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EX-31.1 - EX-31.1 - Federal Home Loan Bank of Pittsburghl38003exv31w1.htm
EX-32.1 - EX-32.1 - Federal Home Loan Bank of Pittsburghl38003exv32w1.htm
EX-32.2 - EX-32.2 - Federal Home Loan Bank of Pittsburghl38003exv32w2.htm
EX-10.15 - EX-10.15 - Federal Home Loan Bank of Pittsburghl38003exv10w15.htm
EX-10.14 - EX-10.14 - Federal Home Loan Bank of Pittsburghl38003exv10w14.htm
EX-31.2 - EX-31.2 - Federal Home Loan Bank of Pittsburghl38003exv31w2.htm
Table of Contents

 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
FORM 10-Q
 
[√] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the quarterly period ended September 30, 2009
 
or
 
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the transition period from ­ ­ to ­ ­
 
Commission File Number: 000-51395
 
FEDERAL HOME LOAN BANK OF PITTSBURGH
(Exact name of registrant as specified in its charter)
 
     
Federally Chartered Corporation
(State or other jurisdiction of
incorporation or organization)
  25-6001324

(IRS Employer Identification No.)
     
601 Grant Street
Pittsburgh, PA 15219
  15219
(Address of principal executive offices)   (Zip Code)
 
(412) 288-3400
(Registrant’s telephone number, including area code)
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  x Yes  o No
 
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  o Yes  o No
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See definition of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
 
             
o Large accelerated filer   
  o Accelerated filer   x Non-accelerated filer   o Smaller reporting company
                                (Do not check if smaller reporting company)
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  o Yes  x No
 
There were 40,134,228 shares of common stock with a par value of $100 per share outstanding at October 31, 2009.


 

 
FEDERAL HOME LOAN BANK OF PITTSBURGH
 
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 EX-31.1
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Item 2: Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
This Overview should be read in conjunction with the Bank’s unaudited financial statements and footnotes to financial statements in this report filed on Form 10-Q as well as the Bank’s 2008 Annual Report filed on Form 10-K.
 
Overview
 
The Federal Home Loan Bank of Pittsburgh (Bank) is one of twelve Federal Home Loan Banks (FHLBanks). The FHLBanks operate as separate entities with their own managements, employees and boards of directors. The twelve FHLBanks, along with the Office of Finance (OF - the FHLBanks’ fiscal agent) and the Federal Housing Finance Agency (Finance Agency - the FHLBanks’ regulator) make up the Federal Home Loan Bank System (FHLBank System). The FHLBanks were organized under the authority of the Federal Home Loan Bank Act of 1932, as amended (Act). The FHLBanks are commonly referred to as government-sponsored enterprises (GSEs), which generally means they are a combination of private capital and public sponsorship. The public sponsorship attributes include: (1) being exempt from federal, state and local taxation, except real estate taxes; (2) being exempt from registration under the Securities Act of 1933 (1933 Act) (although the FHLBanks are required by Finance Agency regulation and the Housing and Economic Recovery Act of 2008 (the Housing Act) to register a class of their equity securities under the Securities Exchange Act of 1934 (1934 Act)); and (3) having a line of credit with the U.S. Treasury.
 
The Bank is a cooperative institution, owned by financial institutions that are also its primary customers. Any building and loan association, savings and loan association, commercial bank, homestead association, insurance company, savings bank, credit union or insured depository institution that maintains its principal place of business in Delaware, Pennsylvania or West Virginia and that meets varying requirements can apply for membership in the Bank. The Housing Act expanded membership to include Community Development Financial Institutions (CDFIs). Pursuant to the Housing Act, the Finance Agency has proposed to amend its membership regulations to authorize non-federally insured CDFIs to become members of an FHLBank. The newly eligible CDFIs would include community development loan funds, venture capital funds and state-chartered credit unions without federal insurance. The proposed regulation sets out the eligibility and procedural requirements for CDFIs that wish to become members of an FHLBank. The comment period for the proposed regulation expired July 14, 2009. Management is evaluating the proposed regulation and its potential effect on the Bank. All members are required to purchase capital stock in the Bank as a condition of membership. The capital stock of the Bank can be purchased only by members.
 
The Bank’s primary mission is to intermediate between the capital markets and the housing market through member financial institutions. The Bank provides credit for housing and community development through two primary programs. First, it provides members with loans against the security of residential mortgages and other types of high-quality collateral; second, the Bank purchases residential mortgage loans originated by or through member institutions. The Bank also offers other types of credit and noncredit products and services to member institutions. These include letters of credit, interest rate exchange agreements (interest rate swaps, caps, collars, floors, swaptions and similar transactions), affordable housing grants, securities safekeeping, and deposit products and services. The Bank issues debt to the public (consolidated obligation bonds and discount notes) in the capital markets through the OF and uses these funds to provide its member financial institutions with a reliable source of credit for these programs. The U.S. government does not guarantee the debt securities or other obligations of the Bank or the FHLBank System.
 
The Bank is a GSE, chartered by Congress to assure the flow of liquidity through its member financial institutions into the American housing market. As a GSE, the Bank’s principal strategic position has historically been derived from its ability to raise funds in the capital markets at narrow spreads to the U.S. Treasury yield curve. Typically, this fundamental competitive advantage, coupled with the joint and several cross-guarantee on FHLBank System debt, has distinguished the Bank in the capital markets and has enabled it to provide attractively priced funding to members. However, as the financial crisis worsened in 2008, the spread between FHLBank System debt


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and Treasury debt widened, making it more difficult for the Bank to provide term funding to members at attractive rates. During the third quarter of 2009, spreads narrowed, allowing the Bank to offer more attractive pricing.
 
Though chartered by Congress, the Bank is privately capitalized by its member institutions, which are voluntary participants in its cooperative structure. The characterization of the Bank as a voluntary cooperative with the status of a federal instrumentality differentiates the Bank from a traditional banking institution in three principal ways.
 
First, members voluntarily commit capital required for membership principally in order to gain access to the funding and other services provided by the Bank. The value in membership may be derived from the access to liquidity and the availability of favorably priced liquidity, as well as the potential for dividend on the capital investment. Management recognizes that financial institutions choose membership in the Bank principally for access to attractively priced liquidity, dividends, and the value of the products offered within this cooperative.
 
Second, because the Bank’s customers and shareholders are predominantly the same group of 317, normally there is a need to balance the pricing expectations of customers with the dividend expectations of shareholders, although both are the same institutions. This is a challenge in the current economic environment. By charging wider spreads on loans to customers, the Bank could potentially generate higher earnings and potentially dividends for shareholders. Yet these same shareholders viewed as customers would generally prefer narrower loan spreads. In normal market conditions, the Bank strives to achieve a balance between the goals of providing liquidity and other services to members at advantageous prices and potentially generating a market-based dividend. The Bank typically does not strive to maximize the dividend yield on the stock, but to produce an earned dividend that compares favorably to short-term interest rates, compensating members for the cost of the capital they have invested in the Bank. As previously announced on December 23, 2008, the Bank has voluntarily suspended dividend payments until the Bank believes it is prudent to restore them, in an effort to build retained earnings.
 
Third, the Bank is different from a traditional banking institution because its GSE charter is based on a public policy purpose to assure liquidity for housing and to enhance the availability of affordable housing for lower-income households. In upholding its public policy mission, the Bank offers a number of programs that consume a portion of earnings that might otherwise become available to its shareholders. The cooperative GSE character of this voluntary membership organization leads management to strive to optimize the primary purpose of membership, access to funding, as well as the overall value of Bank membership.
 
In November 2008, the Bank experienced a significant increase in its risk-based capital requirements due to deterioration in the market values of the Bank’s private label mortgage-backed securities (MBS). The Bank was narrowly in compliance with its risk-based capital requirement. As a result, the Bank submitted a Capital Restoration Plan (CRP) to the Finance Agency on February 27, 2009.
 
Since then, many changes have occurred in the environment affecting the Bank. The Financial Accounting Standards Board (FASB) changed the guidance for how to account for other-than-temporary impairment. There have been multiple and significant downgrades of the Bank’s private label MBS securities, especially those private label MBS of 2007 or 2006 vintage, which have impacted the credit risk-based capital requirement for the Bank. Macroeconomic conditions have not improved at the rate originally expected. The Bank has also implemented significant elements of action plans, including completing its initial analysis on modifying the funding and hedging of the Bank’s balance sheet, simplifying the menu of advance products, and completing its analysis on the Bank’s capital structure. In addition, loans to members balances have decreased more than expected. Collectively, these developments merited an update of the CRP. On September 28, 2009, management submitted a revised CRP to the Bank’s regulator. The plan submitted to the Finance Agency requests that the Bank not be required to increase member capital requirements unless it becomes significantly undercapitalized, which by definition would mean the Bank meets less than 75% of its risk-based, total or leverage capital requirements. As part of that effort, the Bank has reviewed its risk governance structure, risk management practices and expertise. An outside consultant was engaged to assist in this review; management is reviewing the consultant’s report.
 
On August 4, 2009, the Finance Agency issued its final Prompt Corrective Action Regulation (PCA Regulation) incorporating the terms of the Interim Final Regulation issued on January 30, 2009. See also the “Legislative and Regulatory Developments” discussion in Item 7. Management’s Discussion and Analysis of


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Financial Condition and Results of Operations (Management’s Discussion and Analysis) in the Bank’s 2008 Annual Report filed on Form 10-K for additional information regarding the terms of the Interim Final Regulation.
 
The Bank was in compliance with its risk-based, total and leverage capital requirements at September 30, 2009. On September 30, 2009, the Bank received final notification that it was considered adequately capitalized for the quarter ended June 30, 2009; however, the Finance Agency did express concern regarding the ratio of the Bank’s level of AOCI (accumulated other comprehensive income) to retained earnings, the decline in excess permanent capital over risk-based capital requirements and the potential impact of redemption of excess capital stock.
 
Loans to Members
 
The Bank makes loans to members and eligible nonmember housing associates based upon the security of pledged mortgages and other eligible types of collateral. The Act requires the Bank to obtain and maintain a security interest in eligible collateral at the time it originates or renews a loan.
 
Loan Products.  The Bank offers a number of various loan products to its members. These products are discussed in detail in the “Loans to Members” discussion in Item 1. Business in the Bank’s 2008 Annual Report filed on Form 10-K. The Bank has revised the extensive product line in an attempt to simplify the list of options available to customers and provide those products used most by members. These changes became effective August 3, 2009.
 
Collateral.  There are two types of collateral agreements under which members pledge collateral: a blanket collateral pledge agreement and a specific collateral pledge agreement. These agreements require one of three types of collateral status: undelivered, detailed listing or delivered status. All collateral securing loans to members is discounted to help protect the Bank from losses resulting from a decline in the values of the collateral in adverse market conditions. Eligible collateral value represents either book value or fair value of pledged collateral multiplied by the applicable discounts. These discounts, also referred to as collateral weightings, vary by collateral type and whether the calculation is based on book value or fair value of the collateral. They also typically include consideration for estimated costs to sell or liquidate collateral and the risk of a decline in the collateral value due to market or credit volatility. As additional security for each member’s indebtedness, the Bank has a statutory lien on the member’s capital stock in the Bank.
 
