidance amending existing fair value measurement and disclosure guidance. The amended guidance will require the FHLBank to: (1) disclose separately the transfers in and out of Level 1 and Level 2 fair value measurements and describe the reasons for the transfers; (2) present the purchases, sales, issuances, and settlements disclosed in the Level 3 roll forward on a gross basis, instead of net; (3) disaggregate the statement of condition assets and liabilities by class for disclosing the recurring and non-recurring fair value measurements; and (4) disclose the valuation technique used and inputs used in determining the fair value of each class of asset or liability that is classified as a Level 2 or Level 3 fair value measurement. The guidance related to the new disclosures and clarifications of existing disclosures is effective for interim and annual reporting periods beginning after December 15, 2009 (January 1, 2010 for the FHLBank) and the guidance related to the presentation of the Level 3 reconciling items at gross values is effective for interim and annual periods beginning after December 15, 2010 (January 1, 2011 for the FHLBank). Comparative disclosures are not required in the period of initial adoption for any previous periods presented. The FHLBank has determined that adoption of this guidance will increase the FHLBank’s financial statement disclosures but will not affect the FHLBank’s financial condition, results of operations or cash flows.
Fair Value Measurements and Disclosures-Measuring Liabilities at Fair Value. In August 2009, the FASB issued guidance that amends the fair value measurements and disclosures guidance for liabilities to allow a liability to be measured using: (1) a valuation technique that uses the quoted price of an identical liability when traded as an asset; or (2) a valuation technique that uses quoted prices for similar liabilities or similar liabilities when traded as assets. In addition, the guidance clarified that for a liability that is measured using quoted prices of the asset, no adjustment is required for the effect of a restriction preventing its sale. This guidance is effective for the first reporting period, including interim periods, beginning after issuance (October 1, 2009 for the FHLBank). Its adoption did not have a material effect on the FHLBank’s financial condition, results of operations or cash flows.
Codification of Accounting Standards. In June 2009, the FASB established FASB’s Accounting Standards Codification (Codification) as the single source of authoritative GAAP recognized by the FASB to be applied by nongovernmental entities. Securities and Exchange Commission (SEC) rules and interpretive releases are also sources of authoritative GAAP for SEC registrants. This guidance modified the GAAP hierarchy to include only two levels of GAAP: authoritative and non-authoritative. In addition, the FASB no longer will consider new accounting standards updates as authoritative in their own right. Instead, new accounting standards updates will serve only to update the Codification, provide background information about the guidance and provide the bases for conclusions regarding changes in the Codification. The Codification is effective for interim and annual periods ending after September 15, 2009. The FHLBank adopted the Codification on September 30, 2009. As the Codification is not intended to change or alter previous GAAP, its adoption did not affect the FHLBank’s financial condition, results of operations or cash flows. Because the Codification is the single source of authoritative U.S. GAAP, the Notes will generally not refer to the Codification.
Accounting for Transfers of Financial Assets. In June 2009, the FASB issued guidance which is intended to improve the relevance, representational faithfulness, and comparability of the information that a reporting entity provides in its financial reports about a transfer of financial assets; the effects of a transfer on its financial position, financial performance, and cash flows; and a transferor’s continuing involvement in transferred financial assets. Key provisions of the guidance include: (1) the removal of the concept of qualifying special purpose entities; (2) the introduction of the concept of a participating interest, in circumstances in which a portion of a financial asset has been transferred; and (3) the requirement that to qualify for sale accounting, the transferor must evaluate whether it maintains effective control over transferred financial assets either directly or indirectly. The guidance also requires enhanced disclosures about transfers of financial assets and a transferor’s continuing involvement. This guidance is effective as of the beginning of each reporting entity’s first annual reporting period that begins after November 15, 2009 (January 1, 2010 for the FHLBank), for interim periods within that first annual reporting period and for interim and annual reporting periods thereafter. Earlier application is prohibited. The FHLBank adopted this guidance as of January 1, 2010. Its adoption did not have a material effect on the FHLBank’s financial condition, results of operations or cash flows.
Subsequent Events. In May 2009, the FASB issued guidance establishing general standards of accounting for and disclosure of events that occur after the balance sheet date but before financial statements are issued or are available to be issued. This guidance sets forth: (1) the period after the balance sheet date during which management of a reporting entity should evaluate events or transactions that may occur for potential recognition or disclosure in the financial statements; (2) the circumstances under which an entity should recognize events or transactions occurring after the balance sheet date in its financial statements; and (3) the disclosures that an entity should make about events or transactions that occurred after the balance sheet date, including disclosure of the date through which an entity has evaluated subsequent events and whether that represents the date the financial statements were issued or were available to be issued. This guidance does not apply to subsequent events or transactions that are within the scope of other applicable GAAP that provide different guidance on the accounting treatment for subsequent events or transactions. This guidance was effective for interim and annual financial periods ending after June 15, 2009. The FHLBank adopted this guidance as of June 30, 2009. Its adoption resulted in increased interim financial statement disclosures, but did not affect the FHLBank’s financial condition, results of operations or cash flows. In February 2010, the FASB issued amendments to this guidance that clarify which entities are considered SEC filers, requires SEC filers to evaluate subsequent events through the date the financial statements are issued and removes the requirement that SEC filers disclose the date through which subsequent events have been evaluated. These amendments as they apply to the FHLBank are effective upon issuance (December 31, 2009 financial statements). The initial adoption of this guidance resulted in increased interim financial statement disclosures, but did not have any impact on the FHLBank’s financial condition, results of operations or cash flows. The February 2010 amendments remove the requirement to disclose the date through which subsequent events have been evaluated, provided upon initial adoption, from the FHLBank’s financial statements.
Recognition and Presentation of Other-Than-Temporary Impairments. In April 2009, the FASB issued guidance amending the other-than-temporary impairment (OTTI) guidance for debt securities to make the guidance more operational and to improve the presentation and disclosure of OTTI on debt and equity securities in the financial statements. This “OTTI guidance” clarifies the interaction of the factors that should be considered when determining whether a debt security is other than temporarily impaired and changes the presentation and calculation of the OTTI on debt securities recognized in earnings in the financial statements. This guidance does not amend existing recognition and measurement guidance related to OTTI of equity securities. This guidance expands and increases the frequency of existing disclosures about OTTI for debt and equity securities and requires new disclosures to help users of financial statements understand the significant inputs used in determining a credit loss, as well as a roll-forward of that amount each period.
The FHLBank elected to early adopt this OTTI guidance as of January 1, 2009 and recognized the effects of adoption as a change in accounting principle. The FHLBank recognized a $3,349,000 cumulative-effect of initial application as an adjustment to retained earnings (increase or credit) at January 1, 2009, with a corresponding adjustment (decrease or debit) to Accumulated OCI. This adjustment did not affect either the FHLBank’s Affordable Housing Program (AHP) or Resolution Funding Corporation (REFCORP) expense or accruals, as these assessments were calculated based on GAAP net income. The adoption of this guidance also increased financial statement disclosures.
Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly. In April 2009, the FASB issued guidance which clarifies the approach to, and provides additional factors to consider in estimating fair value when the volume and level of activity for the asset or liability have significantly decreased. It also includes guidance on identifying circumstances that indicate a transaction is not orderly. The FHLBank elected to early adopt this guidance effective January 1, 2009. Its adoption resulted in increased financial disclosures but did not have a material impact on the FHLBank’s financial condition, results of operations or cash flows.
Interim Disclosures about Fair Value of Financial Instruments. In April 2009, the FASB issued guidance to require disclosures about the fair value of financial instruments, including disclosure of the method(s) and significant assumptions used to estimate the fair value of financial instruments, in interim financial statements as well as in annual financial statements. Previously, these disclosures were required only in annual financial statements. The FHLBank elected to early adopt this guidance effective January 1, 2009. Its adoption resulted in increased interim financial statement disclosures but did not have any impact on the FHLBank’s financial condition, results of operations or cash flows.
Enhanced Disclosures about Derivative Instruments and Hedging Activities. In March 2008, the FASB issued guidance which is intended to improve financial reporting about derivative instruments and hedging activities by requiring enhanced disclosures to enable investors to better understand their effects on an entity’s financial position, financial performance, and cash flows. This guidance was effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008 (January 1, 2009 for the FHLBank), with early application allowed. The adoption resulted in increased financial statement disclosures but did not affect the FHLBank’s financial condition, results of operations or cash flows.
NOTE 3 - CASH AND DUE FROM BANKS
Balances represent non-interest bearing deposits in banks.
Pass-through Deposit Reserves: The FHLBank acts as a pass-through correspondent for members required to deposit reserves with the Federal Reserve Banks (FRB). The amount shown as cash and due from banks includes $0 and $36,000 of reserve deposits with the FRB as of December 31, 2009 and 2008, respectively.
NOTE 4 - TRADING SECURITIES
Major Security Types: Trading securities as of December 31, 2009 and 2008 are summarized in the following table (in thousands):
See Note 19 for transactions with other FHLBanks.
Federal National Mortgage Association (Fannie Mae) and Federal Home Loan Mortgage Corporation (Freddie Mac) are GSEs. Both entities were placed into conservatorship by the Finance Agency on September 7, 2008 with the Finance Agency named as conservator.
Government National Mortgage Association (Ginnie Mae) securities are guaranteed by the U.S. government.
Redemption Terms: The fair values of trading securities by contractual maturity as of December 31, 2009 and 2008 are shown in the following table (in thousands). Expected maturities of certain securities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment fees.
Net realized and unrealized net gains (losses) on trading securities during the years ended December 31, 2009, 2008 and 2007 were as follows (in thousands):
NOTE 5 - AVAILABLE-FOR-SALE SECURITIES
Gains and Losses: As described in Note 17, during the year ended December 31, 2008, the FHLBank was required to purchase several state housing finance agency (HFA) bonds under standby bond purchase agreements (SBPA). In accordance with the SBPAs, the FHLBank purchased and resold the bonds at par value; therefore, no gains (losses) were recorded in OCI on the purchase and subsequent sale of these bonds. Net losses were realized on the sale of available-for-sale securities during the year ended December 31, 2007 and are included in other income (loss). There were no sales of available-for-sale securities during 2009. Following are details of the 2008 and 2007 sales (in thousands):
NOTE 6 - HELD-TO-MATURITY SECURITIES
Major Security Types: Held-to-maturity securities as of December 31, 2009 are summarized in the following table (in thousands):
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Fannie Mae and Freddie Mac are GSEs. Both entities were placed into conservatorship by the Finance Agency on September 7, 2008.
Ginnie Mae securities are guaranteed by the U.S. government.
Held-to-maturity securities as of December 31, 2008 are summarized in the following table (in thousands):
__________
Fannie Mae and Freddie Mac are GSEs. Both entities were placed into conservatorship by the Finance Agency on September 7, 2008.
Ginnie Mae securities are guaranteed by the U.S. government.
Primarily consists of private-label MBS backed by residential loans.
As of December 31, 2008, carrying value is equivalent to amortized cost.
The following table summarizes (in thousands) the held-to-maturity securities with unrecognized losses as of December 31, 2009. The unrecognized losses are aggregated by major security type and length of time that individual securities have been in a continuous unrecognized loss position.
__________
Fannie Mae and Freddie Mac are GSEs. Both entities were placed into conservatorship by the Finance Agency on September 7, 2008.
Ginnie Mae securities are guaranteed by the U.S. government.
The following table summarizes (in thousands) the held-to-maturity securities with unrecognized losses as of December 31, 2008. The unrecognized losses are aggregated by major security type and length of time that individual securities have been in a continuous unrecognized loss position.
Fannie Mae and Freddie Mac are GSEs. GSE securities are not guaranteed by the U.S. government.
Ginnie Mae securities are guaranteed by the U.S. government
Primarily consists of private-label mortgage-backed securities backed by residential loans.
Other-than-temporary Impairment: The FHLBank evaluates its individual held-to-maturity investment securities holdings in an unrealized loss position for OTTI at least quarterly, or more frequently if events or changes in circumstances indicate that these investments may be other-than-temporarily impaired. As part of this process, if the fair value of a security is less than its amortized cost basis, the FHLBank considers its intent to sell the debt security and whether it is more likely than not that the FHLBank will be required to sell the debt security before its anticipated recovery. If either of these conditions is met, the FHLBank recognizes an OTTI charge in earnings equal to the entire difference between the debt security’s amortized cost and its fair value as of the balance sheet date. For securities in unrealized loss positions that meet neither of these conditions, the FHLBank performs an analysis to determine if any of these securities are other-than-temporarily impaired.
For Agency MBS, 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 has determined that, as of December 31, 2009, all of the gross unrealized losses on its Agency MBS are temporary.
The FHLBanks’ OTTI Governance Committee, which is comprised of representation from all 12 FHLBanks, was formed in the second quarter of 2009 and has responsibility for reviewing and approving the key modeling assumptions, input and methodologies to be used by the FHLBanks to generate cash flow projections used in analyzing credit losses and determining OTTI for private-label MBS. Beginning in the second quarter 2009 and continuing throughout 2009, to support consistency among the FHLBanks, FHLBank Topeka completed its OTTI analysis primarily based upon cash flow analysis prepared by FHLBank of San Francisco on behalf of FHLBank Topeka using key modeling assumptions provided by the FHLBanks’ OTTI Governance Committee for the majority of its private-label residential MBS and home equity loan investments. Certain private-label MBS backed by multi-family and commercial real estate loans, home equity lines of credit and manufactured housing loans were outside of the scope of the OTTI Governance Committee and were analyzed for OTTI by the FHLBank utilizing other methodologies.
For private-label commercial MBS, consistent with the other FHLBanks, the FHLBank assesses the creditworthiness of the issuer, the credit ratings assigned by the Nationally-Recognized Statistical Rating Organizations (NRSRO), the performance of the underlying loans and the credit support provided by the subordinate securities to make a conclusion as to whether the commercial MBS will be settled at an amount less than the amortized cost basis. The FHLBank had only one private-label commercial MBS as of December 31, 2009, and its fair value was higher than its amortized cost, so it was not reviewed for impairment.
