Federal Home Loan Bank of Topeka 10-K2008 FY Annual report

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C.  20549

FORM 10-K

For the fiscal year ended December 31, 2008

OR

For the transition period from ________ to ________

Commission File Number 000-52004

FEDERAL HOME LOAN BANK OF TOPEKA

 

 

 

 

 

 

 

 

 

 

TABLE OF CONTENTS

 

Important Notice about Information in this Annual Report

In this annual report, unless the context suggests otherwise, references to the “FHLBank,” “FHLBank Topeka,” “we,” “us” and “our” mean the Federal Home Loan Bank of Topeka, and “FHLBanks” mean the 12 Federal Home Loan Banks, including the FHLBank Topeka.

 

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

 

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

Special Cautionary Notice Regarding Forward-looking Statements

The information included or incorporated by reference in this annual report on Form 10-K contains certain forward looking statements with respect to our financial condition, results of operations, plans, objectives, projections, estimates, predictions, future financial performance and ongoing business, including without limitation: statements that are not historical in nature, or statements preceded by, followed by or that include words such as “believes,” “expects,” “may,” “will,” “should,” “could,” “anticipates,” “estimates,” “intends” or similar expressions. The FHLBank cautions that, by their nature, forward looking statements are not guarantees of future performance or results. They involve risks, uncertainties and assumptions and actual results may differ materially from those expressed, contemplated or implied by the forward looking statements or could affect the extent to which a certain plan, objective, projection, estimate or prediction is realized.

 

These forward-looking statements involve risks and uncertainties including, but not limited to, the following:

For additional information regarding these and other risks, see Item 1A – “Risk Factors.”

 

Any forward-looking statements made or incorporated by reference in this annual report on Form 10-K or that we may make from time to time are representative only as of the date they are made, and we undertake no obligation to update any forward-looking statement.

One of 12 FHLBanks, FHLBank Topeka is a federally chartered corporation organized 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 FHLBank. The Finance Agency is responsible for ensuring that the FHLBank carries out its housing finance mission, remains adequately capitalized and able to raise funds in the capital markets and operates in a safe and sound manner.

 

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 $1 billion in 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).

 

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 implemented on September 30, 2004. The FHLBank’s capital plan is developed under, 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, advisory board consultant or executive officer of the FHLBank, among others. Information on business activities with related parties is provided in Tables 94 and 95 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.

The FHLBank currently does not segregate its operations by segments.

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:

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 76 through 79 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, 2008 and 2007 (in thousands):

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:

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. Tables 2 and 3 present information on the FHLBank’s five largest borrowers as of December 31, 2008 and December 31, 2007, respectively (in thousands). 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.

 

 

The FHLBank maintains a portfolio of investments for liquidity and income purposes and to fully 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 (CDs), 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:

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 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:

The MPF Program incorporates the following broad underwriting and eligibility guidelines with respect to MPF loans:

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, 2008. 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, private mortgage insurer, 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 into 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 minimal credit losses on MPF loans that have been acquired under the Program. 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:

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, 2008, 2007 and 2006:

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 over the life of that master commitment. 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 basis points (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, 2008:

Table 6 presents an illustration of the FLA and CE obligation calculation for each conventional MPF product type listed as of December 31, 2008:

In order to increase the balance of our mortgage loans held for portfolio and widen the geographic distribution of those mortgages, the FHLBank acquired out-of-district MPF mortgage loans through participation in MPF Plus master commitment agreements that the Federal Home Loan Bank of Chicago (FHLBank of Chicago) entered into with one of its PFIs during 2004. The out-of-district participation percentage was negotiated for each master commitment agreement and could be amended if both FHLBank Topeka and the FHLBank of Chicago agreed to the changes. In addition to owning a percentage share of each mortgage loan sold, the FHLBank is responsible for that participation percentage share of the FLA, which is typically around 35 bps for MPF Plus master commitment agreements. The CE obligations of the PFI and the CE fees 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 FHLBank acquired out-of-district MPF Program mortgage loans totaling $878,918,000 during 2004 through this participation arrangement. The FHLBank of Chicago retained an average participation of 61.1 percent in 2004 loans purchased. The participated mortgage loans were purchased at the same prices as those for similar MPF Program products. No out-of-district mortgage loans were acquired through the FHLBank of Chicago or any other FHLBank during 2005, 2006 or 2007, but the FHLBank did purchase $231.9 million in mortgage loans during 2008 as described in the following paragraph.