The Bank determines the type and amount of collateral each member has available to pledge as security for Bank loans by reviewing, on a quarterly basis, the call reports the members file with their primary banking regulators. Depending on a member’s credit product usage and current financial condition, that member may also be required to file a Qualifying Collateral Report (QCR) on a quarterly or monthly basis. At September 30, 2009, the principal form of eligible collateral to secure loans made by the Bank was single-family residential mortgage loans, which included a very low amount of manufactured housing loans. Securities, including U.S. Treasuries, U.S. agency securities, GSE MBS, and private label MBS with a credit rating of AAA are also accepted as collateral. FHLBank deposits and multi-family residential mortgages, as well as other real estate related collateral (ORERC), comprised a portion of qualifying collateral. See the “Credit and Counterparty Risk” discussion in the Risk Management section of this Item 2. Management’s Discussion and Analysis in this report filed on Form 10-Q for details regarding amounts and percentages of eligible collateral securing loans as of September 30, 2009.
 
On July 20, 2009, the Bank implemented several collateral policy changes affecting the Bank’s members. These changes addressed delivery of securities pledged as collateral, accepting Temporary Liquidity Guaranty Program (TLGP) debt as eligible collateral and accepting limited amounts of private label MBS rated AA for certain members. Details of these changes were discussed in the Overview section of Item 2. Management’s Discussion and Analysis in the Bank’s Second Quarter 2009 report filed on Form 10-Q. As of September 30, 2009, the Bank’s collateral included an immaterial amount of AA-rated securities. On December 21, 2009, several additional collateral policy changes will become effective for the Bank’s members. These changes include: (1) removal of the ORERC cap and various associated collateral weighting changes; (2) adjustments to Total Borrowing Limits set for members; and (3) other changes to collateral weightings based on Second Quarter and Third Quarter 2009 analyses. The details on these policy changes have been communicated to the Bank’s members.
 
Although subprime mortgages are not considered an eligible collateral asset class by the Bank, it is possible that the Bank may have subprime mortgages pledged as collateral through the blanket-lien pledge.


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At September 30, 2009 and December 31, 2008, on a borrower-by-borrower basis, the Bank maintained a security interest in collateral with an eligible collateral value (after collateral weightings) in excess of the book value of all loans. Management believes that adequate policies and procedures are in place to effectively manage the Bank’s credit risk associated with lending to members and nonmember housing associates.
 
From January 1, 2009 through September 30, 2009, nationally 95 Federal Deposit Insurance Corporation (FDIC)–insured institutions have failed. None of the FHLBanks has incurred any losses on loans outstanding to these institutions. Although the majority of these institutions were members of the System, only one was a member of the Bank. The Bank had no loans or other credit products outstanding to this member at the time of the closure.
 
Investments
 
The Bank maintains a portfolio of investments for two main purposes: liquidity and additional earnings. For liquidity purposes, the Bank invests in shorter-term instruments such as overnight Federal funds and securities sold under agreement to repurchase to ensure the availability of funds to meet member credit needs. The Bank also invests in other short-term investments, including term Federal funds, interest-earning certificates of deposit and commercial paper. The Bank also maintains a secondary liquidity portfolio, which may include TLGP investments, U.S. Treasury and agency securities and other GSE securities that can be financed under normal market conditions in securities repurchase agreement transactions to raise additional funds. The Bank further enhances interest income by maintaining a long-term investment portfolio, including securities issued by GSEs and state and local government agencies and MBS.
 
See the “Credit and Counterparty Risk” discussion in the Risk Management section of this Item 2. Management’s Discussion and Analysis in this report filed on Form 10-Q for further discussion of the investment portfolio and related credit risk, including other-than-temporary impairment (OTTI) charges.
 
Mortgage Partnership Finance (MPF®) Program
 
The Bank participates in the Mortgage Partnership Finance (MPF®) Program under which the Bank invests in qualifying 5- to 30-year conventional conforming and government-insured fixed-rate mortgage loans secured by one-to-four family residential properties.
 
The Bank currently offers two products under the MPF Program that are differentiated primarily by their credit risk structures: Original MPF and MPF Government. Further details regarding the credit risk structure for each of the products, as well as additional information regarding the MPF Program and the products offered by the Bank, is provided in the “Mortgage Partnership Finance Program” section in Item 7. Management’s Discussion and Analysis in the Bank’s 2008 Annual Report filed on Form 10-K.
 
The Bank held approximately $5.3 billion and $6.1 billion in mortgage loans at par under the MPF Program at September 30, 2009 and December 31, 2008, respectively. These balances represented approximately 8.0% and 6.7% of total assets at September 30, 2009 and December 31, 2008, respectively. Mortgage loans contributed approximately 22% and 10% of total interest income for the third quarters of 2009 and 2008, respectively. For the nine months ended September 30, 2009 and 2008, the contribution was approximately 18% and 9%, respectively. While interest income on mortgage loans dropped 8.9% in the year-over-year comparison, the Bank’s total interest income decreased 55.1%. This sharp decline in total interest income resulted in the increase in the ratio of mortgage interest income to total interest income.
 
In February 2009 the Bank announced plans to offer a third product, MPF Xtra, to members. MPF Xtra allows Participating Financial Institutions (PFIs) to sell residential, conforming fixed-rate mortgages to FHLBank of Chicago, which concurrently sells them to Fannie Mae on a nonrecourse basis. MPF Xtra does not have the credit enhancement structure of the traditional MPF Program and these loans are not reported on the Bank’s balance sheet. In the MPF Xtra product, there is no credit obligation assumed by the PFI or the Bank and no credit enhancement fees are paid. PFIs which have completed all required documentation and training are eligible to participate in the program. As of September 30, 2009, 30 PFIs were eligible to participate in the program. Of these, nine have sold $12.0 million of mortgage loans through the MPF Xtra program.


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Effective July 15, 2009, the Bank introduced a temporary loan payment modification plan (modification plan) for participating PFIs, which will be available until December 31, 2011 unless further extended by the MPF Program. Borrowers with conventional loans secured by their primary residence, which were closed prior to January 1, 2009 are eligible for the modification plan. This modification plan pertains to borrowers currently in default or in imminent danger of default. In addition, there are specific eligibility requirements that must be met and procedures that the PFIs must follow to participate in the modification plan. As of October 31, 2009, there has been no activity under this modification plan.
 
“Mortgage Partnership Finance,” “MPF,” and “MPF Xtra” are registered trademarks of the FHLBank of Chicago.
 
Debt Financing – Consolidated Obligations
 
The primary source of funds for the Bank is the sale of debt securities, known as consolidated obligations. These consolidated obligations are issued as both bonds and discount notes, depending on maturity. Consolidated obligations are the joint and several obligations of the FHLBanks, backed by the financial resources of the twelve FHLBanks. Consolidated obligations are not obligations of the U.S. government, and the U.S. government does not guarantee them. The OF has responsibility for issuing and servicing consolidated obligations on behalf of the FHLBanks. On behalf of the Bank, the OF issues bonds that the Bank uses primarily to provide loans to members. The Bank also uses bonds to fund the MPF Program and its investment portfolio. Typically, the maturity of these bonds ranges from one year to ten years, but the maturity is not subject to any statutory or regulatory limit. The OF also sells discount notes to provide short-term funds to the FHLBanks. The Bank uses these funds to provide loans to members for seasonal and cyclical fluctuations in savings flows and mortgage financing, short-term investments, and other funding needs. Discount notes are sold at a discount and mature at par. These securities have maturities of up to 365 days.
 
See the “Liquidity and Funding Risk” discussion in the Risk Management section of this Item 2. Management’s Discussion and Analysis in this report filed on Form 10-Q and the “Current Financial and Mortgage Market Events and Trends” discussion below for further information regarding consolidated obligations and related liquidity risk.
 
Current Financial and Mortgage Market Events and Trends
 
Market Actions and Reactions.  Housing and financial markets have been in tremendous turmoil since the middle of 2007, with repercussions throughout the U.S. and global economies, and the U.S. economy is in a recession. Limited liquidity in the credit markets, increasing mortgage delinquencies and foreclosures, falling real estate values, the collapse of the secondary market for MBS, loss of investor confidence, a highly volatile stock market, interest rate fluctuations, and the failure of a number of large and small financial institutions are all indicators of the severe economic crisis facing the U.S. and the rest of the world. These economic conditions, particularly in the housing and financial markets, combined with ongoing uncertainty about the depth and duration of the financial crisis and the recession, continued to affect the Bank’s business and results of operations, as well as its members, during the first nine months of 2009 and may continue to have adverse effects in the future. Specifically, the weakness in the U.S. economy has continued to affect the credit quality of the loan collateral underlying all types of private label MBS in the Bank’s investment portfolio, resulting in OTTI charges on more securities. To continue building retained earnings and preserve the Bank’s capital, the Bank has maintained its suspension of dividend payments and excess capital stock repurchases through the third quarter 2009 and has no current expectation that this will change in the foreseeable future.
 
While the significant deterioration in economic conditions that followed the disruptive financial market events of September 2008 has not reversed, and the economy has remained weak since that time, there is indication that the pace of economic decline may have started to slow. There have been signs that the financial condition of large financial institutions has begun to stabilize. However, despite these early signs of improvement, the prospects for and potential timing of renewed economic growth (employment growth in particular) remain very uncertain. The ongoing weak economic outlook, along with continued uncertainty regarding those conditions, will extend future losses at many financial institutions to a wider range of asset classes, and the nature and extent of the ongoing need for the government to support the banking industry, have combined to maintain market participants’ somewhat cautious approach to the credit markets.


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The ongoing impact of several government programs that were either introduced or expanded during the fourth quarter of 2008 appears to have supported a greater degree of stability in the capital markets. Those programs include the implementation of the Troubled Asset Relief Program (TARP) authorized by Congress in October 2008 and the Federal Reserve’s purchases of commercial paper, agency debt securities (including FHLBank debt) and MBS. In addition, the Federal Reserve’s discount window lending and Term Auction Facility (TAF) for auctions of short-term liquidity and the expansion of insured deposit limits and the Temporary Liquidity Guarantee Program (TLGP) provided by the Federal Deposit Insurance Corporation (FDIC) have provided additional liquidity support for depository institutions.
 
During the third quarter of 2009, the Federal Reserve Bank of New York (FRBNY) continued to support the capital markets through the purchase of GSE term debt, agency MBS, and Treasuries. As such, FRBNY purchased approximately $34.3 billion in GSE term debt, including $6.0 billion of FHLBank mandated global bullets during the quarter. By the end of September 2009, FRBNY purchases of agency debt were up to $131.2 billion, or almost 66% of the $200.0 billion allocated to the program at that time.
 
During the third quarter of 2009, the Federal Reserve made two announcements regarding its agency debt purchase programs. First, it announced that certain securities would be included in the list of CUSIPs eligible for purchase through its agency debt purchase programs. Second, the Federal Reserve announced that it would slow the purchasing of agency debt and MBS, extending those operations into the first quarter of 2010.
 
From July 2 to September 30, the FRBNY purchased approximately $330.4 billion in agency MBS, including approximately $47.2 billion in purchases related to dollar rolls, which, similar to repurchase agreements, provide holders of MBS with a form of short-term financing. Finally, FRBNY purchases of U.S. Treasury securities also continued with the FRBNY buying an additional $105.0 billion in Treasuries during the quarter. With the planned end date for the FRBNY’s U.S. Treasury purchase program set for October 31, 2009, the FRBNY had purchased 95% of the allocated $300 billion by the end of the third quarter of 2009.
 
The FHLBanks continued to maintain access to debt funding at desirable levels during the third quarter of 2009. The FHLBanks had ready access to term debt funding, pricing slightly fewer bonds than in the second quarter of 2009. However, the increase in FHLBank TAP volume during the third quarter of 2009 demonstrated an increased willingness by dealers to assume risk positions in the sector. Meanwhile, agency discount note spreads deteriorated considerably during the third quarter of 2009, making discount notes a less desirable funding option for the FHLBanks. A continued decline in money market fund assets, coupled with proposed changes to the rules that govern money market funds, could further weaken the agency discount note market in the near term.
 