An OTTI cash flow analysis is run by FHLBank of San Francisco for each of the FHLBank’s remaining private-label MBS using the FHLBank System’s common platform and agreed-upon assumptions. For certain private-label MBS where underlying collateral data is not available, alternative procedures as determined by each FHLBank are used to assess these securities for OTTI.
The evaluation includes estimating projected cash flows that are likely to be collected based on assessments of all available information about each individual security, the structure of the security and certain assumptions as determined by the FHLBanks’ OTTI Governance Committee, such as the remaining payment terms for the security, prepayment speeds, default rates, loss severity on the collateral supporting the FHLBank’s security based on underlying borrower and loan characteristics, expected housing price changes, and interest rate assumptions, to determine whether the FHLBank will recover the entire amortized cost basis of the security. In performing a detailed cash flow analysis, the FHLBank identifies the best estimate of the cash flows expected to be collected. If this estimate results in a present value of expected cash flows (discounted at the security’s effective yield) that is less than the amortized cost basis of a security (that is, a credit loss exists), an OTTI is considered to have occurred.
To assess whether the entire amortized cost basis of securities will be recovered, the FHLBank of San Francisco, on behalf of the FHLBank, performed a cash flow analysis using two third-party models. The first third-party model considers borrower characteristics and the particular attributes of the loans underlying the FHLBank’s securities, in conjunction with assumptions about future changes in home prices and interest rates, to project prepayments, defaults and loss severities. A significant input to the first model is the forecast of future housing price changes for the relevant states and core based statistical areas (CBSAs), which are based upon an assessment of the individual housing markets. CBSA refers collectively to metropolitan and micropolitan statistical areas as defined by the United States Office of Management and Budget; as currently defined, a CBSA must contain at least one urban area of 10,000 or more people. The FHLBank’s housing price forecast assumed current-to-trough home price declines ranging from 0 percent to 15 percent over the next 9 to 15 months. Thereafter, home prices are projected to increase zero percent in the first six months, one percent in the next six months, three percent in the second year and four percent in each subsequent year.
The month-by-month projections of future loan performance derived from the first model, which reflect projected prepayments, defaults and loss severities, are then input into a second model that allocates the projected loan level cash flows and losses to the various security classes in the securitization structure in accordance with its prescribed cash flow and loss allocation rules. In a securitization in which the credit enhancement for the senior securities is derived from the presence of subordinate securities, losses are generally allocated first to the subordinate securities until their principal balances are reduced to zero. The projected cash flows are based on a number of assumptions and expectations, and the results of these models can vary significantly with changes in assumptions and expectations. The scenario of cash flows determined based on model approach reflects a best estimate scenario and includes a base case current-to-trough housing price forecast and a base case housing price recovery path.
As a result of these security-level evaluations, the FHLBank determined that eight private-label MBS were other-than-temporarily impaired as of December 31, 2009 because the FHLBank determined that it was likely that it would not recover the entire amortized cost of these securities. These securities included five private-label MBS that were identified as other-than-temporarily impaired in 2008, one private-label MBS that was first identified as other-than-temporarily impaired in the first quarter of 2009 (additional impairment recorded in the second quarter of 2009) and two private-label MBS that were first identified as other-than-temporarily impaired in the third quarter of 2009 (additional credit impairment was recorded on one security in the fourth quarter of 2009). The OTTI amount related to non-credit losses represents the difference between the current fair value of the security and the present value of the FHLBank’s best estimate of the cash flows expected to be collected, which is calculated as described previously. The OTTI amount recognized in OCI is accreted to the carrying value of the security on a prospective basis over the remaining life of the security. That accretion increases the carrying value of the security and continues until the security is sold or matures, or there is an additional OTTI that is recognized in earnings. The FHLBank does not intend to sell any of these securities, nor is it more likely than not that the FHLBank will be required to sell these securities before its anticipated recovery of the remaining amortized cost basis of the eight OTTI securities.
For those securities for which an OTTI was determined to have occurred during the year ended December 31, 2009 (that is, securities for which the FHLBank determined that it was more likely than not that the amortized cost basis would not be recovered), the following table presents a summary of the significant inputs used to measure the amount of credit loss recognized in earnings during this period as well as related current credit enhancement. Credit enhancement is defined as the percentage of subordinated tranches and over-collateralization, if any, in a security structure that will generally absorb losses before the FHLBank will experience a loss on the security. The calculated averages represent the dollar-weighted averages of all the private-label MBS investments in each category shown. The classification (prime, Alt-A and subprime) is based on the model used to run the estimated cash flows for the CUSIP, which may not necessarily be the same as the classification at the time of origination.
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Current credit enhancement weighted average and range percentages are not considered meaningful for home equity loan investments, as the majority of these investments are third-party insured.
For the three private-label securities on which OTTI charges were recognized during the year ended December 31, 2009, the FHLBank’s reported balances as of December 31, 2009 are as follows (in thousands):
For the eight private-label securities identified as other-than-temporarily impaired, the FHLBank’s reported balances as of December 31, 2009 are as follows (in thousands):
The FHLBank recognized OTTI on its held-to-maturity securities portfolio for the years ended December 31, 2009 and 2008, based on the FHLBank’s impairment analysis of its investment portfolio, as follows (in thousands):
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The following table presents a roll-forward of OTTI activity related to credit losses recognized in earnings and OTTI activity related to all other factors recognized in OCI (in thousands):
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The FHLBank adopted the new OTTI guidance as of January 1, 2009 and recognized the cumulative effect of initial application totaling $3,349,000 as an adjustment to the retained earnings balance at January 1, 2009 with a corresponding adjustment to Accumulated OCI.
Securities previously impaired represent all securities that were impaired prior to January 1, 2009.
The FHLBank amortizes the credit component based on estimated cash flows prospectively up to the amount of expected principal to be recovered. The discounted cash flows will move from the discounted loss value to the ultimate principal to be written off at the projected date of loss. If the expected cash flows improve, the amount of expected loss decreases which causes a corresponding decrease in the calculated amortization. Based on the level of improvement in the cash flows, the amortization could become a positive adjustment to income.
Although there has been improvement in the fair value of the FHLBank’s held-to-maturity securities portfolio during 2009, the fair value of a majority of this portfolio remains below the amortized cost of the securities due to interest rate volatility, illiquidity in the marketplace and credit deterioration in the U.S. mortgage markets since early 2008. However, the decline in fair value of these securities is considered temporary as the FHLBank expects to recover the entire amortized cost basis on the remaining held-to-maturity securities in unrecognized loss positions and neither intends to sell these securities nor it is more likely than not that the FHLBank will be required to sell these securities before its anticipated recovery of the remaining amortized cost basis.
Redemption Terms: The amortized cost, carrying value and fair values of held-to-maturity securities by contractual maturity as of December 31, 2009 and 2008 are shown in the following table (in thousands). Expected maturities of certain securities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment fees.
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At December 31, 2008, carrying value is equivalent to amortized cost.
The carrying value of the FHLBank’s MBS included net discounts of $19,531,000, of which $2,034,000 represented credit related impairment discount and $9,719,000 represented non-credit related impairment discount, as of December 31, 2009. The amortized cost of the FHLBank’s MBS included net discounts of $16,504,000, of which $4,773,000 represented impairment discount, as of December 31, 2008. Other investments included net discounts of $0 and $2,728,000 as of December 31, 2009 and December 31, 2008, respectively.
Interest Rate Payment Terms: The following table details interest rate payment terms for held-to-maturity securities as of December 31, 2009 and 2008 (in thousands):
Gains and Losses: Net gains (losses) were realized on the sale of long-term securities during the year ended December 31, 2007 and are included in other income (loss). All securities sold had paid down below 15 percent of the principal outstanding at acquisition. Following are details of the sales (in thousands):
In 2008, a short-term security (original maturity of three months or less) was sold to bring the FHLBank in compliance with its unsecured investment limitation for an unsecured counterparty. A net loss was realized on the sale of the security and is included in other income. Proceeds from the sale are included in net (increase) decrease in short-term held-to-maturity securities on the Statements of Cash Flows. Following are details of the sale (in thousands):
NOTE 7 - ADVANCES
Redemption Terms: The FHLBank had advances outstanding at interest rates ranging from zero percent (AHP advances) to 8.01 percent as of December 31, 2009 and zero percent (AHP advances) to 8.64 percent as of December 31, 2008 as summarized in the following table (in thousands):
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See Note 9 for a discussion of: (1) the FHLBank’s objectives for using derivatives; (2) the types of assets and liabilities hedged; and (3) the accounting for derivatives and the related assets and liabilities hedged.
In general, a borrower is charged a prepayment fee when an advance is repaid before its stated maturity. Prepayment fees are calculated using methods that make the FHLBank financially indifferent to the advance prepayments. The FHLBank’s advances outstanding include advances that contain call options that may be exercised with or without prepayment fees at the borrower’s discretion on specific dates (call dates) before the stated advance maturities (callable advances). The borrowers normally exercise their call options on these advances when interest rates decline (fixed rate advances) or spreads change (adjustable rate advances). The FHLBank’s advances as of December 31, 2009 and 2008 include callable advances totaling $7,318,356,000 and $6,395,434,000, respectively. Of these callable advances, there were $7,287,717,000 and $6,324,845,000 of variable rate advances as of December 31, 2009 and 2008, respectively. The following table summarizes the FHLBank’s advances by year of maturity, or by the next call date for callable advances (in thousands):
The FHLBank’s advances outstanding also include advances that contain conversion options that may be exercised at the FHLBank’s discretion on specific dates (conversion dates) before the stated advance maturities (convertible advances). With convertible advances, the FHLBank effectively purchases put options from the borrowers that allow the FHLBank to convert the fixed rate advances to variable rate advances. In exchange for the options, borrowers are charged interest rates that are below those for fixed rate advances with comparable maturities. The FHLBank normally exercises its conversion options on these advances when interest rates increase. The FHLBank’s advances as of December 31, 2009 and 2008 included convertible advances totaling $5,060,772,000 and $5,759,422,000, respectively. The following table summarizes the FHLBank’s advances by year of maturity, or by the next conversion or put date for convertible advances (in thousands):
Security Terms: The FHLBank lends to members and approved housing associates involved in housing finance within the Tenth District, which comprises the states of Colorado, Kansas, Nebraska and Oklahoma. Advances are made in accordance with federal statutes, including the Bank Act as amended. The FHLBank is required by statute to obtain security interests in sufficient collateral on advances to protect against losses and to accept as collateral on such advances only U.S. government or government agency securities, residential mortgage loans and securities backed by such, cash, deposits in the FHLBank and other real estate-related assets. As provided in the Bank Act, a borrowing member’s investment in the capital stock of the FHLBank is pledged as additional collateral on the member’s advances. CFIs are defined in the Recovery Act as those institutions that have, as of the date of the transaction at issue, less than a specified amount of average total assets over the three years preceding that date (subject to annual adjustment by the Finance Agency director based on the consumer price index). For 2009, this asset cap was $1,011,000,000. CFIs are eligible under expanded statutory collateral rules to pledge as collateral for advances small-business, small-farm and small-agribusiness loans fully secured by collateral other than real estate, or securities representing a whole interest in such secured loans. The Recovery Act also adds secured loans for “community development activities” as a permitted purpose, and as eligible collateral, for advances to CFIs. As of December 31, 2009 and 2008, the FHLBank had security interests in collateral with an estimated value in excess of outstanding advances.
All advances outstanding as of December 31, 2009 and 2008, were collateralized by the above types of collateral pursuant to written security agreements. Based on the financial condition of a member that has advances outstanding, the FHLBank allows two options: (1) members can physically retain collateral assigned to the FHLBank provided they execute written security agreements and agree to hold such collateral for the benefit of the FHLBank; or (2) members can specifically assign or physically place such collateral with the FHLBank or its safekeeping agent.
Beyond these provisions, Section 10(e) of the Bank Act affords any security interest granted by a member to the FHLBank priority over the claims or rights of any other party (including any receiver, conservator, trustee or similar lien creditor). The two exceptions are claims of bona fide purchasers for value and actual secured parties holding perfected security interests, provided that those claims would be entitled to priority under otherwise applicable law.
Credit Risk: While the FHLBank has never experienced a credit loss on an advance to a member, the expanded statutory collateral rules for CFIs provide the potential for additional credit risk for the FHLBank. FHLBank management has policies and procedures in place to appropriately manage the potential for additional credit risk from CFI collateral. To the extent that the expanded eligible collateral for CFIs generally includes higher risk loans and advances to non-member housing associates are made at similar terms to members but without capital stock as collateral, it results in the potential for an increase in the credit risk to the FHLBank. The increased credit risk from CFIs’ and housing associates’ collateral is mitigated by the FHLBank through higher haircuts (lower lending values) on such collateral. Additionally, all non-member borrowers, including housing associates, are placed in possession-collateral status and are required to deliver eligible collateral to the FHLBank in an amount that provides a collateral coverage level sufficient to cover their extensions of credit with the FHLBank. The FHLBank has the policies and procedures in place to appropriately manage credit risk from all advances, 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 each member’s financial condition. The FHLBank continually monitors the collateral pledged by and credit worthiness of its members. Accordingly, the FHLBank has not established an allowance for credit losses on advances.
The FHLBank’s potential credit risk from advances is concentrated in thrifts (35 percent of total advances), commercial banks (36 percent of total advances), credit unions (3 percent of total advances) and insurance companies (26 percent of total advances). As of December 31, 2009 and 2008, the FHLBank had outstanding advances of $5,926,000,000 and $10,389,600,000, respectively, to two members that individually held 10 percent or more of the FHLBank’s advances, which represents 27.1 percent and 29.7 percent, respectively, of total outstanding advances. The income from advances to these members during 2009 and 2008 totaled $111,436,000 and $249,418,000, respectively. One of the members was the same each year. The FHLBank had security interests in collateral with an estimated value in excess of book value of these advances and, therefore, does not expect to incur any credit losses on these advances. See Note 18 for detailed information on transactions with related parties.