 

 

Quarterly, the FHLBank’s Credit Risk Analysis department performs and documents a financial analysis of all out-of-district 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 analysis is presented to the FHLBank’s Credit Underwriting Committee to determine if any further actions, such as discontinuing mortgage loan purchases from the out-of-district PFI, are warranted.

 

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.

 

To date, two Topeka district PFIs have been approved to acquire servicing rights 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. 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.

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 relatively 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, helps the FHLBank in attempting to manage 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. However, for the FHLBank, as interest rates increase so do fixed charges (interest expense), causing the ratio of earnings to fixed charges to decline. Table 7 documents the FHLBank’s ratio of earnings to fixed charges computation for the years ended December 31, 2008, 2007, 2006, 2005 and 2004 (in thousands):

 

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 the issuance 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 the minimum size of issuance. This agreement resulted from the FHLBank system decision made in the fourth quarter of 2008 to adopt a monthly calendar for scheduled 2009 mandated global bullet consolidated obligation issuance.

 

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, 2008 and 2007 (in millions):

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:

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, 2008 and 2007 (in thousands):

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.

 

 

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.

 

 

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 arising 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 and meet its customer needs.

The FHLBank uses interest rate caps and floors, swaptions and callable swaps to manage 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 under SFAS 133. 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. During 2008, the FHLBank significantly increased its purchases of variable rate Agency CMOs with embedded interest rate caps. As a result, we also significantly increased our purchases of interest rate caps to offset the interest-rate risk of the embedded caps.

 

Other common ways in which the FHLBank uses derivatives to manage its assets and liabilities are:

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.

 

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.

 

The FHLBank’s capital stock and retained earnings also provide a source of funding. For the years ended December 31, 2008 and 2007, approximately 4.2 percent and 4.1 percent, respectively of the FHLBank’s assets, on average, were funded by total capital.

 

 

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 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 Federal Open Market Committee’s target rate for overnight Federal funds 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; refer to Table 15 for average overnight Federal funds target rate and three-month LIBOR for 2007 and 2008, and as of December 31, 2008 and 2007). 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 dividends paid in the fourth quarter 2008. The FHLBank’s SFAS 133 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, the SFAS 133 volatility component is likely to stay elevated because of the increased usage of these economic hedge instruments.

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.

 

 

 

 

 

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 is designed to serve as a contingent source of liquidity for the housing government-sponsored enterprises, including each of the 12 FHLBanks. As of December 31, 2008, no FHLBank had drawn on this available source of liquidity. The U.S. Department of the 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.

 

 

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.

As of March 20, 2009, the FHLBank had 186 employees. The employees are not represented by a collective bargaining unit and the FHLBank considers its relationship with its employees good.

 

 

 

 

 

 

 

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 more attractive to investors than the debt securities of the FHLBanks. Additionally, the FDIC’s TLGP has resulted in the debt securities of larger commercial banks being more attractive to members and potential members than the advances offered by the FHLBanks. As a result, our funding costs increased during the last quarter of 2008 and remain elevated in 2009. If these costs continue to increase, our ability to raise funds in the marketplace and price advances competitively may be significantly impacted.

 

The U.S. Treasury’s program to purchase equity interests in certain financial institutions, as well as funds obtained under the TLGP have provided our members with additional access to liquidity that compete with advances. Thus, we have and may continue to experience a decrease in member demand for advances. Additionally, we anticipate that the FDIC’s final rule on deposit insurance assessments could have a negative impact on advance demand by increasing the effective cost of advance borrowings to our members. To the extent that these initiatives, proposed initiatives and other actions by the 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” and Note 20 of the Footnotes to the Financial Statements included under Item 8 for further discussion of the reduction in member borrowings as a result of competition arising from actions of the U.S. Government.

 

 

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.

 

 

Additionally, 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, negative accounting and other announcements by Fannie Mae and Freddie Mac have created pressure on debt pricing, as investors have perceived GSE debt instruments as bearing increased risk. Furthermore, in September 2008, the Finance Agency placed Fannie Mae and Freddie Mac into conservatorship and the U.S. Treasury put in place a set of financing agreements to help them continue to meet their obligations to holders of their debt securities. 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 margins (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 margin, the advances may no longer be 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.