During the third quarter of 2009, as the FHLBanks’ consolidated obligations outstanding continued to shrink, redemptions resulting from both scheduled maturities and exercised calls outpaced FHLBank debt issuance. Consolidated obligations outstanding declined an additional $82 billion during the third quarter of 2009, with consolidated discount notes decreasing significantly more than consolidated bonds. Consolidated obligations outstanding closed the third quarter of 2009 at levels last seen in late July 2007.
 
On a stand-alone basis, discount notes accounted for 19.0% and 27.1% of total Bank consolidated obligations at September 30, 2009 and December 31, 2008, respectively. Total bonds decreased $12.4 billion, or 20.2%, in the same comparison, but comprised a greater percentage of the total debt portfolio, increasing from 72.9% at December 31, 2008 to 81.0% at September 30, 2009.
 
The volume of FHLBank consolidated bonds priced during the third quarter of 2009 was slightly less than during the second quarter of 2009. During the third quarter of 2009, the mix of bonds priced by the FHLBanks changed slightly, with the FHLBanks relying less on negotiated bullet bonds and floating-rate securities and relying more on negotiated callable bonds and step-up bonds. Furthermore, TAP issuance has been on the rise since June 2009, indicating dealers’ willingness to commit balance sheet resources to the agency sector. The FHLBanks priced $4.1 billion in TAPs during the third quarter of 2009, compared to only $30 million during the second quarter of 2009. In terms of FHLBank bond funding costs, while weighted-average consolidated bond funding costs during the third quarter of 2009 deteriorated slightly compared to those of the second quarter of 2009, they were still above the average for the previous twelve months. In July 2009, the FHLBanks priced $4 billion of a new, three-year mandated Global bullet bond. In August 2009, the FHLBanks priced a $1.25 billion re-opening of its most recent two-year mandated Global bullet bond using a Dutch auction process. In September 2009, the FHLBanks priced $3 billion of a new, three-year mandated Global bullet bond.


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Primary securities dealer inventories of agency debt securities, as reported by the FRBNY, were virtually unchanged at the close of the third quarter of 2009 when compared to levels at the end of the second quarter of 2009. However, the mix of securities within these inventories shifted dramatically from discount notes to bonds; dealer inventories of agency discount notes dropped $12.5 billion during the third quarter of 2009, while dealer inventories of agency bonds increased almost $12 billion.
 
Foreign official holdings of agency debt and MBS securities, as reported by the Federal Reserve, continued to fall during the third quarter of 2009, dropping $39 billion during this quarter to levels last seen in August 2007. Meanwhile, during the third quarter of 2009, taxable money market fund assets fell another $148 billion, with assets allocated to “U.S. other agency” securities dropping $49 billion during this time period. In September 2009, the FHLBanks Office of Finance submitted a comment letter to the SEC on proposed rule changes for money market funds; such changes may be detrimental to agency discount note pricing.
 
The Bank’s net interest income is affected by several external factors, including market interest rate levels and volatility, credit spreads and the general state of the economy. Interest rates prevailing during any reporting period affect the Bank’s profitability for that reporting period, due primarily to the short-term structure of earning assets and the effect of interest rates on invested capital. A portion of the Bank’s loans to members has been hedged with interest-rate exchange agreements in which a short-term, variable rate is received. Interest rates also directly affect the Bank through earnings on invested capital. Generally, due to the Bank’s cooperative structure, the Bank earns relatively narrow net spreads between the yield on assets and the cost of corresponding liabilities.
 
The following table presents key market interest rates for the periods indicated (obtained from Bloomberg L.P.).
 
                                                                 
                      Average
    Average
                   
    3rd
    2nd
    3rd
    Year-to-
    Year-to-
    3rd
    2nd
    3rd
 
    Quarter
    Quarter
    Quarter
    Date
    Date
    Quarter
    Quarter
    Quarter
 
    2009
    2009
    2008
    September
    September
    2009
    2009
    2008
 
    Average     Average     Average     2009     2008     Ended     Ended     Ended  
Target overnight
                                                               
Federal funds rate
    0.25%       0.25%       2.00%       0.25%       2.43%       0.25%       0.25%       2.00%  
3-month LIBOR(1)
    0.41%       0.84%       2.91%       0.83%       2.98%       0.29%       0.60%       4.05%  
2-yr U.S. Treasury
    1.02%       1.00%       2.35%       0.97%       2.26%       0.95%       1.12%       1.97%  
5-yr. U.S. Treasury
    2.45%       2.23%       3.11%       2.15%       3.00%       2.32%       2.56%       2.98%  
10-yr. U.S. Treasury
    3.50%       3.30%       3.85%       3.17%       3.79%       3.31%       3.54%       3.83%  
15-yr. mortgage current coupon(2)
    3.82%       3.84%       5.30%       3.80%       5.03%       3.57%       4.01%       5.30%  
30-yr. mortgage current coupon(2)
    4.50%       4.31%       5.79%       4.31%       5.58%       4.26%       4.63%       5.70%  
 
Notes:
 
(1) LIBOR - London Interbank Offered Rate
(2) Simple average of Fannie Mae and Freddie Mac MBS current coupon rates.
 
The Bank is also heavily affected by the residential mortgage market through the collateral securing member loans and holdings of mortgage-related assets. As of September 30, 2009, 60.4% of the Bank’s eligible collateral value, after collateral weightings, was concentrated in 1-4 single family residential mortgage loans or multi-family residential mortgage loans, compared with 45.5% at December 31, 2008. The remaining 39.6% at September 30, 2009 was concentrated in other real estate-related collateral and high quality investment securities, compared to 54.5% at December 31, 2008. For the top ten borrowers, 1-4 single family residential mortgage loans or multi-family residential mortgage loans accounted for 66.6% of total eligible collateral, after collateral weightings, at September 30, 2009, compared to 47.3% at December 31, 2008. The remaining 33.4% at September 30, 2009 was concentrated in other real estate-related collateral and high quality investment securities, compared to 52.7% at December 31, 2008. Due to collateral policy changes implemented in third quarter 2009, the mix of collateral types within the total portfolio shifted. The new requirement to deliver all securities pledged as collateral, as well as refinements in collateral reporting and tracking made through the QCR process, impacted the concentration of collateral types by category. As of September 30, 2009, the Bank’s private label MBS portfolio represented 9.5% of total assets, while net mortgage loans held for portfolio represented 8.0% of total assets. At December 31, 2008, the comparable percentages were 9.4% and 6.8%, respectively.


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The Bank continues to have high concentrations of its loans to members portfolio outstanding to its top ten borrowers. The Bank’s loans to members portfolio declined from December 31, 2008 to September 30, 2009, decreasing $20.8 billion, or 33.4%, due to a slowing of new loan growth and increased access by members to other government funding sources. Also, many of the Bank’s members have reacted to the Bank’s temporary actions of not paying dividends and not repurchasing excess capital stock by limiting their use of the Bank’s loans to members products. As well, the recession has decreased the Bank’s members’ need for funding from the Bank.
 
In addition, see the “Credit and Counterparty Risk” and “Market Risk” discussions in the Risk Management section of this Item 2. Management’s Discussion and Analysis in this report filed on Form 10-Q for information related to derivative counterparty risk and overall market risk of the Bank.
 
Lehman Brothers Holding, Inc. (Lehman) and Lehman Brothers Special Financing, Inc.  On September 15, 2008, Lehman filed for bankruptcy. At that time, Lehman’s subsidiary, Lehman Brothers Special Financing, Inc. (LBSF) was the Bank’s largest derivatives counterparty, with a total of 595 outstanding derivative trades having a total notional value of $16.3 billion. Lehman was a guarantor under the Bank’s agreement with LBSF such that Lehman’s bankruptcy filing triggered an event of default. The Bank posted cash collateral to secure its exposure to Lehman on its derivative transactions. As a result of the bankruptcy filing, the Bank evaluated the outstanding trades it had with LBSF to assess which individual derivatives were most important to the Bank’s overall risk position. Of the 595 trades, 63 represented approximately half of the total LBSF notional value and almost 100% of the base case duration impact of the LBSF portfolio. Therefore, the Bank elected to enter into 63 identical new trades with different counterparties on September 18, 2008.
 
Management determined that it was in the Bank’s best interest to declare an event of default and designate September 19, 2008 as the early termination date of the Bank’s agreement with LBSF, as provided for in the agreement. Accordingly, all LBSF derivatives were legally terminated at that time and the Bank began the process of obtaining third party quotes for all of the derivatives in order to settle its position with LBSF in accordance with the International Swaps Dealers Association, Inc. (ISDA) Master Agreement (Master Agreement). The Bank sent a final settlement notice to LBSF and demanded return of the balance of posted Bank collateral, which, including dealer quotes for all trades, the collateral position, and the applicable accrued interest netted to an approximate $41.5 million receivable from LBSF.
 
The Bank filed an adversary proceeding against LBSF and J.P. Morgan Chase Bank, N.A. (JP Morgan) to return the cash collateral posted by the Bank associated with the derivative contracts. See discussion within Item 3. Legal Proceedings in the Bank’s 2008 Annual Report filed on Form 10-K for more information with respect to the proceeding. In its Third Quarter 2008 Form 10-Q and its 2008 Annual Report filed on Form 10-K, the Bank disclosed that it was probable that a loss has been incurred with respect to this receivable. However, the Bank had not recorded a reserve with respect to the receivable from LBSF because the Bank was unable to reasonably estimate the amount of loss that had been incurred. There have been continuing developments in the adversary proceeding, that have occurred since the filing of the Bank’s Form 10-K. The discovery phase of the adversary proceeding is now underway, which has provided management information related to its claim. Based on this information, management’s most probable estimated loss is $35.3 million and a reserve was recorded in first quarter 2009. As of September 30, 2009, the Bank maintained a $35.3 million reserve on this receivable as this remains the most probable estimated loss.
 
During discovery in the Bank’s adversary proceeding against LBSF, the Bank learned that LBSF had failed to keep the Bank’s posted collateral in a segregated account in violation of the Master Agreement between the Bank and LBSF. In fact, the posted collateral was held in a general operating account of LBSF the balances of which were routinely swept to other Lehman Brother entities, including Lehman Brothers Holdings, Inc. among others. After discovering that the Bank’s posted collateral was transferred to other Lehman entities and not held by JP Morgan, the Bank agreed to discontinue the LBSF adversary proceeding against JP Morgan. JP Morgan was dismissed from the Bank’s proceeding on June 26, 2009. In addition, the Bank discontinued its LBSF adversary proceeding and pursued its claim in the LBSF bankruptcy through the proof of claim process, which made continuing the adversary proceeding against LBSF unnecessary.
 
The Bank has filed a new complaint against Lehman Brothers Holding Inc., Lehman Brothers, Inc., Lehman Brothers Commercial Corporation, Woodlands Commercial Bank, formerly known as Lehman Brothers Commercial Bank, and Aurora Bank FSB (Aurora), formerly known as Lehman Brothers Bank FSB, alleging unjust enrichment, constructive trust, and conversion claims. Aurora is a member of the Bank. Aurora did not hold more than five percent of the Bank’s capital stock as of September 30, 2009.


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Financial Highlights
 
The Statement of Operations data for the three and nine months ended September 30, 2009 and 2008 and the Condensed Statement of Condition data as of September 30, 2009 are unaudited and were derived from the financial statements included in this report. The Condensed Statement of Condition data as of December 31, 2008 was derived from the audited financial statements in the Bank’s 2008 Annual Report filed on Form 10-K.
 