Interest Rate Payment Terms: The following table details additional interest rate payment terms for advances as of December 31, 2009 and 2008 (in thousands):
Information about the fair value of the advances is included in Note 16.
NOTE 8 - MORTGAGE LOANS HELD FOR PORTFOLIO
The MPF Program involves the FHLBank investing in mortgage loans, which are either funded by the FHLBank through or purchased from its participating members. The total loans represent held-for-portfolio loans under the MPF Program whereby participating FHLBank members originate and credit enhance home mortgage loans that are owned by the FHLBank. Depending upon a member’s product selection, however, the servicing rights can be retained or sold by the participating member. The FHLBank does not buy or own any mortgage servicing rights.
The following table presents information as of December 31, 2009 and 2008 on mortgage loans held for portfolio (in thousands):
Medium-term defined as a term of 15 years or less.
See Note 9 for a discussion of: (1) the FHLBank’s objectives for using derivatives; (2) the types of assets and liabilities hedged; and (3) the accounting for derivatives and the related assets and liabilities hedged.
The par value of mortgage loans held for portfolio outstanding as of December 31, 2009 and 2008 was comprised of government-insured or guaranteed (by the Federal Housing Administration, the Department of Veterans Affairs, RHS and HUD) loans totaling $322,245,000 and $195,619,000, respectively, and conventional, size-conforming mortgage loans totaling $3,007,220,000 and $2,824,928,000, respectively.
The FHLBank bases its allowance on management’s estimate of probable credit losses inherent in the FHLBank’s mortgage loan portfolio as of the Statement of Condition date. The estimate is based on an analysis of past and current performance of the FHLBank’s portfolio. The allowance for credit losses on mortgage loans as of December 31, 2009, 2008 and 2007, respectively, was as follows (in thousands):
As of December 31, 2009 and 2008, the FHLBank had $22,730,000 and $8,934,000, respectively, of non-accrual conventional loans. As of December 31, 2009 and 2008, the FHLBank had $2,553,000 and $1,442,000, respectively, of REO included in other assets.
Mortgage loans are considered impaired when, based on current information and events, it is probable that the FHLBank will be unable to collect all principal and interest amounts due according to the contractual terms of the mortgage loan agreement. The FHLBank considers the mortgage loans to be collateral dependent, and thus measures impairment based on the fair value of the collateral. As of December 31, 2009 and 2008, the FHLBank had no recorded investments in impaired mortgage loans.
The fair value of the mortgage loans held for portfolio as of December 31, 2009 and 2008 is reported in Note 16.
The credit enhancement is an obligation on the part of the participating member that ensures the retention of credit risk on loans it originates on behalf of or sells to the FHLBank. The FHLBank pays the participating member a credit enhancement fee for managing this portion of the credit risk in the pool of loans. These fees are paid monthly based upon the remaining unpaid principal balance for the pool of loans. Credit enhancement fees paid by the FHLBank to participating members for assuming the credit enhancement obligation are netted against interest income when paid. Credit enhancement fees paid by the FHLBank to participating members totaled $2,524,000, $2,495,000 and $2,275,000 for the years ended December 31, 2009, 2008 and 2007, respectively.
See Note 18 for detailed information on transactions with related parties.
NOTE 9 - DERIVATIVES AND HEDGING ACTIVITIES
Nature of Business Activity: The FHLBank enters into various types of derivatives to manage its exposure to changes in interest rates. The FHLBank may utilize derivatives to adjust the effective maturity, re-pricing frequency or option characteristics of financial instruments to achieve risk management objectives. The FHLBank uses derivatives in three ways: (1) by designating them as either a fair value or cash flow hedge of an underlying financial instrument or a forecasted transaction; (2) by acting as an intermediary; or (3) in asset/liability management (i.e., an economic hedge). For example, the FHLBank uses derivatives in its overall interest rate risk management to adjust the interest rate sensitivity of consolidated obligations to approximate more closely the interest rate sensitivity of assets (advances, investments and/or mortgage loans), and/or to adjust the interest rate sensitivity of advances, investments or mortgage loans to approximate more closely the interest rate sensitivity of liabilities.
Consistent with Finance Agency regulation, the FHLBank enters into derivatives only to reduce the interest rate risk exposures inherent in otherwise unhedged assets and funding positions to achieve risk management objectives and to act as an intermediary between its members and counterparties. Derivatives are used when they represent the most cost-effective alternative to achieve the FHLBank’s financial and risk management objectives. Accordingly, the FHLBank may enter into derivatives that do not necessarily qualify for hedge accounting (economic hedges as discussed above).
Common ways in which the FHLBank uses derivatives are to:
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Reduce funding costs by combining an interest rate swap with a consolidated obligation, as the cost of a combined funding structure can be lower than the cost of a comparable consolidated obligation;
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Reduce the interest rate sensitivity and repricing gaps of assets and liabilities;
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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 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 consolidated obligation;
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Mitigate the adverse earnings effects of the shortening or extension of certain assets (e.g., advances or mortgage assets) and liabilities; and
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Manage embedded options in assets and liabilities.
Types of Derivatives: The FHLBank’s RMP establishes guidelines for its use of derivatives. The FHLBank commonly enters into interest rate swaps (including callable and putable swaps), swaptions, and interest rate cap and floor agreements (collectively, derivatives) to manage its exposure to changes in interest rates.
Interest Rate Swaps - 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 interest rate index for the same period of time. The variable interest rate received by the FHLBank in most derivative agreements is the London Interbank Offered Rate (LIBOR). Interest rate swaps are recorded at fair value and reported in derivative assets or derivative liabilities on the Statements of Condition.
Swaptions - A swaption is an option on a swap that gives the buyer the right to enter into a specified interest rate swap at a certain time in the future. When used as a hedge, a swaption can protect the FHLBank against future interest rate changes. The FHLBank purchases both payer swaptions and receiver swaptions to decrease its interest rate risk exposure related to the prepayment of certain assets. A payer swaption is the option to make fixed interest payments at a later date and a receiver swaption is the option to receive fixed interest payments at a later date. Premiums paid to acquire swaptions are accounted for as the fair value of the derivative at inception of the hedge. Swaptions are reported at fair value and reported in derivative assets or derivative liabilities on the Statements of Condition.
Interest Rate Caps and Floors - In an interest rate cap agreement, a cash flow is generated if the price or interest rate of an underlying variable rises above a certain threshold (or “cap”) price. In an interest rate floor agreement, a cash flow is generated if the price or interest rate of an underlying variable falls below a certain threshold (or “floor”) price. The FHLBank purchases interest rate caps and floors to hedge option risk on the MBS held in the FHLBank’s held-to-maturity portfolio and to hedge embedded caps or floors in the FHLBank’s advances. Premiums paid to acquire caps or floors are accounted for as the fair value of the derivative at inception of the hedge. Interest rate caps and floors are recorded at fair value and reported in derivative assets or derivative liabilities on the Statements of Condition.
Effectiveness Measurements: Highly effective hedges that use interest rate swaps as the hedging instrument and that meet certain stringent criteria can qualify for “shortcut” fair value hedge accounting. Shortcut hedge accounting allows for the assumption of no ineffectiveness, which means that the change in fair value of the hedged item can be assumed to be equal to the change in fair value of the derivative. This is in contrast to fair value hedges designated under the “long haul” hedge accounting method, where the change in fair value of the hedged item must be measured separately from the derivative, and for which effectiveness testing must be performed regularly with results falling within established tolerances.
Long haul hedge accounting method - For hedge transactions that are not designated under the shortcut hedge accounting method, the FHLBank completes effectiveness testing at inception and on a monthly basis thereafter. The rolling regression method and the dollar offset method are used by the FHLBank to assess hedge effectiveness.
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Under the rolling regression method, the FHLBank models a series of 30 data points (market values) for the hedged item and the hedge instrument, using market data from the previous 30 calendar month-ends. A regression analysis is performed comparing the values of the hedged financial item and the hedge instrument. The hedge is deemed highly effective if: (1) the slope of the regression line is between or equal to -0.80 and -1.20, meaning that on average the change in value of the hedged financial instrument is offset by the change in value of the hedge instrument; (2) the correlation is 0.80 or higher; and (3) the calculated F statistic is 4 or higher. For new hedge transactions, the 30 data points (market values) are generated using historical market data.
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The dollar-offset method measures the change in fair value between periods on the hedge instrument versus the change in the fair value between periods on the hedged item. Under this methodology, at inception, the FHLBank evaluates effectiveness of the hedging relationship using interest rate scenario stress testing (interest rate shock scenarios). Thereafter on a monthly basis, the FHLBank compares the change in cumulative fair value of the hedging instrument to the change in cumulative fair value of the hedged item. The amount of dollar-offset between the two items must fall into a range of between 80 percent and 120 percent in order for the hedge to be deemed effective.
Types of Assets and Liabilities Hedged: At the inception of every hedge transaction, the FHLBank documents all hedging 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 or cash flow hedges to: (1) assets and/or liabilities on the Statements of Condition; (2) firm commitments; or (3) forecasted transactions. The FHLBank formally assesses (both at the hedge’s inception and at least quarterly on an ongoing basis) whether the derivatives that are used have been effective in offsetting changes in the fair value or cash flows of hedged items and whether those derivatives may be expected to remain effective in future periods. The FHLBank typically uses regression analyses or similar statistical analyses to assess the effectiveness of its hedging relationships.
Consolidated Obligations - While consolidated obligations are the joint and several obligations of the 12 FHLBanks, each FHLBank is individually a counterparty to derivatives associated with specific debt issues. For instance, in a typical transaction involving more than one FHLBank, fixed rate consolidated obligation bonds are issued for one or more FHLBanks, including FHLBank Topeka. In connection with its share of the bond issuance, FHLBank Topeka simultaneously enters into a matching derivative in which the counterparty pays fixed cash flows to FHLBank Topeka designed to mirror in timing and amount the cash outflows FHLBank Topeka pays on the consolidated obligation. Such transactions are designated as fair value hedges. In this type of transaction, FHLBank Topeka typically pays the derivative counterparty a variable cash flow that closely matches the interest payments it receives on short-term or variable rate advances. Note, though, that most of the FHLBank’s swapped consolidated obligation bonds are fixed rate, callable bonds where the FHLBank is the sole issuer of the particular debt issue. The swap transaction with a counterparty for debt upon which the FHLBank is the sole issuer follows the same process reflected above (simultaneous, matching terms, etc.). This intermediation between the capital and derivatives markets permits the FHLBank to raise funds at costs lower than would otherwise be available through the issuance of simple fixed or variable rate consolidated obligations in the capital markets.
Advances - With the issuance of a convertible advance, the FHLBank purchases from the member an option that enables the FHLBank to convert an advance from fixed rate to variable rate if interest rates increase. Once the FHLBank exercises its option to convert an advance to an at-the-market variable rate, the member then owns the option to terminate the converted advance without fee or penalty on the conversion date and each interest rate reset date thereafter. The FHLBank hedges a convertible advance by entering into a cancelable derivative with a non-member counterparty where the FHLBank pays a fixed rate and receives a variable rate. The derivative counterparty may cancel the derivative on a put date. This type of hedge is designated as a fair value hedge. The counterparty’s decision to cancel the derivative would normally occur in a rising rate environment. If the option is in-the-money, the derivative is cancelled by the derivative counterparty at par (i.e., without any premium or other payment to the FHLBank). When the derivative is cancelled, the FHLBank exercises its option to convert the advance to a variable rate. If a convertible advance is not prepaid by the member upon conversion to an at-the-market variable rate advance (i.e., callable variable rate advance), any hedge-related unamortized basis adjustment is amortized as a yield adjustment.
When fixed rate advances are issued to one or more borrowers, the FHLBank can either fund the advances with fixed rate consolidated obligations with the same tenor or simultaneously enter into a matching derivative in which the counterparty receives fixed cash flows from the FHLBank designed to mirror in timing and amount the cash inflows the FHLBank receives on the advance. Such transactions are designated as fair value hedges. In this type of transaction, the FHLBank typically receives from the derivative counterparty a variable cash flow that closely matches the interest payments on short-term discount notes or swapped consolidated obligation bonds.
The optionality embedded in certain financial instruments held by the FHLBank can create interest rate risk. For example, when a member prepays an advance, the FHLBank could suffer lower future income if the principal portion of the prepaid advance were invested in lower-yielding assets that continue to be funded by higher-cost debt. To protect against this risk, the FHLBank generally charges a prepayment fee on an advance that makes it financially indifferent to a member’s decision to prepay the advance. When the FHLBank offers advances (other than short-term advances) that a member may prepay without a prepayment fee, it usually finances such advances with callable debt or otherwise hedges the option being sold to the member.
Mortgage Loans - The FHLBank invests in fixed rate mortgage loans through the MPF Program. The prepayment options embedded in mortgage loans can result in extensions or contractions in the expected lives of these investments, depending on changes in estimated future cash flows, which usually occur as a result of interest rate changes. The FHLBank may manage the interest rate and prepayment risk associated with mortgages through a combination of debt issuance and derivatives. The FHLBank issues both callable and non-callable debt to achieve cash flow patterns and liability durations similar to those expected on the mortgage loans. The FHLBank may use derivatives in conjunction with debt issuance to better match the expected prepayment characteristics of its mortgage loan portfolio.
Interest rate caps and floors, swaptions and callable swaps may also be used to hedge prepayment risk on the mortgage loans. Although these derivatives are valid economic hedges against the prepayment risk of the portfolio of mortgage loans, they are not specifically linked to individual loans and, therefore, do not receive either fair value or cash flow hedge accounting. The derivatives are marked-to-market through earnings.