 

 

 

 

 

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. 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.

 

 

 

 

 

 

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 generally accepted accounting principles 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.

 

 

 

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 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.

 

 

 

 

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.

 

 

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 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.

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.

Currently, the board is comprised of 14 directors, eight of whom are member directors and six of whom are independent directors. Members holding FHLBank capital stock on December 31 of the preceding year can participate in the annual election process for FHLBank directors. Eligible members may nominate and elect representatives from members in their state to serve four-year terms on the board of directors of the FHLBank as member directors and also may vote for individuals nominated by the Board of Directors who are then elected at-large from the FHLBank’s district to serve four-year terms as independent directors. The Finance Agency may adjust the length of a director’s term in order to achieve staggering of the board. For each directorship to be filled in an election, each member institution is entitled to cast one vote for each share of capital stock that the member was required to hold as of December 31 of the calendar year immediately preceding the election year, provided, however, the number of votes that any member may cast for any one directorship may not exceed the average number of shares of capital stock that were required to be held by all members located in the state on that date. The rules governing the election of directors were established by the Finance Agency and are codified at 12 C.F.R. Section 1261. Guidance specific to the FHLBank, because of its use of the two-class capital stock structure, is contained in Section 10 of the FHLBank’s capital plan, which is consistent with 12 C.F.R. Section 1261. Furthermore, 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 October 22, 2008 and incorporated herein by this reference.

During 2008, member directorships were open for election in the states of Colorado and Kansas, and two independent directorships were open for the district at-large.

Member Director Elections

On June 30, 2008, the FHLBank commenced its member director election process. However, in anticipation of the issuance of the Finance Agency’s interim final rule on director elections, the FHLBank delayed the election on September 11, 2008. The election re-commenced on October 15, 2008, when the FHLBank mailed ballots to members in Colorado and Kansas. On December 2, 2008, as reported by the FHLBank in its current report on Form 8-K filed on the same day, the FHLBank announced that two incumbent directors were re-elected to terms commencing January 1, 2009. Mr. Michael M. Berryhill was re-elected to a four-year term as a member director from Colorado, and Mr. Ronald K. Wente was re-elected to a four-year term as a member director from Kansas. The election results were as follows:

 

(Total Voting Shares Cast - 664,875; Number of Votes Cast - 97)

 

Total Shares - 541,744 or 81 percent

Term Expires - 12/31/2012

 

Sundie L. Seefried, President and CEO, Eagle Legacy Credit Union, Arvada, Colo.

Total Shares - 123,131 or 19 percent

 

(Total Voting Shares Cast - 881,159; Number of Votes Cast - 169)

 

Total Shares - 750,922 or 85 percent

Term Expires - 12/31/2012

 

Jon W. Pope, President, Peoples State Bank, McDonald, Kan.

Total Shares - 130,237 or 15 percent

 

Independent Director Elections

On November 5, 2008, the FHLBank commenced its independent director election process. Individuals were nominated by the FHLBank’s Board of Directors after consultation with the FHLBank’s Affordable Housing Advisory Council. Those nominees were placed on the ballot for election in the FHLBank’s district at-large. On December 30, 2008, as reported by the FHLBank in its current report on Form 8-K filed on the same day, the FHLBank announced that two incumbent directors were elected to independent director terms commencing January 1, 2009. Due to the need to stagger the expiration date of directorships, Mr. Thomas E. Henning was elected to a three-year term as an independent director, and Mr. Neil F.M. McKay was elected to a four-year term as an independent director. The election results were as follows:

 

Thomas E. Henning, Chairman, President and CEO, Assurity Life Insurance Company

Number of Votes Cast for Mr. Henning - 2,370,543

Term Expires - December 31, 2011

 

Neil F.M. McKay, Retired, Former CFO and Treasurer, Capitol Federal Savings Bank

Number of Votes Cast for Mr. McKay - 2,375,153

Term Expires - December 31, 2012

 

In 2008, only four directorships were up for election. Therefore, 10 incumbents remained on the FHLBank’s Board of Directors without being placed on the ballot for election. These incumbent directors were: Mr. Lindel E. Pettigrew; Mr. Robert E. Caldwell, II; Mr. James R. Hamby; Mr. Steven D. Hogan; Mr. Andrew C. Hove, Jr.; Ms. Jane C. Knight; Mr. Richard S. Masinton; Mr. Lawrence L. McCants; Mr. Thomas H. Olson; and Mr. Bruce A. Schriefer. As noted in Item 1, Legislative and Regulatory Developments, on May 14, 2008, the Finance Board decreased the FHLBank’s number of elective directorships by one to a total of eight member directors, effective January 1, 2009. Consequently, the directorship held by Gordon C. “Bud” Smith, Jr. expired on December 31, 2008.