Statement of Operations
 
                                         
      Three Months Ended
      Nine Months Ended
 
      September 30,       September 30,  
(in millions, except per share data)     2009       2008       2009       2008  
Net interest income before provision for credit losses
    $ 67.5       $ 74.1       $ 199.8       $ 252.4  
Provision for credit losses
      1.4         2.1         2.9         5.5  
Net OTTI losses
      (93.3 )       -         (163.1 )       -  
Net gains (losses) on derivatives and hedging activities
      (4.5 )       71.4         6.7         75.1  
Contingency reserve
      -         -         (35.3 )       -  
All other income
      4.5         2.0         9.6         4.9  
Other expense
      16.2         13.6         46.7         44.7  
                                         
Income before assessments
      (43.4 )       131.8         (31.9 )       282.2  
Assessments
      (3.0 )       35.0         -         74.9  
                                         
Net income (loss)
    $ (40.4 )     $ 96.8       $ (31.9 )     $ 207.3  
                                         
                                         
Earnings per share (1)
    $ (1.01 )     $ 2.43       $ (0.80 )     $ 5.12  
                                         
                                         
Dividends
    $ -       $ 35.2       $ -       $ 121.6  
Weighted average dividend rate (2)
      n/a         3.50 %       n/a         4.07 %
Return on average capital
      (4.39 )%       8.99 %       (1.09 )%       6.36 %
Return on average assets
      (0.23 )%       0.40 %       (0.05 )%       0.28 %
Net interest margin (3)
      0.39 %       0.31 %       0.35 %       0.34 %
Total period-end capital to period-end assets (4)
      5.36 %       4.63 %       5.36 %       4.63 %
Total average capital to average assets
      5.17 %       4.43 %       4.92 %       4.33 %
                                         
n/a - not applicable
Notes:
 
(1) Earnings per share calculated based on net income (loss).
(2) Weighted average dividend rates are calculated as annualized dividends paid in the period divided by the average capital stock balance outstanding during the period on which the dividend is based.
(3) Net interest margin is net interest income before provision for credit losses as a percentage of average interest-earning assets.
(4) Total capital ratio is GAAP capital, which includes capital stock plus retained earnings and AOCI, as a percentage of total assets at period-end.


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Condensed Statement of Condition
 
                 
    September 30,
    December 31,
 
(in millions)   2009     2008  
Loans to members
  $ 41,363.4     $ 62,153.4  
Investments - Federal funds sold, interest-earning deposits and investment securities (1)
    19,039.9       21,798.1  
Mortgage loans held for portfolio, net
    5,339.1       6,165.3  
Prepaid REFCORP assessment
    39.6       39.6  
Total assets
    66,510.5       90,805.9  
Deposits and other borrowings (2)
    1,032.0       1,491.1  
Consolidated obligations, net (3)
    60,484.8       84,263.0  
AHP payable
    28.0       43.4  
Capital stock-putable
    4,013.1       3,981.7  
Retained earnings
    394.5       170.5  
AOCI
    (845.2 )     (17.3 )
Total capital
    3,562.4       4,134.9  
                 
Notes:
 
(1) None of these securities were purchased under agreements to resell.
(2) Includes mandatorily redeemable capital stock.
(3) Aggregate FHLB System-wide consolidated obligations (at par) were $1.0 trillion and $1.3 trillion at September 30, 2009 and December 31, 2008, respectively.
 
Forward-Looking Information
 
Statements contained in this quarterly report on Form 10-Q, including statements describing the objectives, projections, estimates, or predictions of the future of the Bank, may be “forward-looking statements.” These statements may use forward-looking terms, such as “anticipates,” “believes,” “could,” “estimates,” “may,” “should,” “will,” or their negatives or other variations on these terms. The Bank cautions that by their nature, forward-looking statements involve risk or uncertainty and that actual results could differ materially from those expressed or implied in these forward-looking statements or could affect the extent to which a particular objective, projection, estimate, or prediction is realized. These forward-looking statements involve risks and uncertainties including, but not limited to, the following: economic and market conditions, including, but not limited to, real estate, credit and mortgage markets; volatility of market prices, rates, and indices; political, legislative, regulatory, litigation, or judicial events or actions; changes in the Bank’s capital structure; changes in the Bank’s capital requirements; membership changes; changes in the demand by Bank members for Bank loans to members; an increase in loans to members prepayments; competitive forces, including the availability of other sources of funding for Bank members; changes in investor demand for consolidated obligations and/or the terms of interest rate exchange agreements and similar agreements; the ability of the Bank to introduce new products and services to meet market demand and to manage successfully the risks associated with new products and services; the ability of each of the other FHLBanks to repay the principal and interest on consolidated obligations for which it is the primary obligor and with respect to which the Bank has joint and several liability; and timing and volume of market activity. This Management’s Discussion and Analysis should be read in conjunction with the Bank’s unaudited interim financial statements and notes and Risk Factors included in Part II, Item 1A of the Bank’s quarterly report filed on Form 10-Q for the First, Second and Third Quarters of 2009, as well as Risk Factors in Item 1A of the Bank’s 2008 Annual Report filed on Form 10-K.


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Earnings Performance
 
The following is Management’s Discussion and Analysis of the Bank’s earnings performance for the three and nine months ended September 30, 2009 compared to the three and nine months ended September 30, 2008. This discussion should be read in conjunction with the unaudited interim financial statements and notes included in this report filed on Form 10-Q as well as the audited financial statements and analysis for the year ended December 31, 2008, included in the Bank’s 2008 Annual Report filed on Form 10-K.
 
Summary of Financial Results
 
Net Income and Return on Capital.  The Bank recorded a net loss of $40.4 million for third quarter 2009, compared to net income of $96.8 million in third quarter 2008. This decrease was primarily due to $93.3 million of OTTI credit loss charges taken on the Bank’s MBS investment portfolio in the third quarter of 2009, lower net interest income, and a nonrecurring gain in the third quarter of 2008. The increase in the credit portion of OTTI charges for the third quarter of 2009 was primarily due to continued stress in the housing markets. The Bank’s return on average capital was (4.39)% in the third quarter of 2009, compared to 8.99% in the same year-ago period.
 
For the nine months ended September 30, 2009, the Bank recorded a net loss of $31.9 million, compared to net income of $207.3 million in the same prior year period. This significant decline was due to OTTI credit losses of $163.1 million, a first quarter 2009 contingency reserve of $35.3 million, lower net interest income, and a nonrecurring gain in the third quarter of 2008. The Bank’s return on average capital for the nine months ended September 30, 2009 was (1.09)%, compared to 6.36% in the same year-ago period.
 
Both the third quarter 2008 and nine months ended September 30, 2008 results included significant net gains on derivatives and hedging activities related to the termination and replacement of LBSF derivatives as discussed in the Bank’s Third Quarter 2008 quarterly report filed on Form 10-Q on November 12, 2008. This gain did not recur in 2009.
 
Details of the Statement of Operations are presented more fully below.
 
Dividend Rate.  Management regards quarterly dividend payments as an important vehicle through which a direct investment return is provided to the Bank’s members. On December 23, 2008, the Bank announced its decision to voluntarily suspend payment of dividends for the foreseeable future. Therefore, there were no dividends declared or paid in the first nine months of 2009. The Bank’s weighted average dividend rate was 3.50% for third quarter 2008 and 4.07% for the nine months ended September 30, 2008. See additional discussion regarding dividends and retained earnings levels in the “Financial Condition” section of this Item 2. Management’s Discussion and Analysis in this report filed on Form 10-Q.


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Net Interest Income
 
The following table summarizes the rate of interest income or interest expense, the average balance for each of the primary balance sheet classifications and the net interest margin for the three and nine months ended September 30, 2009 and 2008.
 
Average Balances, Interest Income/Expense and Yields/Rates Paid
 
                                                             
      Three Months Ended September 30,  
      2009       2008  
                      Avg.
                      Avg.
 
              Interest
      Yield/
              Interest
      Yield/
 
      Average
      Income/
      Rate
      Average
      Income/
      Rate
 
(dollars in millions)     Balance(1)       Expense       (%)       Balance(1)       Expense       (%)  
Assets
                                                           
Federal funds sold(2)
    $ 5,714.0       $ 1.8         0.13       $ 4,378.3       $ 19.9         1.81  
Interest-earning deposits
      671.5         0.3         0.17         405.6         2.0         1.91  
Investment securities(3)
      16,289.4         128.0         3.12         17,470.7         188.1         4.28  
Loans to members(4)
      40,848.0         115.8         1.12         66,488.2         469.8         2.81  
Mortgage loans held for portfolio(5)
      5,471.2         67.6         4.90         6,046.3         78.3         5.16  
                                                             
Total interest-earning assets
      68,994.1         313.5         1.80         94,789.1         758.1         3.18  
Allowance for credit losses
      (16.0 )                           (10.9 )                    
Other assets(4)(5)(6)
      1,526.6                             2,016.0                      
                                                             
Total assets
    $ 70,504.7                           $ 96,794.2                      
                                                             
                                                             
Liabilities and capital
                                                           
Deposits
    $ 1,799.0         0.3         0.07       $ 1,819.2         8.2         1.78  
Consolidated obligation discount notes
      11,814.8         5.3         0.18         23,939.4         138.0         2.29  
Consolidated obligation bonds(4)
      51,007.8         240.3         1.87         65,115.3         537.7         3.28  
Other borrowings
      8.2         0.1         0.77         31.1         0.1         2.57  
                                                             
Total interest-bearing liabilities
      64,629.8         246.0         1.51         90,905.0         684.0         2.99  
Other liabilities(4)
      2,227.9                             1,600.7                      
Total capital
      3,647.0                             4,288.5                      
                                                             
Total liabilities and capital
    $ 70,504.7                           $ 96,794.2                      
                                                             
                                                             
Net interest spread
                          0.29                             0.19  
Impact of noninterest-bearing funds
                          0.10                             0.12  
                                                             
Net interest income/net interest margin
              $ 67.5         0.39                 $ 74.1         0.31  
                                                             
Notes:
(1)  Average balances of deposits (assets and liabilities) include cash collateral received from/paid to counterparties which are reflected in the Statement of Condition as derivative assets/liabilities.
(2)  The average balance of Federal funds sold, related interest income and average yield calculations may include loans to other FHLBanks and securities sold under agreement to repurchase.
(3)  Investment securities include trading, held-to-maturity and available-for-sale securities. The average balances of held-to-maturity securities and available-for-sale securities are reflected at amortized cost; therefore, the resulting yields do not give effect to changes in fair value or the noncredit component of a previously recognized OTTI reflected in AOCI.
(4)  Average balances reflect reclassification of noninterest-earning/noninterest-bearing hedge accounting adjustments to other assets or other liabilities.
(5)  Nonaccrual mortgage loans are included in average balances in determining the average rate. BOB loans are reflected in other assets.
(6)  The noncredit portion of OTTI losses on investment securities is reflected in other assets for purposes of the average balance sheet presentation.


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Net interest income was $67.5 million for third quarter 2009, a decline of $6.6 million, or 8.9%, from the same year-ago period. Lower interest rates and lower volumes were factors driving the decline. Total average interest-earning assets were $69.0 billion for the third quarter 2009, declining $25.8 billion, or 27.2%, from the same year-ago period. Total average loans to members declined $25.6 billion, or 38.6%, to $40.8 billion in the third quarter 2009 and were the primary driver of lower overall total average assets. The loans to members portfolio declined significantly as members reduced risk, de-levered, increased deposits and utilized government programs aimed at improving liquidity. Also, many of the Bank’s members have reacted to the Bank’s temporary actions of not paying dividends and not repurchasing excess capital stock by limiting their use of the Bank’s loans to members products. As well, the recession has decreased the Bank’s members’ need for funding from the Bank.
 