Firm Commitment Strategies - Commitments that obligate the FHLBank to purchase closed fixed rate mortgage loans from its members are considered derivatives. Accordingly, each mortgage purchase commitment is recorded as a derivative asset or derivative liability at fair value, with changes in fair value recognized in current period earnings. When a mortgage purchase commitment derivative settles, the current market value of the commitment is included with the basis of the mortgage loan and amortized accordingly.
The FHLBank may also hedge a firm commitment for a forward starting advance or consolidated obligation bond through the use of an interest rate swap. In this case, the swap functions as the hedging instrument for both the hedging relationship involving the firm commitment and the subsequent hedging relationship involving the advance or bond. The basis movement associated with the firm commitment is rolled into the basis of the advance or bond at the time the commitment is terminated and the advance or bond is issued. The basis adjustment is then amortized into interest income or expense over the life of the advance or bond.
Investments - The FHLBank invests in U.S. Treasury securities, U.S. Agency securities, GSE securities, MBS and the taxable portion of state or local housing finance agency securities. The interest rate and prepayment risk associated with these investment securities is managed through a combination of debt issuance and derivatives. The FHLBank may manage against prepayment and duration risks by funding investment securities with consolidated obligations that have call features. The FHLBank may also manage the risk arising from changing market prices and volatility of investment securities by entering into derivatives (economic hedges) that offset the changes in fair value or cash flows of the securities. The FHLBank’s derivatives currently associated with investment securities (currently includes interest rate caps, floors and swaps) are designated as economic hedges with the changes in fair values of the derivatives being recorded as “Net gain (loss) on derivatives and hedging activities” in other income (loss) on the Statements of Income. The investment securities hedged with interest rate swaps are classified as “trading” with the changes in fair values recorded as “Net gain (loss) on trading securities” in other income (loss) on the Statements of Income.
Interest rate caps and floors, swaptions and callable swaps may also be used to hedge prepayment and option risk on the MBS held in the FHLBank’s trading and held-to-maturity portfolios. Most of these derivatives are purchased interest rate caps that hedge interest rate caps embedded in the FHLBank’s trading and held-to-maturity variable rate Agency MBS. Although these derivatives are valid economic hedges against the prepayment and option risk of the portfolio of MBS, they are not specifically linked to individual investment securities and, therefore, do not receive either fair value or cash flow hedge accounting. The derivatives are marked-to-market through earnings.
Anticipated Debt Issuance - The FHLBank enters into interest rate swaps for the anticipated issuance of fixed rate consolidated obligation bonds to hedge the variability in forecasted interest payments associated with fixed rate debt that has not yet been issued. The interest rate swap is terminated upon issuance of the fixed rate bond, with the realized gain or loss on the interest rate swap recorded in OCI. Realized gains and losses reported in OCI are recognized as earnings in the periods in which earnings are affected by the cash flows of the fixed rate bonds.
Managing Credit Risk on Derivatives: The FHLBank is subject to credit risk due to nonperformance by counterparties to the derivative agreements. The degree of counterparty risk on derivative agreements depends on the extent to which master netting arrangements are included in such contracts to mitigate the risk. The FHLBank manages counterparty credit risk through credit analyses and collateral requirements and by following the requirements set forth in its RMP. Based on credit analyses and collateral requirements, FHLBank management does not anticipate any credit losses on its derivative agreements and therefore, there is no adjustment to the derivatives for nonperformance risk as of December 31, 2009.
The contractual or notional amount of derivatives reflects the involvement of the FHLBank in the various classes of financial instruments. The notional amount of derivatives does not measure the credit risk exposure of the FHLBank, and the maximum credit exposure of the FHLBank is substantially less than the notional amount. The maximum credit risk is the estimated cost of replacing favorable derivatives if the counterparty defaults, and the related collateral, if any, is of less value to the FHLBank.
As of December 31, 2009 and 2008, the FHLBank’s maximum credit risk, as defined above, was approximately $81,162,000 and $112,688,000, respectively. These totals include $18,825,000 and $25,705,000, respectively, of net accrued interest receivable. In determining its maximum credit risk, the FHLBank considers accrued interest receivables and payables and the legal right to offset derivative assets and liabilities by counterparty. The FHLBank held cash with a fair value of $65,221,000 and $78,162,000 as collateral as of December 31, 2009 and 2008, respectively. Additionally, collateral with respect to derivatives with member institutions includes collateral assigned to the FHLBank, as evidenced by a written security agreement and held by the member institution for the benefit of the FHLBank. The maximum credit risk reflected above applicable to a single counterparty was $38,604,000 and $44,112,000 as of December 31, 2009 and 2008, respectively. The counterparty was different each period. Counterparty credit exposure by rating (lower of Moody’s Investors Service or Standard & Poor’s) as of December 31, 2009, is indicated in the following table (in thousands):
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Collateral held with respect to derivatives with members represents either collateral physically held by or on behalf of the FHLBank or collateral assigned to the FHLBank as evidenced by a written security agreement and held by the member for the benefit of the FHLBank.
Counterparty credit exposure by rating (lower of Moody’s Investors Service or Standard & Poor’s) as of December 31, 2008, is indicated in the following table (in thousands):
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Collateral held with respect to derivatives with members represents either collateral physically held by or on behalf of the FHLBank or collateral assigned to the FHLBank as evidenced by a written security agreement and held by the member for the benefit of the FHLBank.
Certain of the FHLBank’s derivative instruments contain provisions that require the FHLBank to post additional collateral with its counterparties if there is deterioration in the FHLBank’s credit rating. If the FHLBank’s credit rating is lowered by an NRSRO, the FHLBank would be required to deliver additional collateral on derivative instruments in which the FHLBank has a net derivative liability recorded on its Statements of Condition. The aggregate fair value of all derivative instruments with derivative counterparties containing credit-risk-related contingent features that were classified as net derivative liabilities as of December 31, 2009 was $331,756,000 for which the FHLBank has posted collateral with a fair value of $93,064,000 in the normal course of business. If the FHLBank’s credit rating had been lowered one level (e.g., from AAA to AA), the FHLBank would have been required to deliver an additional $140,703,000 of collateral to its derivative counterparties as of December 31, 2009. The FHLBank’s credit rating has not changed in the previous twelve months.
The FHLBank transacts a significant portion of its derivatives with major banks and primary broker/dealers. Some of these banks and broker/dealers or their affiliates buy, sell and distribute consolidated obligations. No single entity dominates the FHLBank’s derivatives business. Assets pledged as collateral by the FHLBank to these counterparties are discussed more fully in Note 17. The FHLBank is not a derivatives dealer and thus does not trade derivatives for short-term profit.
Intermediary Derivatives - To assist its members in meeting their hedging needs, the FHLBank acts as an intermediary between the members and other counterparties by entering into offsetting derivatives. This intermediation allows smaller members access to the derivatives market. The derivatives used in intermediary activities do not qualify for hedge accounting treatment and are separately marked-to-market through earnings. The net result of the accounting for these derivatives does not significantly affect the operating results of the FHLBank. Gains and losses are recorded in other income (loss) and presented as “Net gain (loss) on derivatives and hedging activities.”
As of December 31, 2009 and 2008, the notional principal of derivative agreements in which the FHLBank is an intermediary was $306,000,000 and $218,587,000, respectively.
Financial Statement Impact and Additional Financial Information: The notional amount of derivatives reflects the volume of the FHLBank’s hedges, but it does not measure the credit exposure of the FHLBank because there is no principal at risk. The notional amount in derivative contracts serves as a factor in determining periodic interest payments or cash flows received and paid.
The FHLBank considers accrued interest receivables and payables and the legal right to offset derivative assets and liabilities by counterparty. Consequently, derivative assets and liabilities reported on the Statements of Condition include the net cash collateral and accrued interest from counterparties. Therefore, an individual derivative may be in an asset position [counterparty would owe the FHLBank the current fair value (fair value includes net accrued interest receivable or payable on the derivative) if the derivative was settled as of the Statement of Condition date] but when the derivative fair value and cash collateral fair value (includes accrued interest on the collateral) are netted by counterparty, the derivative may be recorded on the Statements of Condition as a derivative liability. Conversely, a derivative may be in a liability position (FHLBank would owe the counterparty the fair value if settled as of the Statements of Condition date) but may be recorded on the Statements of Condition as a derivative asset after netting.
The following table represents outstanding notional balances and fair values (includes net accrued interest receivable or payable on the derivatives) of the derivatives outstanding by type of derivative and by hedge designation as of December 31, 2009 (in thousands):
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The FHLBank held cash with a fair value of $65,221,000 as collateral as of December 31, 2009. Derivative fair values are netted by counterparty where such legal right exists and offset against fair value recognized for the obligation to return cash collateral held or the right to reclaim cash collateral pledged to the particular counterparty. If these netted amounts are positive, they are classified as a derivative asset and, if negative, a derivative liability. Exposure can change on a daily basis; and thus, there is often a short lag time between the date the exposure is identified, collateral is requested and when the collateral is actually received. Likewise, there is a lag time for excess collateral to be returned. Excess collateral held by the FHLBank as of December 31, 2009 resulted in positive exposure (fair value plus net accrued interest) with one counterparty being recorded as a derivative liability.
The following table represents outstanding notional balances and fair values (includes net accrued interest receivable or payable on the derivatives) of the derivatives outstanding by type of derivative and by hedge designation as of December 31, 2008 (in thousands):
The following tables provide information regarding gains and losses on derivatives and hedging activities by type of hedge and type of derivative, gains and losses by hedged item for fair value hedges, and the notional and fair values by type of hedge and type of derivative.
For the years ended December 31, 2009, 2008 and 2007, the FHLBank recorded net gain (loss) on derivatives and hedging activities as follows (in thousands):
The FHLBank carries derivative instruments at fair value on its Statements of Condition. Any change in the fair value of derivatives designated under a fair value hedging relationship is recorded each period in current period earnings. Fair value hedge accounting allows for the offsetting fair value of the hedged risk in the hedged item to also be recorded in current period earnings. For the years ended December 31, 2009, 2008 and 2007, the FHLBank recorded net gain (loss) 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 as follows (in thousands):
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The differentials between accruals of interest receivables and payables on derivatives designated as fair value hedges as well as the amortization/accretion of hedging activities are recognized as adjustments to the interest income or expense of the designated underlying hedged item.
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The differentials between accruals of interest receivables and payables on derivatives designated as fair value hedges as well as the amortization/accretion of hedging activities are recognized as adjustments to the interest income or expense of the designated underlying hedged item.
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The differentials between accruals of interest receivables and payables on derivatives designated as fair value hedges as well as the amortization/accretion of hedging activities are recognized as adjustments to the interest income or expense of the designated underlying hedged item.
On September 15, 2008, Lehman Brothers Holding, Inc. filed a voluntary petition under Chapter 11 of the U.S. Bankruptcy Code. Lehman Brothers Holding, Inc. was guarantor of Lehman Brothers Special Financing (LESF) with which the FHLBank had derivative transactions. Consequently, the FHLBank terminated and replaced the derivative instruments outstanding with LESF on September 19, 2008. On October 6, 2008, Lehman Brothers Financial Products (LEFP) filed a petition for protection from its creditors in the U.S. Bankruptcy Court. Consequently, the FHLBank terminated and replaced all derivative instruments outstanding with LEFP on October 15, 2008. The FHLBank concluded that the new derivatives would be highly effective both at inception and on an ongoing basis. In total, the FHLBank terminated and replaced 253 derivative instruments with total notional and fair value (excluding accrued interest) amounts of $6,316,812,000 and $(54,031,000), respectively. The net realized gain (loss) on the derivative terminations was $(592,000) and was recorded in net gain (loss) on derivative and hedging activities on the Statement of Income. An additional five derivative instruments with LESF with total notional and fair value (excluding accrued interest) amounts of $145,000,000 and $(1,189,000), respectively, were not replaced because they were to be called within one week of termination date. Under the FHLBank’s International Swaps and Derivatives Association, Inc. agreements with LESF and LEFP, the derivatives were settled on a net basis from the time that bankruptcy was declared or protection was filed through termination of the agreements. As of December 31, 2008, the FHLBank had a net liability of $17,875,000, which included the final settlement amounts due LESF and LEFP net of any cash collateral delivered and accrued interest, recorded in other liabilities on the Statement of Condition.
There were no amounts for the years ended December 31, 2009, 2008 and 2007 that were reclassified into earnings as a result of the discontinuance of cash flow hedges because it became probable that the original forecasted transactions would not occur by the end of the originally specified time period or within a two-month period thereafter. As of December 31, 2009, no amounts relating to hedging activities remain in Accumulated OCI.
NOTE 10 - DEPOSITS
The FHLBank offers demand and overnight deposit programs to its members and to other qualifying non-members. In addition, the FHLBank offers short-term deposit programs to members. A member that services mortgage loans may deposit with the FHLBank funds collected in connection with the mortgage loans, pending disbursement of such funds to owners of the mortgage loans. The FHLBank classifies these items as “Non-interest-bearing other deposits” on its Statements of Condition.
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 average deposits were 0.29 percent, 1.92 percent and 4.93 percent during 2009, 2008 and 2007, respectively.
See Note 18 for detailed information on transactions with related parties.