 

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. There is no established marketplace for the FHLBank’s stock and it is not publicly traded. 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, 2008, the FHLBank had 886 stockholders and 6,686,666 shares of Class A Common Stock and 16,064,741 shares of Class B Common Stock outstanding, including 347,256 shares of Class A Common Stock and 799 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, 2008, 2007 and 2006, 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):

Management anticipates that the FHLBank will continue to pay quarterly dividends in the future, primarily in shares of Class B Common Stock. 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. See Item 1 – “Business – Capital, Capital Rules and Dividends – Dividends” for information regarding the FHLBank’s retained earnings policy.

 

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.

 

Despite a very difficult market environment during late 2007 and throughout 2008, the FHLBank continued to fulfill its mission by providing stable funding and ample liquidity to its member financial institutions. As a result, total assets grew 5.9 percent to $58.6 billion at December 31, 2008, up from $55.3 billion at December 31, 2007. The overall increase was primarily due to advance growth during 2008, with advances increasing 11.7 percent from $32.1 billion as of the end of 2007 to $35.8 billion as of the end of 2008. The five largest advance borrowers accounted for only $0.5 billion of the increase in advances, while the remaining increase in advances was spread among the remainder of the FHLBank member borrowers. The MPF Program grew significantly during 2008 with total mortgage loans increasing 28.5 percent from $2.4 billion as of December 31, 2007 to $3.0 billion at December 31, 2008, as the FHLBank offered favorable prices compared to Fannie Mae and Freddie Mac during that period. A portion of this increase resulted from the purchase of $0.2 billion of out-of-district mortgage loans participated through the FHLBank of Chicago. The FHLBank continues to strive for growth in both advances and mortgage loans, but its primary business remains the advance business.

 

The FHLBank’s net income for 2008 was $28.4 million compared to $150.3 million for 2007. The significant changes in the components of net income are as follows:

The FHLBank’s net interest margin was 0.43 percent for 2008, compared to 0.44 percent for 2007. This decrease in net interest margin was more than offset by the increase in average earning assets, which resulted in an increase in net interest income from $231.8 million in 2007 to $247.3 million in 2008. However, return on equity averaged 1.17 percent in 2008 and 6.93 percent in 2007. The increase in net interest income and the positive impact of the change in net gain (loss) on trading securities were offset by the negative impact of the change in net gain (loss) on derivatives and hedging activities and the loss on other-than-temporarily impaired held-to-maturity securities. These two factors are the major reason for the significant decrease in net income and the resulting return on equity for 2008 compared to 2007. The loss on derivatives and hedging activities is primarily due to a change in the relationship between interest rates on GSE debt securities and interest rate swaps during 2008, but also includes losses on purchased interest rate caps that are economic hedges of caps embedded in variable rate MBS/CMOs. Interest rates on GSE debt securities and interest rate swaps typically moved together and were very well correlated until financial difficulties at Fannie Mae and Freddie Mac created a considerable divergence. This divergence caused the losses on derivatives (interest rate swaps) to be much larger than gains on the hedged items (GSE debentures).

 

The average dividend rates paid during 2008 were 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. This was a decrease over average dividends paid during 2007 of 4.37 percent and 6.48 percent for Class A Common Stock and Class B Common Stock, respectively, with an overall average dividend rate of 6.00 percent for 2007. With short-term interest rates falling to historic lows in December 2008 and into 2009, we anticipate that average 2009 dividend rates will fall from the 2008 levels. Refer to this Item 7 – “Capital Distributions” for further information regarding FHLBank dividend payments.

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.

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:

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.

 

 

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.