Net interest margin improved 8 basis points to 39 basis points in the third quarter 2009 compared to the third quarter 2008. Lower funding costs and increased funding of the investment securities portfolio with short-term debt, particularly discount notes, were the factors that drove the improvement. The rates paid on discount notes declined 211 basis points to 18 basis points in third quarter 2009. Partially offsetting the improved cost of funds was the drastic decline in yields on interest-free funds (capital) which are typically invested in short-term assets, generally Federal funds sold. The yield on Federal funds sold was 13 basis points for third quarter 2009, 168 basis points lower than the same year-ago period. Earlier in 2009, the Bank shifted much of its overnight investments to interest-earning FRB accounts, as the yield was higher than Federal funds sold. Beginning in July 2009, the FRB stopped paying interest on these excess balances it holds on the Bank’s behalf, and consequently the Bank shifted its investments back to Federal funds sold at a lower yield.


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Average Balances, Interest Income/Expense and Yields/Rates Paid
 
                                                             
      Nine Months Ended September 30,  
      2009       2008  
                      Avg.
                      Avg.
 
              Interest
      Yield/
              Interest
      Yield/
 
      Average
      Income/
      Rate
      Average
      Income/
      Rate
 
(dollars in millions)     Balance(1)       Expense       (%)       Balance(1)       Expense       (%)  
Assets
                                                           
Federal funds sold(2)
    $ 1,968.3       $ 1.9         0.13       $ 4,186.3       $ 73.0         2.33  
Interest-earning deposits
      6,087.1         11.1         0.24         444.0         8.1         2.43  
Investment securities(3)
      15,856.4         424.7         3.58         18,905.5         629.2         4.45  
Loans to members(4)
      47,403.6         527.4         1.49         68,409.4         1,682.1         3.28  
Mortgage loans held for portfolio(5)
      5,779.9         214.8         4.97         6,098.8         235.6         5.16  
                                                             
Total interest-earning assets
      77,095.3         1,179.9         2.05         98,044.0         2,628.0         3.58  
Allowance for credit losses
      (15.1 )                           (9.3 )                    
Other assets(4)(5)(6)
      2,174.4                             2,389.3                      
                                                             
Total assets
    $ 79,254.6                           $ 100,424.0                      
                                                             
                                                             
Liabilities and capital
                                                           
Deposits
    $ 1,792.5         1.1         0.08       $ 1,961.2         33.5         2.28  
Consolidated obligation discount notes
      15,158.5         38.9         0.34         28,467.1         590.4         2.77  
Consolidated obligation bonds(4)
      55,837.7         940.0         2.25         63,742.4         1,751.4         3.67  
Other borrowings
      7.6         0.1         0.88         14.1         0.3         3.25  
                                                             
Total interest-bearing liabilities
      72,796.3         980.1         1.80         94,184.8         2,375.6         3.37  
Other liabilities(4)
      2,562.4                             1,886.5                      
Total capital
      3,895.9                             4,352.7                      
                                                             
Total liabilities and capital
    $ 79,254.6                           $ 100,424.0                      
                                                             
                                                             
Net interest spread
                          0.25                             0.21  
Impact of noninterest-bearing funds
                          0.10                             0.13  
                                                             
Net interest income/net interest margin
              $ 199.8         0.35                 $ 252.4         0.34  
                                                             
Notes:
 
(1) Average balances of deposits (assets and liabilities) include cash collateral received from/paid to counterparties which are reflected in the Statement of Condition as derivative assets/liabilities.
(2) The average balance of Federal funds sold, related interest income and average yield calculations may include loans to other FHLBanks and securities sold under agreement to repurchase.
(3) Investment securities include trading, held-to-maturity and available-for-sale securities. The average balances of held-to-maturity securities and available-for-sale securities are reflected at amortized cost; therefore, the resulting yields do not give effect to changes in fair value or the noncredit component of a previously recognized OTTI reflected in AOCI.
(4) Average balances reflect reclassification of noninterest-earning/noninterest-bearing hedge accounting adjustments to other assets or other liabilities.
(5) Nonaccrual mortgage loans are included in average balances in determining the average rate. BOB loans are reflected in other assets.
(6) The noncredit portion of OTTI losses on investment securities is reflected in other assets for purposes of the average balance sheet presentation.
 
Net interest income was $199.8 million for the nine months ended September 30, 2009, a decline of $52.6 million, or 20.8%, from the same year-ago period. Lower interest rates combined with lower volumes were the drivers of the decline. Total average interest-earning assets were $77.1 billion for the nine months ended September 30, 2009 compared to $98.0 billion for the same year-ago period, declining $20.9 billion, or 21.4%. The primary driver of the decline was lower total average loans which decreased $21.0 billion, or 30.7%, to $47.4 billion for the nine months ended September 30, 2009 compared to the same year-ago period. The loans to member portfolio declined significantly as members reduced risk, de-levered, increased deposits and utilized government


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programs aimed at improving liquidity. Also, many of the Bank’s members have reacted to the Bank’s temporary actions of not paying dividends and not repurchasing excess capital stock by limiting their use of the Bank’s loans to members products. As well, the recession has decreased the Bank’s members’ need for funding from the Bank. Average investments in short-term assets increased generally in response to regulatory demands, and largely offset the reductions in the MBS and mortgage loan portfolios.
 
Net interest margin improved 1 basis point to 35 basis points, compared to 34 basis points a year ago. Favorable funding costs, partially offset by the lower yields on interest-free funds (capital), contributed to the slight improvement. Yields on interest-earning assets fell 153 basis points in the year-over-year comparison, while rates paid on interest-bearing liabilities fell 157 basis points. The impact of favorable funding was most evident within the investment securities portfolio. The improvement in cost of funds associated with this portfolio combined with the increased use of short-term debt has greatly improved spreads. Offsetting this improvement was the lower yield on interest-free funds (capital), typically invested in short-term assets, as evidenced by the 220 basis point and 219 basis point decline in yields on Federal funds sold and interest-bearing deposits, respectively. Over the past year, as the yields on Federal funds sold declined, the Bank shifted its investments to higher-yield interest-bearing FRB accounts. Beginning in July 2009, the Federal Reserve stopped paying interest on these excess balances that it holds on the Bank’s behalf and the Bank shifted its investments back to Federal funds sold. Additional details and analysis regarding the shift in the mix of these categories is included in the “Rate/Volume Analysis” discussion below.
 
Rate/Volume Analysis.  Changes in both volume and interest rates influence changes in net interest income and net interest margin. The following table summarizes changes in interest income and interest expense between 2009 and 2008.
 
                                                             
      Increase (Decrease) in Interest Income/Expense Due to Changes
 
      in Rate/Volume  
      Three Months Ended September 30       Nine Months Ended September 30  
(in millions)     Volume       Rate       Total       Volume       Rate       Total  
Federal funds sold
    $ (5.2 )     $ (12.9 )     $ (18.1 )     $ (15.9 )     $ (55.2 )     $ (71.1 )
Interest-earning deposits
      (0.5 )       (1.2 )       (1.7 )       0.7         2.3         3.0  
Investment securities
      (34.6 )       (25.5 )       (60.1 )       (119.4 )       (85.1 )       (204.5 )
Loans to members
      (135.1 )       (218.9 )       (354.0 )       (384.3 )       (770.4 )       (1,154.7 )
Mortgage loans held for portfolio
      (9.5 )       (1.2 )       (10.7 )       (18.3 )       (2.5 )       (20.8 )
Other(1)
      (19.9 )       19.9         -         (26.2 )       26.2         -  
                                                             
Total interest-earning assets
    $ (204.8 )     $ (239.8 )     $ (444.6 )     $ (563.4 )     $ (884.7 )     $ (1,448.1 )
                                                             
Interest-bearing deposits
    $ (2.3 )     $ (5.6 )     $ (7.9 )     $ (7.6 )     $ (24.8 )     $ (32.4 )
Consolidated obligation discount notes
      (40.3 )       (92.4 )       (132.7 )       (138.9 )       (412.6 )       (551.5 )
Consolidated obligation bonds
      (143.7 )       (153.7 )       (297.4 )       (351.1 )       (460.3 )       (811.4 )
Other borrowings
      -         -         -         (0.1 )       (0.1 )       (0.2 )
Other(1)
      (10.1 )       10.1         -         (43.5 )       43.5         -  
                                                             
Total interest-bearing liabilities
    $ (196.4 )     $ (241.6 )     $ (438.0 )     $ (541.2 )     $ (854.3 )     $ (1,395.5 )
                                                             
Total increase (decrease) in net interest income
    $ (8.4 )     $ 1.8       $ (6.6 )     $ (22.2 )     $ (30.4 )     $ (52.6 )
                                                             
                                                             
Note:
 
(1) Total interest income/expense rate and volume amounts are calculated values. The difference between the weighted average total amounts and the individual balance sheet components is reported in other above.
 
Net interest income decreased $6.6 million from third quarter 2008 to third quarter 2009, driven by the volume of interest-earning assets and interest-bearing liabilities. This decline was slightly offset by a nominal rate benefit in the quarter-over-quarter comparison. Total interest income decreased $444.6 million in the quarter-over-quarter comparison. This decline included a decrease of $239.8 million due to rate and $204.8 million due to volume, driven primarily by the loans to members portfolio and, to a lesser extent, the investment securities portfolio, as discussed below. Total interest expense decreased $438.0 million in the same comparison, including a rate impact of


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$241.6 million and a volume impact of $196.4 million, both due to the consolidated obligation bonds and discount notes portfolios, discussed in more detail below.
 
For the nine months ended September 30, 2009, net interest income decreased $52.6 million, also driven by both volume of and rates on interest-earning assets and interest-bearing liabilities. Total interest income decreased $1.4 billion in the year-over-year comparison, including $884.7 million due to rate and $563.4 million due to volume, both primarily related to the loans to members portfolio and, to a lesser extent, the investment securities portfolio, as discussed below. Total interest expense also decreased $1.4 billion in the same comparison, including $854.3 million driven by rate and $541.2 million driven by volume. Both decreases were driven by the consolidated obligation bonds and discount notes portfolios, which are discussed in more detail below.
 
Federal funds sold increased $1.3 billion from third quarter 2008 to third quarter 2009; however, interest income on the portfolio decreased $18.1 million primarily due to a decline in yield of 168 basis points. Interest-earning deposits increased $265.9 million quarter-over-quarter; however, interest income on the portfolio decreased $1.7 million in the same comparison primarily due to a decline in yield of 174 basis points. For the nine months ended September 30, 2009, Federal funds sold decreased $2.2 billion from the same prior year period, reflecting a shift in the first part of 2009 to interest-earning deposits due to favorable rates paid on FRB balances, as previously discussed. Related interest income declined $71.1 million, driven in large part by a 220 basis point decline in yield on the portfolio. For the nine months ended September 30, 2009, interest-earning deposits increased $5.6 billion, although related interest income only increased $3.0 million due to the relatively low yields on short-term investments.
 
The decrease in yields on both Federal funds sold and interest-earning deposits in the quarter-over-quarter and year-over-year comparisons reflects the significant downward change in overall short-term rates. These decreases are evidenced in the interest rate trend presentation in the “Current Financial and Mortgage Market Events and Trends” discussion in the Overview Section of this Item 2. Management’s Discussion and Analysis in this report filed on Form 10-Q. The net $1.6 billion and $3.4 billion increases in balances between these two categories in the quarter-over-quarter and year-over-year comparisons, respectively, reflect the Bank’s continued strategy in part to maintain a strong liquidity position in short-term investments in order to meet members’ loan demand under conditions of market stress and to maintain adequate liquidity in accordance with Finance Agency guidance and Bank policies.
 