NOTE 11 - CONSOLIDATED OBLIGATIONS
Consolidated obligations consist of consolidated bonds and discount notes and, as provided by the Bank Act or Finance Agency regulation, are backed only by the financial resources of the FHLBanks. The FHLBanks jointly issue consolidated obligations with the Office of Finance acting as their agent. The Office of Finance tracks the amounts 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. Prior to 2009, each FHLBank specified the amount of debt it wanted the Office of Finance to issue on its behalf. During December 2008, a debt issuance process was implemented by the FHLBanks and the Office of Finance to provide a scheduled monthly issuance of global bullet consolidated obligation bonds during and after 2009. As part of this process, management from each of the FHLBanks determine and communicate a firm commitment to the Office of Finance for an amount of scheduled global debt to be issued on its behalf. If the FHLBanks’ orders do not meet the minimum debt issue size, the proceeds are allocated to all FHLBanks based on the larger of the FHLBank’s commitment or allocated proceeds based on the individual FHLBank’s capital to total system capital. If the FHLBanks’ commitments exceed the minimum debt issue size, the proceeds are allocated based on relative regulatory capital of the FHLBanks’ with the allocation limited to the lesser of the allocation amount or actual commitment amount.
The Finance Agency and the U.S. Secretary of the Treasury have oversight over the issuance of FHLBank debt through the Office of Finance. The FHLBanks can, however, pass on any scheduled calendar slot and not issue any global bullet consolidated obligation bonds upon agreement of 8 of the 12 FHLBanks. Consolidated obligation bonds are issued primarily to raise intermediate- and long-term funds for the FHLBanks and are not subject to any statutory or regulatory limits as to maturities. Consolidated obligation discount notes, which are issued to raise short-term funds, are issued at less than their face amounts and redeemed at par 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 11 FHLBanks for the payment of principal and interest on all consolidated obligations of each of the FHLBanks. The Finance Agency, at its discretion, may require any FHLBank to make principal or interest payments due on any consolidated obligations for which the FHLBank is not the primary obligor. Although it has never occurred, to the extent that an FHLBank would be required to make a payment on a consolidated obligation on behalf of another FHLBank, the paying FHLBank would be entitled to reimbursement from the non-complying FHLBank. However, if the Finance Agency determines that the non-complying FHLBank is unable to satisfy its obligations, then the Finance Agency may allocate the non-complying FHLBank’s outstanding consolidated obligation debt among the remaining FHLBanks on a pro rata basis in proportion to each FHLBank’s participation in all consolidated obligations outstanding, or on any other basis the Finance Agency may determine.
The par value of outstanding consolidated obligations of all FHLBanks, including outstanding consolidated obligations issued on behalf of the FHLBank, was approximately $930,616,850,000 and $1,251,541,664,000 as of December 31, 2009 and 2008, respectively. See Note 19 for FHLBank obligations acquired by FHLBank Topeka as investments. Finance Agency regulations require that each FHLBank maintain qualifying assets, free from any lien or pledge, in an amount at least equal to the amount of that FHLBank’s participation in the total consolidated obligations outstanding. Qualifying assets are defined as cash; obligations of, or fully guaranteed by, the United States; secured advances; mortgages, which have any guaranty, insurance, or commitment from the U.S. or any agency of the United States; investments described in Section 16(a) of the Bank Act (e.g., securities that a fiduciary or trust fund may purchase under the laws of the state in which the FHLBank is located); and other securities that are assigned a rating or assessment by an NRSRO that is equivalent or higher than the rating or assessment assigned by that NRSRO to consolidated obligations.
General Terms: Consolidated obligation bonds are issued with either fixed rate coupon or variable rate coupon payment terms. Variable rate coupon bonds use a variety of indices for interest rate resets including the London Interbank Offered Rate (LIBOR), Constant Maturity Treasuries (CMT) and Eleventh District Cost of Funds Index (COFI). In addition, to meet the specific needs of certain investors in consolidated obligation bonds, fixed rate and variable rate bonds may contain certain features that may result in complex coupon payment terms and call features. When the FHLBank issues such structured bonds that present interest rate or other risks that are unacceptable to the FHLBank, it will simultaneously enter into derivatives containing offsetting features that effectively alter the terms of the complex bonds to the equivalent of simple fixed rate coupon bonds or variable rate coupon bonds tied to indices such as those detailed above.
In addition to consolidated obligation bonds having fixed rate or simple variable rate coupon payment terms, the FHLBank also issued or had outstanding consolidated obligation bonds with the following broad terms, regarding either the principal repayment or coupon payment:
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Optional principal redemption bonds (callable bonds) that may be redeemed in whole or in part at the discretion of the FHLBank on predetermined call dates in accordance with terms of bond offerings;
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Range bonds that have coupons at fixed or variable rates and pay the fixed or variable rate as long as the index rate is within the established range, but generally pay zero percent or a minimal interest rate if the specified index rate is outside the established range;
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Step bonds that have coupons at fixed or variable rates for specified intervals over the lives of the bonds. At the end of each specified interval, the coupon rate or variable rate spread increases (decreases) or steps up (steps down). These bond issues generally contain call provisions enabling the bonds to be called at the FHLBank’s discretion on the step dates; and
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Zero coupon bonds that are long-term, discounted instruments earning fixed yields to maturity or to the optional principal redemption date. All principal and interest payments are made at bond maturity or the optional principal redemption date, if exercised by the FHLBank before bond maturity.
Redemption Terms: Following is a summary of the FHLBank’s participation in consolidated obligation bonds outstanding as of December 31, 2009 and 2008 (in thousands):
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See Note 9 for a discussion of: (1) the FHLBank’s objectives for using derivatives; (2) the types of assets and liabilities hedged; and (3) the accounting for derivatives and the related assets and liabilities hedged.
The FHLBank’s participation in consolidated obligation bonds outstanding as of December 31, 2009 and 2008 includes callable bonds totaling $8,630,400,000 and $9,850,000,000, respectively. The FHLBank uses the unswapped callable bonds for financing its callable advances (Note 7), mortgage-backed securities (Notes 4 and 6) and MPF mortgage loans (Note 8). Contemporaneous with a majority of its fixed rate callable bond issues, the FHLBank will also enter into interest rate swap agreements (in which the FHLBank generally pays a variable rate and receives a fixed rate) with call features that mirror the options in the callable bonds (a sold callable swap). The combined sold callable swap and callable debt transaction allows the FHLBank to obtain attractively priced variable rate financing.
The following table summarizes the FHLBank’s participation in consolidated obligation bonds outstanding by year of maturity, or by the next call date for callable bonds (in thousands):
Interest Rate Payment Terms: The following table summarizes interest rate payment terms for consolidated obligation bonds as of December 31, 2009 and 2008 (in thousands):
Discount Notes: The following table summarizes the FHLBank’s participation in consolidated obligation discount notes, all of which are due within one year (in thousands):
Information about the fair value of the consolidated obligations is included in Note 16.
NOTE 12 - AFFORDABLE HOUSING PROGRAM
The Bank Act, as amended by the Financial Institutions Reform, Recovery and Enforcement Act of 1989, requires each FHLBank to establish an AHP. As a part of its AHP, the FHLBank provides subsidies in the form of direct grants or below-market interest rate advances to members that use the funds to assist in the purchase, construction or rehabilitation of housing for very low-, low- and moderate-income households. By regulation, to fund the AHP, the 12 district FHLBanks as a group must annually set aside the greater of $100,000,000 or 10 percent of the current year’s net earnings after the assessment for REFCORP. For purposes of the AHP calculation, the term "net earnings" is defined as income before interest expense related to mandatorily redeemable capital stock and the assessment for AHP, but after the assessment to REFCORP. The exclusion of interest expense related to mandatorily redeemable capital stock is a regulatory calculation determined by the Finance Agency. The AHP and REFCORP assessments are calculated simultaneously because of their interdependence on each other. The FHLBank accrues this expense monthly based on its net earnings. Calculation of the REFCORP assessment is discussed in Note 13.
The amount set aside for AHP is charged to expense and recognized as a liability. As subsidies are provided through the disbursement of grants or issuance of subsidized advances, the AHP liability is reduced accordingly. If the FHLBank’s net earnings before AHP and REFCORP would ever be zero or less, the amount of AHP liability would generally be equal to zero. However, if the result of the aggregate 10 percent calculation described above is less than the $100,000,000 minimum for all 12 FHLBanks, then the Bank Act requires the shortfall to be allocated among the FHLBanks based on the ratio of each FHLBank’s income for the previous year. There was no shortfall in 2009, 2008 or 2007. If an FHLBank determines that its required AHP contributions are exacerbating any financial instability of that FHLBank, it may apply to the Finance Agency for a temporary suspension of its AHP contributions. The FHLBank has never applied to the Finance Agency for a temporary suspension of its AHP contributions.
As of December 31, 2009, the FHLBank’s AHP accrual on its Statement of Condition consisted of $27,939,000 for the 2010 AHP (uncommitted, including amounts recaptured and reallocated from prior years) and $16,178,000 for prior years’ AHP (committed but undisbursed).
The following table details the change in the AHP liability for the years ended December 31, 2009, 2008 and 2007 (in thousands):
Recaptured funds are direct grants returned to the FHLBank in those instances where the commitments associated with the approved use of funds are not met and repayment to the FHLBank is required by regulation. Recaptured funds are returned as a result of: (1) AHP-assisted homeowner’s transfer or sale of property within the five-year retention period that the assisted homeowner is required to occupy the property; (2) homeowner’s failure to acquire sufficient loan funding (funds previously approved and disbursed cannot be used); or (3) unused grants. Recaptured funds are reallocated to future periods.
NOTE 13 - RESOLUTION FUNDING CORPORATION (REFCORP)
Each FHLBank is required to pay 20 percent of income calculated in accordance with GAAP after the assessment for AHP, but before the assessment for REFCORP. The AHP and REFCORP assessments are calculated simultaneously because of their interdependence on each other. The FHLBank accrues its REFCORP assessment on a monthly basis. Calculation of the AHP assessment is discussed in Note 12. The Resolution Funding Corporation has been designated as the calculation agent for AHP and REFCORP assessments. Each FHLBank provides its interest expense related to mandatorily redeemable capital stock and net income before AHP and REFCORP assessments to the Resolution Funding Corporation, which then performs the calculations for each quarter end and levies the assessments to the FHLBanks for the quarter.
The FHLBanks will continue to expense these amounts until the aggregate amounts actually paid by all 12 FHLBanks are equivalent to a $300,000,000 annual annuity (or a scheduled payment of $75,000,000 per quarter) whose final maturity date is April 15, 2030, at which point the required payment of each FHLBank to REFCORP will be fully satisfied. The Finance Agency in consultation with the Secretary of the Treasury selects the appropriate discounting factors to be used in this annuity calculation. The FHLBanks use the actual payments made to determine the amount of the future obligation that has been defeased. The cumulative amount to be paid to REFCORP by FHLBank Topeka cannot be determined at this time because of the interrelationships of all future FHLBanks’ earnings and interest rates. If the FHLBank experienced a net loss during a quarter, but still had net income for the year, the FHLBank’s obligation to REFCORP would be calculated based on the FHLBank’s year-to-date net income. The FHLBank would be entitled to a credit against future REFCORP assessments, without any time constraints, if amounts paid for the full year were in excess of its calculated annual obligation that would be recorded in other assets on the FHLBank’s Statements of Condition. If the FHLBank had net income 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 REFCORP for the year.
The Finance Agency is required to extend the term of the FHLBanks’ obligation to REFCORP for each calendar quarter in which there is a deficit quarterly payment. A deficit quarterly payment is the amount by which the actual quarterly payment by the 12 FHLBanks falls short of $75,000,000.
The FHLBanks’ aggregate payments through 2009 exceeded the scheduled payments, effectively accelerating payment of the REFCORP obligation and shortening its remaining term to April 15, 2012, effective December 31, 2009. The FHLBanks’ aggregate payments through 2009 have satisfied $2,318,000 of the $75,000,000 scheduled payment due on April 15, 2012 and all scheduled payments thereafter. This date assumes that all $75,000,000 quarterly payments required after December 31, 2009, will be made as scheduled.
The benchmark payments or portions thereof could be reinstated if the actual REFCORP payments of the FHLBanks fall short of $75,000,000 in a quarter in the future. The maturity date of the REFCORP obligation may be extended beyond April 15, 2030, if such extension is necessary to ensure that the value of the aggregate amounts paid by the FHLBanks exactly equals a $300,000,000 annual annuity. Any payment beyond April 15, 2030 will be paid to the Department of the Treasury.
The following table details the change in the REFCORP liability for the years ended December 31, 2009, 2008 and 2007 (in thousands):
NOTE 14 - CAPITAL
The FHLBank is subject to three capital requirements (i.e., risk-based capital, total capital-to-asset ratio and leverage capital ratio) under the provisions of the Gramm-Leach-Bliley Act (GLB Act) and the Finance Agency’s capital structure regulation. The FHLBank must maintain at all times permanent capital in an amount at least equal to the sum of its credit risk, market risk and operations risk capital requirements. The risk-based capital requirements are all calculated in accordance with the rules and regulations of the Finance Agency. Only permanent capital, defined as Class B Common Stock and retained earnings, can be used by the FHLBank to satisfy its risk-based capital requirement. The Finance Agency may require the FHLBank to maintain a greater amount of permanent capital than is required by the risk-based capital requirement as defined, but the Finance Agency has not placed any such requirement on the FHLBank to date. In addition, the GLB Act requires the FHLBank to maintain at all times at least a 4.0 percent total capital-to-asset ratio and at least a 5.0 percent leverage capital ratio, with the leverage capital ratio defined as the sum of permanent capital weighted 1.5 times and non-permanent capital (currently only Class A Common Stock) weighted 1.0 times divided by total assets.
The following table illustrates that the FHLBank was in compliance with its regulatory capital requirements as of December 31, 2009 and 2008 (in thousands):
Note that for the purposes of the regulatory capital calculations in the above table, actual capital includes all capital stock subject to mandatory redemption that has been reclassified to a liability.