 

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 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 of SFAS 133 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 under SFAS 133, changes in the market value of the derivative are reflected in monthly income. As of December 31, 2008 and 2007, the FHLBank held a portfolio of derivatives that are marked to market with no offsetting SFAS 133 qualifying hedged item. This portfolio includes interest rate caps and floors, interest rate swaps hedging trading securities, interest rate swaps hedging 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 $(187.9) million and $(3.4) million as of December 31, 2008 and 2007, respectively. While the fair value of these derivative instruments, with no offsetting SFAS 133 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: (1) notional amount of interest rate caps and floors of $6.7 billion as of December 31, 2008 and $3.5 billion as of December 31, 2007 that were not designated as SFAS 133 qualifying hedges (economic hedges of embedded caps in and overall duration of variable-rate MBS); (2) notional amount of interest rate swaps of $0.9 billion as of December 31, 2008 and $0.5 billion as of December 31, 2007 that were not designated as SFAS 133 qualifying hedges (economic hedges of the cost of consolidated obligation bonds); (3) notional amounts of $1.6 billion and $0.8 billion of interest rate swaps that were not designated as SFAS 133 qualifying hedges at December 31, 2008 and 2007, respectively, (economic hedges of GSE debentures in trading securities); and (4) par value of trading securities was only $1.6 billion and $0.8 billion related to economic hedges held by the FHLBank at December 31, 2008 and 2007, respectively. 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 61 through 63 under this Item 7, which show the relationship of gains/losses on economic derivative hedges and gains/losses on the Ginnie Mae and non-mortgage-backed trading securities being hedged by economic derivatives. The FHLBank’s projections of changes in estimated 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 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.

 

 

The FHLBank will conclude that a loss is other-than-temporary if it is probable that the FHLBank will not receive all of the investment security’s contractual cash flows. If the FHLBank determines that an other-than-temporary impairment exists, the investment security is written down to fair value (its new cost basis), any premiums or discounts related to the investment security are written off, and a realized loss is recognized in other income (loss). A new accretable, or effective, yield is calculated and utilized to accrete the discount on a prospective basis over the remaining life of the investment security based on the amount and timing of future expected cash flows. The fair value measurement the FHLBank uses to determine the amount of other-than-temporary impairment to record may be less than the actual amount we expect to realize by holding the security to maturity. Accordingly, we may subsequently recover some other-than-temporary impairment amounts if we collect all of the contractual principal and interest payments due on the security. The portion of the impairment charges associated with any recoveries is recognized as net interest income in future periods.

 

 

 

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.

At December 31, 2008, the FHLBank’s assets totaled $58.6 billion, up 5.9 percent from December 31, 2007. This increase is primarily attributable to a $3.8 billion increase in advances and a $0.7 billion increase in mortgage loans offset by a $1.1 billion decrease in investment securities.

 

Total advances increased 11.7 percent at December 31, 2008 to $35.8 billion from $32.1 billion in advance balances at December 31, 2007, primarily due to growth in advances to the FHLBank’s mid-sized to smaller members. Advances to FHLBank’s largest members accounted for only $0.5 billion or 13.3 percent of the increase. Despite the turmoil in the United States economy and the disruptions in the capital market in 2008, loan demand at small and mid-sized member institutions remained strong which in turn resulted in strong advance demand throughout the year. Additionally, funding sources normally available to our members became practically unavailable. As these funding sources began drying up, the demand for advances, primarily short-term advances, increased.

 

Most of the FHLBank’s total asset growth during 2008 was funded with consolidated obligations, which increased from $51.1 billion at December 31, 2007 to $53.7 billion at December 31, 2008, representing a 5.0 percent increase. Consolidated obligations are the FHLBank’s primary funding source. The changes in consolidated obligation balances generally matched the changes in advance balances throughout 2008.

Total capital increased from $2.3 billion at December 31, 2007 to $2.4 billion at December 31, 2008, with most of the increase from capital stock supporting member advance activity. During 2007 and 2008, the FHLBank did not carry out any mandatory repurchases of member capital stock; however, the FHLBank completed periodic exchanges of excess Class B Common Stock for Class A Common Stock under the provisions of its capital plan. These periodic exchanges were performed during all of 2007 and 2008. The frequency of these exchanges was weekly in 2008, thereby reducing the average amount of excess Class B Common Stock held by members. The FHLBank discontinued these periodic exchanges on January 28, 2009 to allow the FHLBank to increase its permanent capital position. The FHLBank anticipates that growth or reduction in capital stock should closely parallel advance increases or decreases in future periods.