The decrease in the third quarter 2009 average investment securities portfolio balance compared to third quarter 2008 was $1.2 billion, or 6.8%. Correspondingly, the interest income on this portfolio decreased $60.1 million, driven by both volume and rate. Yields on the portfolio fell 116 basis points, also contributing to the decline. The average investment securities portfolio balance for the nine months ended September 30, 2009 decreased $3.0 billion, or 16.1%, from the same prior year period. In the same year-over-year comparison, interest income decreased $204.5 million, driven by the decrease in volume and an 87 basis point decline in yields.
 
The investment securities portfolio includes trading, available-for-sale and held-to-maturity securities, the majority of which are held-to-maturity. The decrease in investments quarter-over-quarter was due to declining certificates of deposit balances and run-off of the held-to-maturity MBS portfolio as well as credit-related OTTI recorded on certain private label MBS. The Bank has been cautious toward investments linked to the U.S. housing market, including MBS. The Bank purchased only $260.0 million and $735.0 million of agency MBS in the three and nine months ended September 30, 2009, respectively.
 
The average loans to members portfolio decreased significantly from third quarter 2008 to third quarter 2009, declining $25.6 billion, or 38.6%, in the comparison. This decline in volume, coupled with a 169 basis point decrease in the yield, resulted in a $354.0 million decline in interest income on this portfolio quarter-over-quarter. For the nine months ended September 30, 2009, the average loans to members portfolio declined $21.0 billion, or 30.7%, over the same prior year period. This volume decrease, as well as a 179 basis point decline in the yield on the portfolio, resulted in a $1.2 billion decline in interest income year-over-year.
 
During the second half of 2007 and continuing into the first half of 2008, the Bank experienced unprecedented growth in the loans to members portfolio due to instability in the credit market, which resulted in increased demand from members for liquidity. This demand leveled off in the second and third quarters of 2008. Loan demand began


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to decline in the fourth quarter of 2008 and continued through the first nine months of 2009, as members grew core deposits and gained access to additional liquidity from the FRB and other government programs that only became available in the second half of 2008. The interest income on this portfolio was significantly impacted by the decline in short-term rates, the decrease of which is presented in the interest rate trend presentation in the “Current Financial and Mortgage Market Events and Trends” discussion in this Item 2. Management’s Discussion and Analysis in this report filed on Form 10-Q. Specific mix changes within the portfolio are discussed more fully below under “Loans to Members Portfolio Detail.”
 
The mortgage loans held for portfolio balance declined $575.1 million, or 9.5%, from third quarter 2008 to third quarter 2009. The related interest income on this portfolio declined $10.7 million quarter-over-quarter. For the nine months ended September 30, 2009, the mortgage loans held for portfolio balance decreased $318.9 million, or 5.2%, from the same prior year period. The corresponding interest income declined $20.8 million in the same comparison. The volume of mortgages purchased from members was steady from quarter-to-quarter and year-over-year, but was outpaced by acceleration in the run-off of the existing portfolio. The decline in interest income was due primarily to lower average portfolio balances in both comparisons although yields on the portfolio also declined 26 basis points and 19 basis points quarter-over-quarter and year-over-year, respectively.
 
Interest-bearing deposits decreased $20.2 million, or 1.1%, from third quarter 2008 to third quarter 2009, with a corresponding decrease in interest expense of $7.9 million, driven primarily by the 171 basis point decline in rates paid. For the nine months ended September 30, 2009, interest-bearing deposits decreased $168.7 million, or 8.6%, from the same prior year period. Interest expense on interest-bearing deposits decreased $32.4 million in the year-over-year comparison driven by a 220 basis point decline in rates paid. Average interest-bearing deposit balances fluctuate periodically and are driven by member activity.
 
The consolidated obligations portfolio balance decreased in both the quarter-over-quarter and year-over-year comparisons. The third quarter 2009 discount notes average balance decreased $12.1 billion, or 50.6%, compared to the third quarter 2008 average balance, while the average bonds balance for third quarter 2009 decreased $14.1 billion, or 21.7%, compared to third quarter 2008. For the nine months ended September 30, 2009, average discount notes decreased $13.3 billion, or 46.8%, compared to the same prior year period, while average bonds decreased $7.9 billion, or 12.4%, in the same comparison. The declines in discount notes were consistent with the decline in short-term loan demand from members as noted above. Interest expense on discount notes decreased $132.7 million from third quarter 2008 to third quarter 2009. For the nine months ended September 30, 2009, interest expense on discount notes decreased $551.5 million from the same year-ago period. These decreases were partially attributable to the volume decline and partially due to the 211 and 243 basis point declines in rates paid in the quarter-over-quarter and year-over-year, respectively. The declines in rates paid were consistent with the general decline in short-term rates as previously mentioned. Interest expense on bonds decreased $297.4 million quarter-over-quarter and $811.4 million year-over-year. These decreases were due in part to volume decline as well as decreases in rates paid on bonds of 141 and 142 basis points quarter-over-quarter and year-over-year, respectively.
 
A portion of the bond portfolio is swapped to 3-month LIBOR; therefore, as the LIBOR rate (decreases) increases, interest expense on swapped bonds, including the impact of swaps, (decreases) increases. Market conditions continued to impact spreads on the Bank’s consolidated obligations. Bond spreads were volatile in the beginning of 2009 and the Bank had experienced some obstacles in attempting to issue longer-term debt as investors had been reluctant to buy longer-term GSE obligations. However, investor demand for shorter-term GSE debt has been strong during the first nine months of 2009 and the Bank continued to be able to issue discount notes at attractive rates as needed. The Bank has also experienced an increase in demand for debt with maturities ranging from one to three years during the second and third quarters of 2009. See details regarding the impact of swaps on the quarterly rates paid in the “Net Interest Income Derivatives Effects” discussion below.
 
For additional information, see the “Liquidity and Funding Risk” discussion in Risk Management in this Item 2. Management’s Discussion and Analysis in this report filed on Form 10-Q.


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Average Loans to Members Portfolio Detail
 
                                   
      Three Months Ended September 30,     Nine Months Ended September 30,  
(in millions)            
                 Product     2009     2008     2009     2008  
Repo
    $ 19,927.2     $ 40,433.6     $ 23,914.8     $ 42,923.0  
Term Loans
      12,978.8       13,186.8       13,677.3       12,487.3  
Convertible Select
      7,173.9       9,105.5       7,290.7       9,314.6  
Hedge Select
      120.4       160.0       127.7       160.0  
Returnable
      612.3       3,601.5       2,352.1       3,523.8  
                                   
Total par value
    $ 40,812.6     $ 66,487.4     $ 47,362.6     $ 68,408.7  
                                   
                                   
 
The par value of the Bank’s average loans to members portfolio decreased 38.6% in third quarter 2009 from third quarter 2008 and 30.8% in the nine months ended September 30, 2009 from the same prior year period. The most significant percentage decrease in both the quarter-over-quarter and year-over-year comparisons was in the Repo product, which decreased $20.5 billion, or 50.7%, and $19.0 billion, or 44.3%, respectively. In addition, the Returnable product decreased $3.0 billion, or 83.0%, and $1.2 billion, or 33.3%, in the quarter-over-quarter and year-over-year comparisons, respectively. The most significant dollar decrease in both comparisons was in the Mid-Term RepoPlus product which decreased $13.0 billion, or 40.7%, and $11.8 billion, or 35.1%, respectively.
 
Average balances for the Repo product decreased in 2009 reflecting the impact of members’ access to additional liquidity from government programs as well as members’ reactions to the Bank’s pricing of short-term loans to members products. Members have also taken other actions during the credit crisis, such as raising core deposits and reducing the size of their balance sheets. Also, many of the Bank’s members have reacted to the Bank’s temporary actions of not paying dividends and not repurchasing excess capital stock by limiting their use of the Bank’s loans to members products. As well, the recession has decreased the Bank’s members’ need for funding from the Bank. The majority of the decline was driven by decreases in average loans to members of the Bank’s larger borrowers, with five banks reducing their total average loans outstanding by $15.8 billion. The decline in Returnable product loans in both the quarter-over-quarter and year-over-year comparisons was due to significant paydowns by one of the Bank’s largest borrowers. To a much lesser extent, the decrease in interest rates also contributed to the decline in these balances.
 
The year-over-year increase in the average balance of Term Loans was driven primarily by a decline in interest rates; members elected to lock in lower rates on longer-term funding when possible. In addition, certain members had funding needs for term liquidity.
 
As of September 30, 2009, 42.8% of the par value of loans in the portfolio had a remaining maturity of one year or less, compared to 37.0% at December 31, 2008. Details of the portfolio components are included in Note 7 to the unaudited financial statements in this report filed on Form 10-Q.
 
The ability to grow the loans to members portfolio may be affected by, among other things, the following: (1) the liquidity demands of the Bank’s borrowers; (2) the composition of the Bank’s membership itself; (3) the Bank’s liquidity position and how management chooses to fund the Bank; (4) current, as well as future, credit market conditions and the Bank’s pricing levels on loans to members; (5) member reaction to the Bank’s voluntary decision to suspend dividend payments and excess capital stock repurchases until further notice; (6) actions of the U.S. government which have created additional competition; (7) housing market trends; and (8) the shape of the yield curve.
 
During 2008, the Federal Reserve took a series of unprecedented actions that have made it more attractive for eligible financial institutions to borrow directly from the FRBs, creating increased competition for the Bank. See the “Legislative and Regulatory Actions” discussion in Item 7. Management’s Discussion and Analysis in the Bank’s 2008 Annual Report filed on Form 10-K for additional information regarding these government actions.
 
The Bank accepts various forms of collateral including, but not limited to, AAA-rated investment securities and residential mortgage loans. In light of recent market conditions, the Bank recognizes that there is the potential for an increase in the credit risk of the portfolio. However, the Bank continues to monitor its collateral position and the related policies and procedures, to help ensure adequate collateral coverage. The Bank believes it was fully secured as of September 30, 2009. For more information on collateral, see the “Loan Products” discussion in Overview and the “Credit and Counterparty Risk” discussion in Risk Management both in this Item 2. Management’s Discussion and Analysis in this report filed on Form 10-Q.


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Net Interest Income Derivative Effects.  The following tables separately quantify the effects of the Bank’s derivative activities on its interest income and interest expense for the three and nine months ended September 30, 2009 and 2008. Derivative and hedging activities are discussed below in the “Other Income (Loss)” section.
 
                                                                     
Three Months Ended
                                                     
September 30, 2009                   Avg.
              Avg.
                 
            Interest Inc./
      Yield/
      Interest Inc./
      Yield/
              Incr./
 
      Average
    Exp. with
      Rate
      Exp. without
      Rate
      Impact of
      (Decr.)
 
(dollars in millions)     Balance     Derivatives       (%)       Derivatives       (%)       Derivatives(1)       (%)  
Assets:
                                                                   
Loans to members
    $ 40,848.0     $ 115.8         1.12       $ 396.7         3.85       $ (280.9 )       (2.73 )
Mortgage loans held for portfolio
      5,471.2       67.6         4.90         68.7         4.99         (1.1 )       (0.09 )
All other interest-earning assets
      22,674.9       130.1         2.28         130.1         2.28         -         -  
                                                                     
Total interest-earning assets
    $ 68,994.1     $ 313.5         1.80       $ 595.5         3.42       $ (282.0 )       (1.62 )
                                                                     
                                                                     
Liabilities and capital:
                                                                   
Consolidated obligation bonds
    $ 51,007.8     $ 240.3         1.87       $ 352.5         2.74       $ (112.2 )       (0.87 )
All other interest-bearing liabilities
      13,622.0       5.7         0.16         5.7         0.16         -         -  
                                                                     
Total interest-bearing liabilities
    $ 64,629.8     $ 246.0         1.51       $ 358.2         2.20       $ (112.2 )       (0.69 )
                                                                     
Net interest income/net interest spread
            $ 67.5         0.29       $ 237.3         1.22       $ (169.8 )       (0.93 )
                                                                     
                                                                     
Note:
 
(1) Impact of Derivatives includes net interest settlements and amortization of basis adjustments resulting from previously terminated hedging relationships.
 