The FHLBank offers two classes of stock, Class A Common Stock and Class B Common Stock. Each member is required to hold capital stock to become and remain a member of the FHLBank (Asset-based Stock Purchase Requirement; Class A Common Stock) and enter into specified activities with the FHLBank including but not limited to access to the FHLBank’s credit products and selling AMA to the FHLBank (Activity-based Stock Purchase Requirement; Class A Common Stock to the extent of a member’s Asset-based Stock Purchase Requirement, then Class B Common Stock for the remainder). The amount of Class A Common Stock a member must acquire and maintain is the Asset-based Stock Purchase Requirement, which is equal to 0.2 percent of a member’s total assets as of December 31 of the preceding calendar year, with a minimum requirement of $1,000, and a maximum requirement of $1,000,000. The amount of Class B Common Stock a member must acquire and maintain is the Activity-based Stock Purchase Requirement, which is equal to the sum of the following less the member’s Asset-based Stock Purchase Requirement:
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5.0 percent of the principal amount of advances outstanding to the member; plus
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2.0 percent of the current outstanding principal balance of AMA originated by or through the member and acquired by the FHLBank subject to a maximum AMA requirement of 1.5 percent of the member’s total assets as of December 31 of the preceding calendar year; plus
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0 percent of the principal amount of letters of credit outstanding at the request of the member; plus
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0 percent of the notional principal of any outstanding derivatives with the member.
The percentages listed above are subject to change by the FHLBank within ranges established in its capital plan. Changes to the percentages outside of the capital plan percentages require the FHLBank to request Finance Agency approval of an amended capital plan. See Note 18 for detailed information on transactions with related parties.
Any member may make a written request not in connection with a notice of withdrawal or attaining nonmember status for the redemption of a part of its Class A Common Stock or all or part of its Class B Common Stock (i.e., excess stock redemption request). Within five business days of receipt of a member’s written redemption request, the FHLBank may notify the member that it declines to repurchase the excess stock before the end of that five business day period, at which time the applicable redemption period shall commence. Otherwise, the FHLBank will repurchase any excess stock within the five business day period. The redemption periods are six months for Class A Common Stock and five years for Class B Common Stock. Subject to certain limitations, the FHLBank may choose to repurchase a member’s excess stock on or before the end of the applicable redemption period.
The GLB Act made membership voluntary for all members. As outlined in the FHLBank’s capital plan, members that withdraw from membership must wait five years from the divestiture date for all capital stock that is held as a condition of membership (Class A Common Stock up to member’s Asset-based Stock Purchase Requirement), unless the member cancels its notice of withdrawal prior to that date, before being readmitted to membership in any FHLBank.
The FHLBank’s board of directors may declare and pay non-cumulative dividends, expressed as a percentage rate per annum based upon the par value of capital stock on shares of Class A Common Stock outstanding and on shares of Class B Common Stock outstanding, out of previously retained earnings and current earnings in either cash or Class B Common Stock. There is no dividend preference between Class A Common Stockholders and Class B Common Stockholders up to the Dividend Parity Threshold (DPT). Dividend rates in excess of the DPT may be paid on Class A Common Stock or Class B Common Stock at the discretion of the board of directors, provided, however, that the dividend rate paid per annum on the Class B Common Stock equals or exceeds the dividend rate per annum paid on the Class A Common Stock for any dividend period. The DPT can be changed at any time by the board of directors but will only be effective for dividends paid at least 90 days after the date members are notified by the FHLBank. The DPT effective for dividends paid during the first three quarters of 2007 was equal to the average of three-month LIBOR for a dividend period minus 100 basis points. In September 2007, the board of directors changed the DPT to be equal to the average overnight Federal funds effective rate minus 100 basis points. This DPT was effective for dividends paid during the fourth quarter of 2007 and all of 2008 and 2009 and will continue to be effective until such time as it may be changed by the FHLBank’s board of directors. When the overnight Federal funds effective rate is below 1.00 percent, the DPT is zero percent for that dividend period (DPT is floored at zero).
The board of directors cannot declare a dividend if: (1) the FHLBank’s capital position is below its minimum regulatory capital requirements; (2) the FHLBank’s capital position will be below its minimum regulatory capital requirements after paying the dividend; (3) the principal or interest due on any consolidated obligation of the FHLBank has not been paid in full; (4) the FHLBank fails to provide the Finance Agency the quarterly certification prior to declaring or paying dividends for a quarter; or (5) the FHLBank fails to provide notification upon its inability to provide such certification or upon a projection that 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.
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. 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. After the reclassification, dividends on the capital stock would no longer be classified as interest expense. For the years ended December 31, 2009, 2008 and 2007, dividends on mandatorily redeemable capital stock in the amount of $504,000, $609,000 and $2,101,000, respectively, were recorded as interest expense.
As of December 31, 2009 and 2008, the FHLBank had $22,437,000 and $34,806,000, respectively, in capital stock subject to mandatory redemption from members and former members, consisting of $18,514,000 and $34,726,000, respectively, of Class A Common Stock and $3,923,000 and $80,000, respectively, of Class B Common Stock. These amounts have been classified as a liability (mandatorily redeemable capital stock) in the Statements of Condition.
The Finance Agency issued a regulatory interpretation confirming that the mandatorily redeemable capital stock accounting treatment for certain shares of FHLBank capital stock does not affect the definition of regulatory capital for purposes of determining the FHLBank’s compliance with its regulatory capital requirements, calculating its mortgage securities investment authority (various percentages of total FHLBank capital depending on the date acquired), calculating its unsecured credit exposure to other GSEs (100 percent of total FHLBank capital) or calculating its unsecured credit limits to other counterparties (various percentages of total FHLBank capital depending on the rating of the counterparty).
The following table shows the amount of mandatorily redeemable capital stock by year of redemption as of December 31, 2009 and 2008 (in thousands). The year of redemption in the table is the later of the end of the redemption period or the maturity date of the activity the stock is related to if the capital stock represents the Activity-based Stock Purchase Requirement for a non-member (former member that withdrew from membership, merged into a non-member or was otherwise acquired by a non-member). The FHLBank will not redeem or repurchase membership stock (Asset-based Stock Purchase Requirement held in form of Class A Common Stock) until six months after the FHLBank receives notice for withdrawal. The FHLBank is not required to redeem or repurchase activity-based stock until any activity-based stock becomes excess stock as a result of an activity no longer remaining outstanding. However, the FHLBank intends to repurchase the excess activity-based stock of non-members to the extent that it can do so and still meet its regulatory capital requirements.
The FHLBank’s activity for mandatorily redeemable capital stock was as follows during 2009, 2008 and 2007 (in thousands).
A member may cancel or revoke its written redemption request prior to the end of the redemption period (six months for Class A Common Stock and five years for Class B Common Stock) or its written notice of withdrawal from membership prior to the end of a six-month period starting on the date the FHLBank received the member’s written notice of withdrawal from membership. At the end of the six-month period, the member’s membership is terminated and the Class A Common Stock held to meet its Asset-based Stock Purchase Requirement will be redeemed by the FHLBank, as long as the FHLBank will continue to meet its regulatory capital requirements and as long as the Class A Common Stock is not needed to meet the former member’s Activity-based Stock Purchase Requirements. The FHLBank’s capital plan provides that the FHLBank will charge the member a cancellation fee in accordance with a schedule where the amount of the fee increases with the passage of time, the fee being 1.0 percent for any Class A Common Stock cancellation and starting at 1.0 percent in year one for Class B Common Stock and increasing by 1.0 percent each year to a maximum of 5.0 percent for cancellations in the fifth year for Class B Common Stock. During the year ended December 31, 2009, the FHLBank received two withdrawal requests due to submission of voluntary membership withdrawals. Additionally, the FHLBank’s Board of Directors terminated the memberships of eight members after their placement into FDIC receivership. During 2009, two members cancelled their membership withdrawal requests within the initial six-month notice period: one who submitted a withdrawal request in 2008, and one who submitted a withdrawal request in 2009. Upon notification of cancellation, the members’ stock was reclassified from mandatorily redeemable capital stock to equity. As of December 31, 2009, the balance of mandatorily capital stock represented two former members in FDIC receivership and twelve out-of-district mergers.
Excess Capital Stock. Excess capital stock is defined as the amount of stock held by a member (or former member) in excess of that institution’s minimum stock purchase requirement. Finance Agency rules limit the ability of the 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 the FHLBank’s 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. As of December 31, 2009, the FHLBank’s excess stock was less than one percent of total assets.
Statutory and Regulatory Restrictions on Capital Stock Redemption: In accordance with the GLB Act, each class of FHLBank capital stock is considered putable with restrictions given the significant restrictions on the obligation/right to redeem and the limitation of the redemption privilege to a small fraction of outstanding capital stock. Statutory and regulatory restrictions on the redemption of FHLBank capital stock include the following:
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In no instance may the FHLBank redeem any capital stock if, following such redemption, the FHLBank would fail to satisfy its minimum regulatory capital requirements (i.e., the statutory risk-based capital requirement and the total capital and weighted leverage ratio requirements established by the GLB Act and by the Finance Agency, all three of which were discussed previously). By law, all member holdings of FHLBank capital stock immediately become non-redeemable if their FHLBank becomes undercapitalized and, at the macro level, only a minimal portion of outstanding stock qualifies for redemption consideration.
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In no instance may the FHLBank redeem any capital stock if either its board of directors or the Finance Agency determines that it has incurred, or is likely to incur, losses resulting, or expected to result, in a charge against capital.
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In addition to possessing the authority to prohibit capital stock redemptions, the FHLBank’s board of directors has a right and an obligation to call for additional capital stock purchases by its members, as a condition of membership, as needed to satisfy statutory and regulatory capital requirements. These requirements include the maintenance of a stand-alone “AA” credit rating from an NRSRO.
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If, during the period between receipt of a capital stock redemption notification or request from a member and the actual redemption (which lasts indefinitely if the FHLBank is undercapitalized, does not have the required credit rating, etc.), the FHLBank becomes insolvent and is either liquidated or forced to merge with another FHLBank, the redemption value of the capital stock will be established either through the market liquidation process or through negotiation with a merger partner. In either case, all senior claims must first be settled at par, and there are no claims which are subordinated to the rights of the FHLBank stockholders.
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The GLB Act states that the FHLBank may repurchase, at its sole discretion, capital stock that exceeds the required minimum stock purchase requirements as long as the FHLBank continues to meet its regulatory capital requirements.
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In no instance may the FHLBank redeem any capital stock if the principal or interest due on any consolidated obligation issued by the Office of Finance has not been paid in full.
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In no instance may the FHLBank redeem any capital stock if it fails to provide the Finance Agency quarterly certification required by section 966.9(b)(1) of the Finance Agency’s rules prior to declaring or paying dividends for a quarter.
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In no case may the FHLBank redeem any capital stock if the FHLBank is unable to provide the required certification, projects that it will fail to comply with statutory or regulatory liquidity requirements or will be unable to timely and fully meet all its obligations, actually fails to satisfy these requirements or obligations, or negotiates to enter or enters into an agreement with another FHLBank to obtain financial assistance to meet its current obligations.
NOTE 15 - EMPLOYEE RETIREMENT PLANS
The FHLBank participates in the Pentegra Defined Benefit Plan for Financial Institutions (Pentegra Defined Benefit Plan), a tax-qualified defined-benefit pension plan, formerly known as the Financial Institutions Retirement Fund. Substantially all officers and employees of the FHLBank, which began employment prior to January 1, 2009, are covered by the plan. Funding and administrative costs of the Pentegra Defined Benefit Plan charged to compensation and benefits expense were $2,917,000, $2,008,000 and $2,494,000 in 2009, 2008 and 2007, respectively. The Pentegra Defined Benefit Plan is a multiemployer plan and does not segregate its assets, liabilities or costs by participating employer. As a result, disclosure of the accumulated benefit obligations, plan assets and the components of annual pension expense attributable to the FHLBank cannot be made.
The FHLBank also participates in the Pentegra Defined Contribution Plan for Financial Institutions, a tax-qualified defined contribution pension plan, formerly known as the Financial Institutions Thrift Plan. Substantially all officers and employees of the FHLBank are covered by the plan. The FHLBank contributes a matching amount equal to a percentage of voluntary employee contributions, subject to certain limitations. The FHLBank’s contributions of $697,000, $671,000 and $569,000 to the Pentegra Defined Contribution Plan in 2009, 2008 and 2007, respectively, were charged to compensation and benefits expense.
In addition, the FHLBank maintains a benefit equalization plan (BEP) covering certain senior officers. This non-qualified plan contains provisions for a deferred compensation component and a defined benefit pension component. The BEP is, in substance, an unfunded supplemental retirement plan. The cost of the defined benefit pension component of the BEP charged to compensation and benefits expense was $751,000, $769,000 and $771,000 in 2009, 2008 and 2007, respectively. Compensation and benefits expense and other interest expense includes deferred compensation and accrued earnings under the BEP of $369,000, $254,000 and $225,000 in 2009, 2008 and 2007, respectively.
As indicated previously, the BEP is a supplemental retirement plan for covered retirees. There are no funded plan assets that have been designated to provide for the deferred compensation component or defined benefit pension component of the BEP. The obligations and funding status of the defined benefit portion of the FHLBank’s BEP as of December 31, 2009 and 2008 were as follows (in thousands):
The following table details the change in the Accumulated OCI balances related to the defined benefit portion of the FHLBank’s BEP for the years ended December 31, 2009 and 2008 (in thousands):
Components of the net periodic pension cost for the defined benefit portion of the FHLBank’s BEP for the years ended December 31, 2009, 2008 and 2007, were (in thousands):
The measurement date used to determine the current year’s benefit obligation was December 31, 2009.
Key assumptions and other information for the actuarial calculations for the defined benefit portion of the FHLBank’s BEP for the years ended December 31, 2009, 2008 and 2007 were (dollar amounts in thousands):
The estimated actuarial (gain) loss and prior service cost that will be amortized from Accumulated OCI into net periodic benefits costs over the next fiscal year are (in thousands):
The FHLBank estimates that its required contributions to the defined benefit portion of the FHLBank’s BEP for the year ended December 31, 2010 will be $265,000.