 

 

We expect total advances to decline in 2009: (1) because of the conservatorship of U.S. Central Federal Credit Union, which may result in reduced advance activity (see previous discussion under Item 1 – "Business – Advances" and Note 20 of the Notes to the Financial Statements included under Item 8 – "Financial Statements and Supplementary Data"); and (2) as members begin de-leveraging their balance sheets in order to shore up their capital positions and weather the current recession. We also expect that some members will begin utilizing various U.S. government-guaranteed and Federal Reserve lending programs as an alternative to FHLBank advances. Excess liquidity from maturing investments and from other sources, if available, will likely be used to reduce member demand for wholesale borrowings including advances. However, difficulties in issuing brokered certificates of deposit and in entering into security repurchase transactions could somewhat offset the expected reduction in demand for FHLBank advances at many of the mid-sized to smaller members during 2009. Although the FHLBank experienced a moderate decrease in membership during the two-year period ending December 31, 2008, advance balances continued to grow. The growth in advance balances during 2008 primarily reflects increases in advances outstanding from the FHLBank’s mid-sized and smallest members. The number of members and non-members with outstanding advances was 645 as of December 31, 2007 and increased to 687 as of December 31, 2008 as some of our mid-sized and smaller members utilized advances to meet their liquidity and funding needs.

 

Table 17 summarizes the par amount of FHLBank advances by year of maturity, or next call date for callable advances, as of December 31, 2008 (in thousands):

Total advances represented 61.2 percent of total assets as of December 31, 2008 compared with 58.0 percent at the end of 2007. The percentage of total advances to total assets has historically exceeded 60 percent of FHLBank assets; however, with the anticipated member de-leveraging, we expect this percentage to be in the range of 55 to 60 percent of total assets in future years. The average yield on advances was 2.97 percent for the year ended December 31, 2008 compared to 5.26 percent for 2007 and 5.07 percent for 2006. The decrease in average advance yields from the year ended December 31, 2007 to the year ended December 31, 2008 is consistent with the general decrease in market interest rates, especially short-term rates.

 

Short-term rates declined rather dramatically throughout 2008, with the average short-term advance rate dropping 400 basis points by year end. The FOMC lowered the overnight Federal funds target rate several times during 2008 resulting in the current overnight Federal funds target rate being a range from zero to 0.25 percent. As of December 31, 2008, line of credit advances (which re-price daily) and short-term, fixed rate advances (maturities of 93 days or less) represented 38.0 percent of outstanding advances. Adjustable rate advances (re-pricing daily to every three months) represented 19.8 percent, and convertible advances (swapped to three-month LIBOR, synthetically creating three-month advances) represented 16.5 percent. Fixed rate bullet advances and callable advances either swapped to one-month or three-month LIBOR (synthetically creating one-month or three-month advances) represented 12.2 percent.  As of December 31, 2007, line of credit advances and short-term, fixed rate advances represented 33.7 percent of outstanding advances. Adjustable rate advances represented 20.7 percent, and convertible advances represented 15.2 percent. Fixed rate bullet advances and callable advances either swapped to one-month or three-month LIBOR (synthetically creating one-month or three-month advances) represented 12.4 percent. As a result, 86.5 percent of the FHLBank’s advance portfolio as of December 31, 2008 and 82.0 percent of the FHLBank’s advance portfolio as of December 31, 2007 effectively re-priced at least every three months. See Table 1 under Item 1 for a summary of the advance products outstanding at December 31, 2008 and 2007. Because of the relatively short nature of the FHLBank’s advance portfolio, the average yield in this portfolio typically responds quickly to changes in short-term interest rates. 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. In January 2009, the FOMC left the Federal funds target rate unchanged at zero to 0.25 percent and, given the ongoing recession and worsening economic conditions in early 2009, it does not appear that the FOMC will begin increasing its target range any time soon. Therefore, we anticipate advance yields will remain relatively stable in 2009 unless there is a significant change in our advance mix. See Item 7 – Table 59, Spread and Yield Analysis, and Table 60, Rate and Volume Analysis, in the “Financial Review – Results of Operations” for further information on 2006 through 2008 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.