                                                                     
Three Months Ended
                                                     
September 30, 2008                   Avg.
              Avg.
                 
            Interest Inc./
      Yield/
      Interest Inc./
      Yield/
              Incr./
 
      Average
    Exp. with
      Rate
      Exp. without
      Rate
      Impact of
      (Decr.)
 
(dollars in millions)     Balance     Derivatives       (%)       Derivatives       (%)       Derivatives(1)       (%)  
Assets:
                                                                   
Loans to members
    $ 66,488.2     $ 469.8         2.81       $ 660.5         3.95       $ (190.7 )       (1.14 )
Mortgage loans held for portfolio
      6,046.3       78.3         5.16         78.9         5.20         (0.6 )       (0.04 )
All other interest-earning assets
      22,254.6       210.0         3.75         210.0         3.75         -         -  
                                                                     
Total interest-earning assets
    $ 94,789.1     $ 758.1         3.18       $ 949.4         3.98       $ (191.3 )       (0.80 )
                                                                     
                                                                     
Liabilities and capital:
                                                                   
Consolidated obligation bonds
    $ 65,115.3     $ 537.7         3.28       $ 636.8         3.89       $ (99.1 )       (0.61 )
All other interest-bearing liabilities
      25,789.7       146.3         2.26         146.3         2.26         -         -  
                                                                     
Total interest-bearing liabilities
    $ 90,905.0     $ 684.0         2.99       $ 783.1         3.43       $ (99.1 )       (0.44 )
                                                                     
Net interest income/net interest spread
            $ 74.1         0.19       $ 166.3         0.55       $ (92.2 )       (0.36 )
                                                                     
                                                                     
Note:
 
(1) Impact of Derivatives includes net interest settlements and amortization of basis adjustments resulting from previously terminated hedging relationships.
 


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Nine Months Ended
                                                     
September 30, 2009                   Avg.
              Avg.
                 
            Interest Inc./
      Yield/
      Interest Inc./
      Yield/
              Incr./
 
      Average
    Exp. with
      Rate
      Exp. without
      Rate
      Impact of
      (Decr.)
 
(dollars in millions)     Balance     Derivatives       (%)       Derivatives       (%)       Derivatives(1)       (%)  
Assets:
                                                                   
Loans to members
    $ 47,403.6     $ 527.4         1.49       $ 1,352.2         3.81       $ (824.8 )       (2.32 )
Mortgage loans held for portfolio
      5,779.9       214.8         4.97         218.2         5.05         (3.4 )       (0.08 )
All other interest-earning assets
      23,911.8       437.7         2.45         437.7         2.45         -         -  
                                                                     
Total interest-earning assets
    $ 77,095.3     $ 1,179.9         2.05       $ 2,008.1         3.48       $ (828.2 )       (1.43 )
                                                                     
                                                                     
Liabilities and capital:
                                                                   
Consolidated obligation bonds
    $ 55,837.7     $ 940.0         2.25       $ 1,255.0         3.01       $ (315.0 )       (0.76 )
All other interest-bearing liabilities
      16,958.6       40.1         0.32         40.1         0.32         -         -  
                                                                     
Total interest-bearing liabilities
    $ 72,796.3     $ 980.1         1.80       $ 1,295.1         2.38       $ (315.0 )       (0.58 )
                                                                     
Net interest income/net interest spread
            $ 199.8         0.25       $ 713.0         1.10       $ (513.2 )       (0.85 )
                                                                     
                                                                     
Note:
 
(1) Impact of Derivatives includes net interest settlements and amortization of basis adjustments resulting from previously terminated hedging relationships.
 
                                                                     
Nine Months Ended
                                                     
September 30, 2008                   Avg.
              Avg.
                 
            Interest Inc./
      Yield/
      Interest Inc./
      Yield/
              Incr./
 
      Average
    Exp. with
      Rate
      Exp. without
      Rate
      Impact of
      (Decr.)
 
(dollars in millions)     Balance     Derivatives       (%)       Derivatives       (%)       Derivatives(1)       (%)  
Assets:
                                                                   
Loans to members
    $ 68,409.4     $ 1,682.1         3.28       $ 2,111.4         4.12       $ (429.3 )       (0.84 )
Mortgage loans held for portfolio
      6,098.8       235.6         5.16         237.8         5.21         (2.2 )       (0.05 )
All other interest-earning assets
      23,535.8       710.3         4.03         710.3         4.03         -         -  
                                                                     
Total interest-earning assets
    $ 98,044.0     $ 2,628.0         3.58       $ 3,059.5         4.17       $ (431.5 )       (0.59 )
                                                                     
                                                                     
Liabilities and capital:
                                                                   
Consolidated obligation bonds
    $ 63,742.4     $ 1,751.4         3.67       $ 1,995.4         4.18       $ (244.0 )       (0.51 )
All other interest-bearing liabilities
      30,442.4       624.2         2.74         624.2         2.74         -         -  
                                                                     
Total interest-bearing liabilities
    $ 94,184.8     $ 2,375.6         3.37       $ 2,619.6         3.72       $ (244.0 )       (0.35 )
                                                                     
Net interest income/net interest spread
            $ 252.4         0.21       $ 439.9         0.45       $ (187.5 )       (0.24 )
                                                                     
                                                                     
Note:
 
(1) Impact of Derivatives includes net interest settlements and amortization of basis adjustments resulting from previously terminated hedging relationships.
 
The Bank uses derivatives to hedge the fair market value changes attributable to the change in the LIBOR benchmark interest rate. The hedge strategy generally uses interest rate swaps to hedge a portion of loans to members and consolidated obligation bonds which convert the interest rates on those instruments from a fixed rate

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to a LIBOR-based variable rate. The purpose of this strategy is to protect the interest rate spread. Using derivatives to convert interest rates from fixed to variable can increase or decrease net interest income. The variances in the loans to members and consolidated obligation derivative impacts from period to period are driven by the change in the average LIBOR-based variable rate, the timing of interest rate resets and the average hedged portfolio balances outstanding during any given period.
 
For third quarter 2009, the impact of derivatives decreased net interest income by $169.8 million and reduced the net interest spread 93 basis points, compared to a reduction to net interest income of $92.2 million and a reduction to the net interest spread of 36 basis points for third quarter 2008. The decline was driven by a 250 basis point decrease in average 3-month LIBOR. The Bank hedged more loans to members than consolidated obligations in the periods presented, thus causing a negative impact to net interest income in the falling interest rate environment. This unfavorable variance was partially offset by interest rate changes to variable-rate debt.
 
For the nine months ended September 30, 2009, the impact of derivatives decreased net interest income $513.2 million and reduced the interest rate spread 85 basis points, compared to a decrease in net interest income of $187.5 million and a reduction in net interest spread of 24 basis points for the same year-ago period. The decline was driven by a 215 basis point decrease in average 3-month LIBOR. The Bank hedged more loans to members than consolidated obligations in the periods presented, thus causing a negative impact to net interest income in the falling interest rate environment. This unfavorable variance was partially offset by interest rate changes to variable-rate debt.
 
The mortgage loans held for portfolio derivative impact for all periods presented was affected by the amortization of basis adjustments resulting from hedges of commitments to purchase mortgage loans through the MPF program.
 


Other Income (Loss)
 
                                                         
      Three Months Ended
              Nine Months Ended
         
      September 30,               September 30,          
(in millions)     2009     2008       % Change       2009     2008       % Change  
Services fees
    $ 0.6     $ 0.7         (14.3 )     $ 1.8     $ 2.6         (30.8 )
Net gains (losses) on trading securities
      1.5       (0.4 )       (475.0 )       1.2       (0.7 )       (271.4 )
Net gains (losses) on derivatives and hedging activities
      (4.5 )     71.4         (106.3 )       6.7       75.1         (91.1 )
Total OTTI losses
      (190.5 )     -         n/m         (975.5 )     -         n/m  
Portion of OTTI losses recognized in other comprehensive loss
      97.2       -         n/m         812.4       -         n/m  
                                                         
Net OTTI credit losses
      (93.3 )     -         n/m         (163.1 )     -         n/m  
Contingency reserve
      -       -         -         (35.3 )     -         n/m  
Other income, net
      2.4       1.7         41.2         6.6       3.0         120.0  
                                                         
Total other income (loss)
    $ (93.3 )   $ 73.4         (227.1 )     $ (182.1 )   $ 80.0         (327.6 )
                                                         
                                                         
n/m - not meaningful
 
Third quarter 2009 financial results included total other losses of $93.3 million, compared to total other income of $73.4 million in third quarter 2008. Third quarter 2009 reflected net losses on derivatives and hedging activities of $4.5 million compared to gains of $71.4 million in third quarter 2008. Net OTTI credit losses for 2009 represented the credit loss portion of the OTTI charges taken on the private label MBS portfolio in third quarter 2009. There were no impairment charges in the same prior-year period.
 
Year-to-date September 2009 financial results included total other losses of $182.1 million, compared to total other income of $80.0 million for year-to-date September 2008. The year-to-date September 2009 net gains on derivatives and hedging activities totaled $6.7 million compared to $75.1 million for the same prior year period. Net OTTI credit losses for 2009 represented the credit loss portion of the OTTI charges taken on the private label MBS


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portfolio in the first nine months of 2009. There were no impairment charges in the same prior year period. The $35.3 million contingency reserve represents the establishment of a contingency reserve for the Bank’s LBSF receivable in first quarter 2009.
 
Both the third quarter 2008 and nine months ended September 30, 2008 results included higher net gains on derivatives and hedging activities related to the termination and replacement of LBSF derivatives as discussed in the Bank’s Third Quarter 2008 quarterly report filed on Form 10-Q on November 12, 2008. These one-time gains did not recur in 2009.
 
See additional discussion regarding OTTI charges in “Critical Accounting Policies” in this Item 2. Management’s Discussion and Analysis and Note 6 to the unaudited financial statements, both in this report filed on Form 10-Q. See additional discussion regarding the LBSF receivable and reserve in the “Current Financial and Mortgage Events and Trends” disclosure of the Overview section in this Item 2. Management’s Discussion and Analysis in this report filed on Form 10-Q. The activity related to net gains (losses) on derivatives and hedging activities is discussed in more detail below.
 
Derivatives and Hedging Activities.  The following table details the net gains and losses on derivatives and hedging activities, including hedge ineffectiveness.
 