The estimated benefits to be paid by the FHLBank under the defined benefit portion of the BEP for the next five fiscal years and the combined five fiscal years thereafter are provided in the following table (in thousands):
NOTE 16 - FAIR VALUES
The FHLBank records trading securities, derivative assets and derivative liabilities at fair value. Fair value is a market-based measurement and is defined as the price that would be received to sell an asset, or paid to transfer a liability, in an orderly transaction between market participants at the measurement date. The transaction to sell the asset or transfer the liability is a hypothetical transaction at the measurement date, considered from the perspective of a market participant that holds the asset or owes the liability. In general, the transaction price will equal the exit price and, therefore, represents the fair value of the asset or liability at initial recognition. In determining whether a transaction price represents the fair value of the asset or liability at initial recognition, each reporting entity is required to consider factors specific to the asset or liability, the principal or most advantageous market for the asset or liability, and market participants with whom the entity would transact in that market.
Fair Value Hierarchy. The fair value hierarchy is used to prioritize the inputs of valuation techniques used to measure fair value. The inputs are evaluated and an overall level for the fair value measurement is determined. This overall level is an indication of the market observability of the fair value measurement. Fair value is the price in an orderly transaction between market participants to sell an asset or transfer a liability in the principal (or most advantageous) market for the asset or liability at the measurement date (an exit price). In order to determine the fair value or the exit price, entities must determine the unit of account, highest and best use, principal market and market participants. These determinations allow the reporting entity to define the inputs for fair value and level of hierarchy.
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.
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Level 1 - inputs to the valuation methodology are quoted prices (unadjusted) for identical assets or liabilities in active markets. An active market for the asset or liability is a market in which the transactions for the asset or liability occur with sufficient frequency and volume to provide pricing information on an ongoing basis.
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Level 2 - inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets, and inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the financial instrument. The types of assets and liabilities carried at Level 2 fair value generally include trading investment securities and derivative contracts.
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Level 3 - inputs to the valuation methodology are unobservable and significant to the fair value measurement. A significant portion of the unobservable inputs are supported by little or no market activity and reflect the entity’s own assumptions. The types of assets and liabilities carried at Level 3 fair value generally include private-label MBS that the FHLBank has determined to be OTTI.
The FHLBank utilizes valuation techniques that maximize the use of observable inputs and minimize the use of unobservable inputs. Fair value is first determined based on quoted market prices or market-based prices, where available. If quoted market prices or market-based prices are not available, fair value is determined based on valuation models that use market-based information available to the FHLBank as inputs to the models.
Fair Value on a Recurring Basis. The following table presents, for each hierarchy level, the FHLBank’s assets and liabilities that are measured at fair value on a recurring basis on the Statement of Condition as of December 31, 2009 (in thousands):
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See Note 19 for transactions with other FHLBanks.
Fannie Mae and Freddie Mac are GSEs. Both entities were placed into conservatorship by the Finance Agency on September 7, 2008.
Ginnie Mae securities are guaranteed by the U.S. government.
The following table presents, for each hierarchy level, the FHLBank’s assets and liabilities that are measured at fair value on a recurring basis on the Statement of Condition as of December 31, 2008 (in thousands):
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, if any, are reported as transfers in/out of Level 3 at fair value in the quarter in which the changes occur. The FHLBank had no financial assets or liabilities measured on a recurring basis at Level 3 fair value as of December 31, 2009.
Fair Value on a Nonrecurring Basis. The FHLBank measures certain held-to-maturity securities and mortgage loans (including real estate owned) at fair value on a nonrecurring basis. These assets are not measured at fair value on an ongoing basis, but are subject to fair value adjustments only in certain circumstances (i.e., when there is evidence of OTTI).
The following table presents these assets by level within the valuation hierarchy, for which a nonrecurring change in fair value has been recorded (in thousands):
Although the FHLBank recognized OTTI on three held-to-maturity securities during the year ended December 31, 2009, none of these securities were recorded at fair value as of December 31, 2009. At the dates of impairment, these held-to-maturity securities were measured at Level 3 fair value. OTTI charges for which a fair value adjustment has been included in the Statement of Income for the year ended December 31, 2009 are summarized in Note 6.
The FHLBank recognized an other-than-temporary impairment charge as of December 31, 2008. The following table presents the investment securities by level within the valuation hierarchy, for which a nonrecurring change in fair value was recorded (in thousands):
OTTI charges for which a fair value adjustment has been included in the Statement of Income for the year ended December 31, 2008 are summarized in Note 6.
Fair Values. The following fair value amounts have been determined by the FHLBank using available market information and the FHLBank’s best judgment of appropriate valuation methodologies. These fair values are based on pertinent information available to the FHLBank as of December 31, 2009 and 2008. Although the FHLBank uses its best judgment in estimating the fair value of these financial instruments, there are inherent limitations in any estimation technique or valuation methodology. For example, because an active secondary market does not exist for a portion of the FHLBank’s financial instruments, fair values in certain cases are not subject to precise quantification or verification and may change as economic and market factors and evaluation of those factors change. Therefore, these fair values are not necessarily indicative of the amounts that would be realized in current market transactions, although they do reflect the FHLBank’s judgment of how a market participant would estimate the fair values. The Fair Value Summary Tables do 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.
Subjectivity of Estimates. Estimates of the fair value of advances with options, mortgage instruments, derivatives with embedded options and consolidated obligation bonds with options using the methods described below and other methods are highly subjective and require judgments regarding significant matters such as the amount and timing of future cash flows, prepayment speed assumptions, expected interest rate volatility, methods to determine possible distributions of future interest rates used to value options, and the selection of discount rates that appropriately reflect market and credit risks. Changes in these judgments often have a material effect on fair values. Since these fair values are determined as of a specific point in time, they are susceptible to material near term changes.
Cash and Due From Banks: The fair values approximate the recorded book balances.
Interest-bearing Deposits: The balance is comprised of interest-bearing deposits in banks. Based on the nature of the accounts, the recorded book value approximates the fair value.
Federal Funds Sold: The book value of overnight Federal funds approximates fair value, and term Federal funds are valued using projected future cash flows discounted at the current replacement rate.
Investment Securities: The fair values of investments are determined based on quoted prices, excluding accrued interest, as of the last business day of each period. Certain investments for which quoted prices are not readily available are valued by third parties or by using internal pricing models using the assumptions in the following table:
Investment Type
Method of Valuation
Certificates of deposit
Estimated cash flows discounted at the certificate of deposit market replacement rate based on tenor.
Commercial paper
Estimated cash flows discounted at the commercial paper market replacement rate based on tenor.
FHLBank obligations
Fair value is derived from market trades or quotes for similar securities or estimated cash flows incorporating estimates of future interest rate volatility, if applicable, and discounted using the estimated replacement rate based upon tenor for issuing debt for the FHLBank System.
Fannie Mae obligations and Freddie Mac obligations
Fair value is derived from market trades or quotes for similar securities or estimated cash flows incorporating estimates of future interest rate volatility, if applicable, and discounted using the estimated replacement rate based upon tenor for issuing debt for Fannie Mae and Freddie Mac.
State or local housing agencies
Fair value is derived from market trades or quotes for similar securities.
Mortgage-backed securities
Fair value is derived from market trades or quotes for similar securities or estimated cash flows incorporating actual specific collateral performance, estimates of future specific collateral performance, estimates of future interest rate volatility, and issuer credit indications, if applicable, and discounted using the adjusted benchmark tranche yield. The FHLBank changed the technique used to estimate the fair value of MBS during the quarter ended September 30, 2009. Under the new methodology, the FHLBank requests prices for all MBS from four specific third-party vendors, and, depending on the number of prices received for each security, selects a median or average price as defined by the methodology. The methodology also incorporates variance thresholds to assist in identifying median or average prices that may require further review. In certain limited instances (i.e., prices are outside of variance thresholds or the third-party services do not provide a price), the FHLBank will obtain a price from securities dealers or internally model a price that is deemed most appropriate after consideration of all relevant facts and circumstances that would be considered by market participants. This change in pricing technique did not have a significant impact on the fair values of the FHLBank’s MBS.
Advances: The fair values of advances are determined by calculating the present values of the expected future cash flows from the advances. The calculated present values are reduced by the accrued interest receivable. The discount rate used in the variable rate advance calculations was current LIBOR. The discount rates used in the fixed rate advance calculations were the replacement advance rates with no distinction for volume discounts.
Advance Type
Method of Valuation
Fixed rate non-callable and fixed rate callable advances
Valued using discounted cash flows incorporating estimates of future interest rate volatility, if applicable, and discounted using advance replacement rates with no distinction for volume discounts.
Fixed rate convertible and step-up advances
Valued using discounted cash flows incorporating estimates of future interest rate volatility and discounted using LIBOR adjusted for spread to LIBOR on advance replacement rates with no distinction for volume discounts.
All other advances
Valued using discounted cash flows incorporating estimates of future interest rate volatility, if applicable, and discounted using LIBOR.
Mortgage Loans Held for Portfolio: Fair values are determined based on quoted market prices of similar mortgage loans. These prices, however, can change rapidly based upon market conditions and are highly dependent upon the underlying prepayment assumptions.
Commitments to Extend Credit: The fair values of the FHLBank’s commitments to extend credit are estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present creditworthiness of the counterparties. For fixed rate mortgage loan commitments, fair value also considers any difference between current levels of interest rates and the committed rates. Certain mortgage loan purchase commitments are recorded as derivatives at their fair values. With one particular MPF product, the member originates mortgage loans as an agent for the FHLBank, and the FHLBank funds to close the mortgage loans. The commitments that unconditionally obligate the FHLBank to fund the mortgage loans related to this product are not considered derivatives. Their fair values were negligible as of December 31, 2009 and 2008.
Accrued Interest Receivable and Payable: The fair values approximate the recorded book balances.
Derivative Assets/Liabilities: The FHLBank bases the fair values of derivatives on instruments with similar terms or available market prices including accrued interest receivable and payable. The fair values are based on the LIBOR swap curve and forward rates at period end and, for agreements containing options, the market’s expectations of future interest rate volatility implied from current market prices of similar options. The fair values use standard valuation techniques for derivatives, such as discounted cash flow analysis and comparisons to similar instruments. The FHLBank is subject to credit risk in derivative transactions because of the potential nonperformance by the derivative counterparties. To mitigate this risk, the FHLBank enters into master netting agreements for derivative agreements with highly-rated institutions. In addition, the FHLBank has entered into bilateral security agreements with all active derivative dealer counterparties. These agreements provide for delivery of collateral at specified levels tied to counterparty credit ratings to limit the FHLBank’s net unsecured credit exposure to these counterparties. 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 of derivatives. The derivative fair values are netted by counterparty where such legal right exists and offset against fair value amounts recognized for the obligation to return cash collateral held or the right to reclaim cash collateral pledged to the particular counterparty. If these netted amounts are positive, they are classified as an asset and, if negative, a liability.
Deposits: The fair values of deposits are determined by calculating the present values of the expected future cash flows from the deposits, regardless of re-pricing or maturity. The calculated present values are reduced by the accrued interest payable. The discount rates used in these calculations were the cost of deposits with similar terms.
Consolidated Obligations: The fair values for consolidated obligation bonds and discount notes are determined based on projected future cash flows. Fixed rate consolidated obligations that do not contain options are discounted using a replacement rate. Variable rate consolidated obligations that do not contain options are discounted using LIBOR. Consolidated obligations that contain optionality are valued using estimates of future interest rate volatility and discounted using LIBOR.
Mandatorily Redeemable Capital Stock: The fair value of capital stock subject to mandatory redemption is generally at par value. Fair value also includes estimated dividends earned at the time of reclassification from equity to liabilities, until such amount is paid, and any subsequently declared stock dividend. FHLBank Topeka’s dividends are declared and paid at each quarter end; therefore, fair value equaled par value as of the end of the periods presented. Stock can only be acquired by members at par value and redeemed or repurchased at par value. Stock is not traded and no market mechanism exists for the exchange of stock outside the cooperative structure.
Standby Letters of Credit: The fair values of standby letters of credit are based on the present value of fees currently charged for similar agreements. The value of these guarantees is recognized and recorded in other liabilities.
Standby Credit Facility: The fair value of the FHLBank’s commitments to extend credit through the SCF product outstanding as of December 31, 2008 was based on the present value of future fees on existing agreements with fees determined using rates currently charged for similar agreements. The value of these commitments to extend credit through the SCF product was recognized and recorded in other liabilities as of December 31, 2008.
Standby Bond Purchase Agreements: The fair values of the standby bond purchase agreements are estimated using the present value of the future fees on existing agreements with fees determined using rates currently charged for similar agreements.
The carrying value, net unrealized gains (losses) and fair values of the FHLBank’s financial instruments as of December 31, 2009 are summarized in the following table (in thousands):
The carrying value, net unrealized gains (losses) and fair values of the FHLBank’s financial instruments as of December 31, 2008 are summarized in the following table (in thousands):
NOTE 17 - COMMITMENTS AND CONTINGENCIES
As provided by the Bank Act or Finance Agency regulation and as described in Note 11, consolidated obligations are backed only by the financial resources of the FHLBanks. FHLBank Topeka is jointly and severally liable with the other 11 FHLBanks for the payment of principal and interest on all of the consolidated obligations issued by the FHLBanks. The par amounts for which FHLBank Topeka is jointly and severally liable were approximately $891,666,741,000 and $1,198,203,815,000 as of December 31, 2009 and 2008, respectively. To the extent that an FHLBank makes any consolidated obligation payment on behalf of another FHLBank, the paying FHLBank is entitled to reimbursement from the FHLBank with primary liability. However, if the Finance Agency determines that the primary obligor is unable to satisfy its obligations, then the Finance Agency may allocate the outstanding liability among the remaining FHLBanks on a pro rata basis in proportion to each FHLBank’s participation in all consolidated obligations outstanding, or on any other basis that the Finance Agency may determine. No FHLBank has ever failed to make any payment on a consolidated obligation for which it was the primary obligor. As a result, the regulatory provisions for directing other FHLBanks to make payments on behalf of another FHLBank or allocating the liability among other FHLBanks have never been invoked.