 

 

The FHLBank has no foreign advances as of December 31, 2008, 2007, 2006, 2005 and 2004. Table 18 presents the book value of total advances as of December 31, 2008, 2007, 2006, 2005 and 2004 (in thousands):

 

 

The FHLBank has continued its efforts to increase the number of members participating in the MPF Program. As of December 31, 2008 and 2007, agreements were in place with 161 and 142 PFIs, respectively. The number of PFIs that delivered and sold loans was 147 and 126 at December 31, 2008 and 2007, respectively. We anticipate that the number of PFIs delivering and selling loans to the FHLBank will increase during 2009 and beyond as we strive to increase the number of participating members. However, there is no guarantee that our efforts will increase the number of PFIs. The FHLBank devoted resources during 2007 and 2008 to increasing the volume of mortgage loans acquired from PFIs. To increase the number of PFIs, our account managers focused on members that are active mortgage originators or purchasers. In addition, we added an MPF account manager at the beginning of 2008 who is focused solely on increasing the number of PFIs and the dollar amount of mortgage loans sold into the FHLBank’s MPF Program by PFIs. Future volume growth for mortgage loans held in portfolio will depend on a number of factors, including the number of new PFIs and the mortgage loan origination volume of the new PFIs; the amount of mortgage loan activity all existing PFIs expect to deliver in 2009; refinancing activity; the level of interest rates and the shape of the yield curve; the relative competitiveness of MPF pricing to the prices offered by Fannie Mae, Freddie Mac and other buyers of mortgage loans; the willingness of other FHLBanks to allow the FHLBank to participate in a percentage of mortgage loans that their PFIs are selling into the MPF Program; and the willingness of the FHLBank to acquire additional out-of-district mortgage loans at the prevailing relative value (the difference between the yield on the mortgage loans and the FHLBank’s cost of funding and hedging the mortgage loans). Mortgage market conditions early in 2008 led Fannie Mae and Freddie Mac to adjust their practices and prices paid for mortgage loans, which increased the relative competitiveness of the MPF Program. This situation continued for much of 2008, and it assisted the FHLBank in increasing the number of active PFIs delivering mortgage loans into the MPF Program. Toward the end of 2008, the U.S. Treasury and Federal Reserve Banks began direct purchases of mortgages from Fannie Mae and Freddie Mac. These purchases, which are funded with U.S. Treasury debt, resulted in much lower interest rates on residential mortgages. Because the FHLBank’s funding costs were generally higher than those of the U.S. Treasury, there were periods when the FHLBank was unable to profitably acquire mortgages sold under the MPF Program at comparable prices. FHLBank management made it a priority to explore the MPF Xtra product, offered only to-date by the FHLBank of Chicago. It is the FHLBank’s intent to be prepared to add this product to our MPF product mix to ensure our ability to offer a secondary market outlet to our PFIs, specifically the small PFIs, when market conditions deem it undesirable to hold the assets in portfolio.

 

Table 20 presents the FHLBank’s top five PFIs, the outstanding balances (in thousands) of mortgage loans acquired from them as of December 31, 2008 and 2007, 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 average yields on mortgage loans were 5.16 percent, 5.21 percent and 5.12 percent during 2008, 2007 and 2006, respectively. The average yield on mortgage loans decreased in 2008 and is primarily attributable to the falling interest rate environment late in 2008 due to the turmoil in the financial market. The average yield on mortgage loans increased in 2007 and 2006 primarily due to the increase in mortgage interest rates and a decrease in the net write-off of the amortization of premium as a result of the decline in mortgage loan prepayments and the increase in estimated average lives of existing mortgage loans because of increasing mortgage interest rates. The average yield on mortgage loans is expected to decrease in response to anticipated decreases in market interest rates on mortgage loans during 2009. See Table 59, Spread and Yield Analysis, and Table 60, Rate and Volume Analysis, under Item 7 for further information.

 

Table 22 presents the unpaid principal for performing mortgage loans, non-performing mortgage loans and mortgage loans 90 or more past due and accruing as of December 31, 2008, 2007, 2006, 2005 and 2004 (in thousands):

Information regarding the interest income shortfall on the non-performing loans during the periods ending December 31, 2008 and 2007 is included in Table 23 (in thousands):

 

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 down payments of less than 20 percent of the original purchase price (purchase transactions only). 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, 2008 and 2007 (in thousands):

Table 25 presents the allowance for mortgage loan losses as of December 31, 2008, 2007, 2006, 2005 and 2004 (in thousands):