The joint and several obligations are mandated by Finance Agency regulations and are not the result of arms-length transactions among the FHLBanks. As described above, 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 liability. Because the FHLBanks are subject to the authority of the Finance Agency as it relates to decisions involving the allocation of the joint and several liability for the FHLBank’s consolidated obligations, the FHLBank Topeka regularly monitors the financial condition of the other 11 FHLBanks to determine whether it should expect a loss to arise from its joint and several obligations. If the FHLBank were to determine that a loss was probable and the amount of such loss could be reasonably estimated, the FHLBank would charge to income the amount of the expected loss. Based upon the creditworthiness of the other 11 FHLBanks as of December 31, 2009, FHLBank Topeka believes that a loss accrual is not necessary at this time.
During the third quarter of 2008, each FHLBank entered into a Lending Agreement with the U.S. Treasury in connection with the U.S. Treasury’s establishment of the Government Sponsored Enterprise Credit Facility (GSECF), as authorized by the Recovery Act. The GSECF was designed to serve as a contingent source of liquidity for the housing government-sponsored enterprises, including each of the 12 FHLBanks. Any borrowings by one or more of the FHLBanks under the GSECF would have been considered obligations with the same joint and several liability as all other consolidated obligations. The terms of the borrowings would have been agreed to at the time of issuance. Loans under the Lending Agreement were to be secured by collateral acceptable to the U.S. Treasury, which consists of FHLBank advances to members that had been collateralized in accordance with regulatory standards and MBS issued by Fannie Mae or Freddie Mac. Each FHLBank was required to submit to the Federal Reserve Bank of New York, acting as fiscal agent of the U.S. Treasury, a weekly list of eligible advance collateral based upon the Lending Agreement. The amount of collateral was subject to increase or decrease (subject to the approval of the U.S. Treasury) at any time through the delivery of an updated listing of advance collateral held by the FHLBank as borrower-in-custody or through the delivery of MBS issued by Fannie Mae or Freddie Mac to a custodial National Book Entry System account established through the Federal Reserve Bank of New York for the benefit of the Treasury. The GSECF expired on December 31, 2009 with no FHLBank having ever drawn on this available source of liquidity.
Standby credit facility (SCF) commitments that legally bind and unconditionally obligate the FHLBank for additional advances to stockholders totaled $0 and $1,000,000,000 as of December 31, 2009 and 2008, respectively. SCF commitments are executed for members for a fee and are for terms of one year. Standby letters of credit are executed for members for a fee. A standby letter of credit is a short-term financing arrangement between the FHLBank and its member or non-member housing associate. If the FHLBank is required to make payment for a beneficiary’s draw, these amounts are converted into a collateralized advance to the member. As of December 31, 2009, outstanding standby letters of credit totaled $3,093,204,000 and had original terms of six days to seven years with a final expiration in 2013. As of December 31, 2008, outstanding standby letters of credit totaled $2,751,362,000 and had original terms of seven days to seven years with a final expiration in 2013. Unearned fees as well as the value of the guarantees related to standby letters of credit are recorded in other liabilities and amounted to $1,213,000 and $1,321,000 as of December 31, 2009 and 2008, respectively. The standby letters of credit are fully collateralized with assets allowed by the FHLBank’s Member Products Policy (MPP). Based upon management’s credit analysis of members and collateral requirements under the MPP, the FHLBank does not expect to incur any credit losses on the letters of credit.
Commitments that unconditionally obligate the FHLBank to fund/purchase mortgage loans from participating FHLBank Topeka members in the MPF Program totaled $35,364,000 and $141,357,000 as of December 31, 2009 and 2008, respectively. Commitments are generally for periods not to exceed 60 calendar days. Certain commitments are recorded as derivatives at their fair values on the Statement of Condition. The FHLBank recorded mortgage delivery commitment derivative asset (liability) balances of $(312,000) and $(1,539,000) as of December 31, 2009 and 2008, respectively. With one particular MPF product, the member originates mortgage loans as an agent for the FHLBank, and the FHLBank provides funds to close the mortgage loans. The commitments that unconditionally obligate the FHLBank to fund the mortgage loans related to this product are not considered derivatives. There were $2,128,000 outstanding commitments for this product as of December 31, 2009.
The total FLA, which represents commitments that unconditionally obligate the FHLBank to absorb credit losses associated with PFI master commitments (mortgage loan pools), amounted to $17,344,000 and $14,669,000 as of December 31, 2009 and 2008, respectively. Under the MPF Program, the first layer of credit loss is absorbed by the equity of the borrower in the real estate securing the loan. As is customary for conventional mortgage loans, primary mortgage insurance (PMI) is required for MPF loans with down payments of less than 20 percent of the property value in order to raise the effective equity level to at least 20 percent. Losses beyond the equity layer are absorbed by the FHLBank up to the FLA predefined limit for a pool of mortgage loans. If losses beyond this layer are incurred for the pool of mortgage loans, the losses are absorbed through the CE obligation for the pool of mortgage loans provided by the PFI that sold the mortgage loans to the FHLBank. The CE obligation provided by a PFI ensures that the PFI retains a credit stake in the loans it sells to the FHLBank. For managing this risk, the FHLBank pays CE fees to the PFI. The size of each PFI’s CE obligation is generally calculated on pools of mortgage loans sold into the MPF Program by the PFI so that the likelihood of losses on the pool in excess of the second layer is the same as the likelihood of losses for an investor in a AA-rated MBS. As a result of the protection afforded by these procedures, and its credit loss experience through December 31, 2009, the FHLBank anticipates its total exposure to absorbing probable FLA losses related to the MPF Program as of December 31, 2009 will not exceed its allowance for credit losses, which was $1,897,000 as of December 31, 2009.
The FHLBank has entered into standby bond purchase agreements with state housing authorities within its four-state district whereby the FHLBank, for a fee, agrees to purchase and hold the authorities’ bonds until the designated marketing agent can find a suitable investor or the housing authority repurchases the bond according to a schedule established by the standby agreement. Each standby agreement dictates the specific terms that would require the FHLBank to purchase the bond. The bond purchase commitments entered into by the FHLBank expire no later than 2015, though some are renewable at the option of the FHLBank. Total commitments for bond purchases with two state housing authorities were $1,617,134,000 and $1,311,906,000 as of December 31, 2009 and 2008, respectively. The FHLBank was required to purchase $193,730,000 in bonds under these agreements during 2008. These bonds were classified as AFS securities, and were acquired at par and sold at par. The FHLBank was not required to purchase any bonds under these agreements during 2009. The fair values of standby bond purchase agreements as of December 31, 2009 and 2008 are reported in Note 16.
The FHLBank generally executes derivatives with counterparties having ratings of single-A or better by either Standard & Poor’s or Moody’s. These agreements are generally covered under bilateral collateral agreements between the FHLBank and the counterparties. As of December 31, 2009 and 2008, the FHLBank had delivered cash with a book value of $93,050,000 and $245,600,000, respectively, as collateral to broker/dealers that have market-risk exposure to the FHLBank. The delivered collateral is netted against derivative liabilities on the Statements of Condition.
As of December 31, 2009, the FHLBank committed to enter into the sale of consolidated obligation discount notes and bonds at par amounts of $750,000,000 and $485,000,000, respectively, with January 2010 settlement dates.
Net rental costs under operating leases of approximately $93,000, $94,000 and $101,000 in 2009, 2008 and 2007, respectively, for premises and equipment have been charged to other operating expenses. Future minimum net rentals are summarized in the following table (in thousands):
During 2002, the FHLBank entered into a 20-year direct financing lease with a member for a building complex and property. In conjunction with this lease transaction, the FHLBank acquired $50,000,000 in industrial revenue bonds (IRBs) from the City of Topeka, which are collateralized by the building complex and property. The IRBs are recorded in other assets. The FHLBank is leasing the building complex and property from the City of Topeka for a period of 10 years. The IRBs have a maturity of 10 years with interest, principal amounts and payment dates that correspond to the FHLBank’s lease with the City of Topeka. All rental payments flow from the FHLBank through a trustee, and the FHLBank receives payments on the IRBs. The present value of the net minimum lease payments under this capital lease with the City of Topeka is recorded in other liabilities. The FHLBank is leasing the portion of the property and building occupied by the member back to the member under a 20-year direct financing lease. Either party has the option to terminate this lease after 15 years. The net investment in the direct financing lease with the member is recorded in other assets. The FHLBank’s $7,896,000 up-front payment for its portion of the building complex is recorded in premises, software and equipment. On October 31, 2005, the FHLBank amended its lease to occupy additional building space, thereby reducing the portion of the property previously leased back to the member and decreasing the member’s future lease payments. All other provisions of the original lease remain in effect. The net reduction in the lease receivable is recorded in premises, software and equipment.
The following table shows the future minimum lease receivable under the direct financing lease, as amended, with the member and future minimum lease payment obligation under the capital lease with the City of Topeka as of December 31, 2009 (in thousands):
Unearned income on the direct financing lease is recognized in such a manner as to produce a constant periodic rate of return on the net investment in the direct financing lease.
The FHLBank acts as a securities safekeeping custodian on behalf of participating members. Actual securities are held by a third-party custodian acting as agent for the FHLBank. As of December 31, 2009, the total original par value of customer securities held by the FHLBank under this arrangement was $52,583,622,000.
The FHLBank is subject to 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.
Other commitments and contingencies are discussed in Notes 1, 7, 8, 9, 11, 12, 13, 14 and 15.
NOTE 18 - TRANSACTIONS WITH STOCKHOLDERS AND HOUSING ASSOCIATES
The FHLBank is a cooperative whose members own the capital stock of the FHLBank and generally receive dividends on their investments. In addition, certain former members that still have outstanding transactions are also required to maintain their investments in FHLBank capital stock until the transactions mature or are paid off. Nearly all outstanding advances are with current members, and the majority of outstanding mortgage loans held for portfolio were purchased from current or former 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.
As provided by statute, the FHLBank’s members have the right to vote on the election of directors. In accordance with the Bank Act and Finance Agency regulations, members elect all of the FHLBank’s board of directors. Under the statute and regulations, each member directorship is designated to one of the four states in the FHLBank’s district, and a member is entitled to vote only for candidates for the state in which the member’s principal place of business is located. Each independent director is elected by the members at large from among individuals nominated by the FHLBank’s board of directors. A member is entitled to cast, for each applicable directorship, one vote for each share of capital stock that the member is required to hold as of the record date for voting, subject to a statutory limitation. 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. Non-member stockholders are not entitled to cast votes for the election of directors. As of December 31, 2009 and 2008, no member owned more than 10 percent of the voting interests of the FHLBank due to the statutory limitation on members’ voting rights as discussed above.
Transactions with members are entered into in the ordinary course of business. In instances where members also have officers or directors who are directors of the FHLBank, transactions with those members are subject to the same eligibility and credit criteria, as well as the same terms and conditions, as other transactions with members. For financial reporting and disclosure purposes, the FHLBank defines related parties as FHLBank directors’ financial institutions and members with capital stock investments in excess of 10 percent of the FHLBank’s total regulatory capital stock outstanding, which includes mandatorily redeemable capital stock.
Activity with Members that Exceed a 10 Percent Ownership in FHLBank Capital Stock: The following tables present information as of December 31, 2009 and 2008 on members that owned more than 10 percent of outstanding FHLBank regulatory capital stock in either 2009 or 2008 (in thousands). None of the officers or directors of these members currently serve on the FHLBank’s board of directors.
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U.S. Central Federal Credit Union was placed into conservatorship by the National Credit Union Administration on March 20, 2009.
Advance and deposit balances with members that owned more than 10 percent of outstanding FHLBank regulatory capital stock as of December 31, 2009 and 2008 are summarized in the following table (in thousands). Information is only listed for the year in which the member owned more than 10 percent of outstanding FHLBank regulatory capital stock. If the member did not own more than 10 percent for one of the years presented, the applicable column is left blank.
Excludes cash pledged as collateral by derivative counterparties, netted against derivative liabilities, and Member Pass-through Deposit Reserves, classified as non-interest-bearing deposits.
U.S. Central Federal Credit Union was placed into conservatorship by the National Credit Union Administration on March 20, 2009.
Neither U.S. Central Federal Credit Union nor MidFirst Bank originated mortgage loans for or sold mortgage loans into the MPF program during the year ended December 31, 2008. Additionally, MidFirst Bank did not originate any mortgage loans for or sell mortgage loans into the MPF program during the year ended December 31, 2009.
Transactions with FHLBank Directors’ Financial Institutions: The following tables present information as of December 31, 2009 and 2008 for members that had an officer or director serving on the FHLBank’s board of directors (in thousands) in 2009 or 2008. Information is only listed for the year in which the officer or director served on the FHLBank’s board of directors. Capital stock listed is regulatory capital stock, which includes mandatorily redeemable capital stock.
Advance and deposit balances with members that had an officer or director serving on the FHLBank’s board of directors as of December 31, 2009 and 2008 are summarized in the following table (in thousands). Information is only listed for the year in which the officer or director served on the FHLBank’s board of directors.
The following table presents mortgage loans funded or acquired during the years ended December 31, 2009 and 2008 for members that had an officer or director serving on the FHLBank’s board of directors in 2009 or 2008 (in thousands). Information is only listed for the year in which the officer or director served on the FHLBank’s board of directors.
NOTE 19 - TRANSACTIONS WITH OTHER FHLBANKS
FHLBank Topeka had the following business transactions with other FHLBanks during the years ended December 31, 2009, 2008 and 2007 (in thousands). All transactions occurred at market prices.