                                     
      For the Three Months Ended
      For the Nine Months Ended
 
      September 30,       September 30,  
      2009
    2008
      2009
    2008
 
(in millions)     Gain (Loss)     Gain (Loss)       Gain (Loss)     Gain (Loss)  
Derivatives and hedged items in hedge accounting relationships
                                   
Loans to members
    $ (8.9 )   $ (43.6 )     $ (18.1 )   $ (47.9 )
Consolidated obligations
      4.6       33.6         24.1       43.3  
                                     
Total net gain (loss) related to fair value hedge ineffectiveness
      (4.3 )     (10.0 )       6.0       (4.6 )
                                     
                                     
Derivatives not designated as hedging instruments under hedge accounting
                                   
Economic hedges
      (1.8 )     69.1         (4.3 )     67.7  
Mortgage delivery commitments
      1.4       0.4         4.4       (0.1 )
Intermediary transactions
      -       -         -       -  
Other
      0.2       11.9         0.6       12.1  
                                     
Total net gain (loss) related to derivatives not designated as hedging instruments under hedge accounting
      (0.2 )     81.4         0.7       79.7  
                                     
Net gains (losses) on derivatives and hedging activities
    $ (4.5 )   $ 71.4       $ 6.7     $ 75.1  
                                     
                                     
 
Fair Value Hedges.  The Bank uses fair value hedge accounting treatment for most of its fixed-rate loans to members and consolidated obligation bonds using interest rate swaps. The interest rate swaps convert these fixed-rate instruments to a variable-rate (i.e., LIBOR). For the third quarter of 2009, total ineffectiveness related to these fair value hedges resulted in a loss of $4.3 million compared to a loss of $10.0 million in the third quarter of 2008. For the nine months ended September 30, 2009, total ineffectiveness related to fair value hedges resulted in a gain of $6.0 million compared to a loss of $4.6 million in the same prior year period. The loans to member fair value hedge ineffectiveness for the three and nine months ended September 30, 2008 included a loss of $10.9 million resulting from the replacement of 63 LBSF derivatives that were in fair value hedging relationships. See discussion of the Lehman bankruptcy and the resulting effects on the Bank’s financial statements in the Bank’s September, 30 2008 quarterly report filed on Form 10-Q. The overall notional amount decreased from $63.0 billion at September 30, 2008 to $50.6 billion at September 30, 2009. Fair value hedge ineffectiveness represents the difference between the change in the fair value of the derivative compared to the change in the fair value of the underlying asset/liability


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hedged. Fair value hedge ineffectiveness is generated by movement in the benchmark interest rate being hedged and by other structural characteristics of the transaction involved. For example, the presence of an upfront fee associated with a structured debt hedge will introduce valuation differences between the hedge and hedged item that will fluctuate through time.
 
Economic Hedges.  For economic hedges, the Bank includes the net interest income and the changes in the fair value of the hedges in net gain (loss) on derivatives and hedging activities. Total amounts recorded for economic hedges were a loss of $1.8 million in third quarter 2009 compared to a gain of $69.1 million in third quarter 2008. For the nine months ended September 30, 2009, total amounts recorded on economic hedges resulted in a loss of $4.3 million compared to a gain of $67.7 million in the same prior year period. For the three and nine months ended September 30, 2008, a nonrecurring gain was recorded, which was associated with economic hedges. The $69.0 million gain was associated with the replaced LBSF derivatives that remained as economic hedges for a one day period after they were replaced in the fair value hedges of certain loans to members as described above. See discussion of the Lehman bankruptcy and the resulting effects on the Bank’s financial statements in the Bank’s September, 30 2008 quarterly report filed on Form 10-Q. The overall notional amount of economic hedges decreased from $1.3 billion at September 30, 2008 to $1.2 billion at September 30, 2009.
 
Mortgage Delivery Commitments.  Certain mortgage purchase commitments are considered derivatives. When the mortgage purchase commitment derivative settles, the current market value of the commitment is included with the basis of the mortgage loan and amortized accordingly. Total gains relating to mortgage delivery commitments for the third quarter of 2009 were $1.4 million compared to total gains of $0.4 million for the third quarter of 2008. For the nine months ended September 30, 2009, total gains relating to mortgage delivery commitments were $4.4 million and net losses relating to mortgage delivery commitments for the same prior year-to-date period were $0.1 million. Changing market rates are the primary cause for fluctuations in the levels of gain(loss) associated with mortgage delivery commitments. Total notional of the Bank’s mortgage delivery commitments decreased from $62.2 million at September 30, 2008 to $12.7 million at September 30, 2009.
 
Intermediary Transactions.  Derivatives in which the Bank is an intermediary may arise when the Bank enters into derivatives with members and offsetting derivatives with other counterparties to meet the needs of members. Net gains on intermediary activities were not significant for the three and nine months ended September 30, 2009 and 2008.
 
Other.  Other net gains on derivatives and the related hedged items for the three and nine months ended September 30, 2009 were $0.2 million and $0.6 million, respectively, compared to gains of $11.9 million and $12.1 million for the three and nine months ended September 30, 2008. For the three and nine months ended September 30, 2008, other gains (losses) on derivatives and hedging activities include a nonrecurring gain of $11.8 million associated with the termination of the Bank’s LBSF derivatives.
 
Other Expense
 
                                                         
      For the Three Months Ended
              For the Nine Months Ended
         
      September 30,               September 30,          
(in millions)     2009     2008       % Change       2009     2008       % Change  
Operating - salaries and benefits
    $ 8.6     $ 7.7         11.7       $ 24.8     $ 26.5         (6.4 )
Operating - occupancy
      0.7       0.7         -         2.0       2.3         (13.0 )
Operating - other
      5.7       4.0         42.5         15.8       11.8         33.9  
Finance Agency
      0.7       0.8         (12.5 )       2.2       2.3         (4.4 )
Office of Finance
      0.5       0.4         25.0         1.9       1.8         5.6  
                                                         
Total other expenses
    $ 16.2     $ 13.6         19.1       $ 46.7     $ 44.7         4.5  
                                                         
                                                         
 
Other expense totaled $16.2 million in the third quarter of 2009, compared to $13.6 million in the third quarter of 2008, an increase of $2.6 million, or 19.1%, driven by salaries and benefits and other operating expenses. The operating expenses of the Finance Agency and the OF remained relatively flat quarter-over-quarter. The increase in other expenses was due to a $0.9 million increase in salaries and benefits expense and a $1.7 million increase in


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other operating expenses. The increase in benefits was driven by the market value of the nonqualified thrift obligation. Other operating expenses included higher professional fees resulting from increased consulting fees and services related to the Bank’s OTTI assessment process, and other Board of Directors’ initiatives.
 
For the nine months ended September 30, 2009, other expense totaled $46.7 million compared to $44.7 million for the same prior year period, an increase of $2.0 million, or 4.5%, driven entirely by other operating expenses. The operating expenses of the Finance Agency and the OF remained relatively flat year-over-year. The increase in operating expenses was due to a $4.0 million increase in other expenses, partially offset by decreases of $1.7 million and $0.3 million, respectively, in salaries and benefits expense and occupancy expense. The increase in other operating expenses was due primarily to higher consulting fees and services as noted above. Year-to-date 2008 salaries and benefits expense included severance costs as well as a lump sum settlement benefit payment.
 
Collectively, the twelve FHLBanks are responsible for the operating expenses of the OF and a portion of the operating expenses of the Finance Agency. These payments, allocated among the FHLBanks according to a cost-sharing formula, are reported as other expense on the Bank’s Statement of Operations and totaled $1.2 million for the three months ended both September 30, 2009 and 2008. For the nine months ended both September 30, 2009 and 2008, these expenses totaled $4.1 million. The Bank has no control over the operating expenses of the Finance Agency. The FHLBanks are able to exert a limited degree of control over the operating expenses of the OF due to the fact that two directors of the OF are also FHLBank Presidents.
 
Affordable Housing Program (AHP) and Resolution Funding Corp. (REFCORP) Assessments
 
                                                         
      For the Three Months
              For the Nine Months
         
      Ended September 30,               Ended September 30,          
(in millions)     2009     2008       % Change       2009     2008       % Change  
Affordable Housing Program (AHP)
    $ (0.9 )   $ 10.8         (108.3 )     $ -     $ 23.1         (100.0 )
REFCORP
      (2.1 )     24.2         (108.7 )       -       51.8         (100.0 )
                                                         
Total assessments
    $ (3.0 )   $ 35.0         (108.6 )     $   -     $ 74.9         (100.0 )
                                                         
                                                         
 
Assessment Calculations.  Although the FHLBanks are not subject to federal or state income taxes, the combined financial obligations of making payments to REFCORP (20%) and AHP contributions (10%) equate to a proportion of the Bank’s net income comparable to that paid in income tax by fully taxable entities. Inasmuch as both the REFCORP and AHP payments are each separately subtracted from earnings prior to the assessment of each, the combined effective rate is less than the simple sum of both (i.e., less than 30%). In passing the Financial Services Modernization Act of 1999, Congress established a fixed 20% annual REFCORP payment rate beginning in 2000 for each FHLBank. The fixed percentage replaced a fixed-dollar annual payment of $300 million which had previously been divided among the twelve FHLBanks through a complex allocation formula. The law also calls for an adjustment to be made to the total number of REFCORP payments due in future years so that, on a present value basis, the combined REFCORP payments of all twelve FHLBanks are equal in amount to what had been required under the previous calculation method. The FHLBanks’ aggregate payments through the third quarter of 2009 exceeded the scheduled payments, effectively accelerating payment of the REFCORP obligation and shortening its remaining term to a final payment during the second quarter of 2012. This date assumes that the FHLBanks pay exactly $300 million annually until 2012. The cumulative amount to be paid to REFCORP by the FHLBank is not determinable at this time due to the interrelationships of the future earnings of all FHLBanks and interest rates.
 
The pre-assessment loss the Bank incurred in the third quarter 2009 also resulted in a pre-assessment loss for the nine months ended September 30, 2009. In third quarter 2009, the assessments recorded in second quarter 2009, associated with year-to-date June 2009 pre-assessment earnings, were reversed. For the three and nine months ended September 30, 2008, the Bank incurred REFCORP expense of $24.2 million and $51.8 million, respectively. The Bank does not receive an assessment “benefit” on REFCORP and AHP assessments during annual reporting periods in which a loss is incurred.
 
For full year 2008, the Bank overpaid its 2008 REFCORP assessment as a result of the loss recognized in fourth quarter 2008. As instructed by the U.S. Treasury, the Bank is using its overpayment as a credit against future


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REFCORP assessments (to the extent the Bank has positive net income in the future) over an indefinite period of time. This overpayment is recorded as a prepaid asset by the Bank and reported as “prepaid REFCORP assessment” on the Statement of Condition. Over time, as the Bank uses this credit against its future REFCORP assessments, the prepaid asset will be reduced until it has been exhausted. If any amount of the prepaid asset still remains at the time that the REFCORP obligation for the FHLBank System as a whole is fully satisfied, REFCORP, in consultation with the U.S. Treasury, will implement a procedure so that the Bank would be able to collect on its remaining prepaid asset. The Bank’s prepaid REFCORP assessment balance at September 30, 2009 was $39.6 million.
 
Financial Condition
 
The following is Management’s Discussion and Analysis of the Bank’s financial condition at September 30, 2009 compared to December 31, 2008. This should be read in conjunction with the Bank’s unaudited interim financial statements and notes in this report and the audited financial statements in the Bank’s 2008 Annual Report filed on Form 10-K.
 
Asset Composition.  As a result of declining loan demand by members, the Bank’s total assets decreased $24.3 billion, or 26.8%, to $66.5 billion at September 30, 2009, down from $90.8 billion at December 31, 2008. Loans to members decreased $20.8 billion, while total interest-earning deposits (including interest-earning deposits and Federal funds sold) reflected a net decrease of $2.3 billion.
 
Total housing finance-related assets, which include MPF Program loans, loans to members, MBS and other mission-related investments, decreased $23.6 billion, or 29.6%, to $56.0 billion at September 30, 2009, down from $79.6 billion at December 31, 2008. Total housing finance-related assets accounted for 84.2% of assets as of September 30, 2009 and 87.7% of assets as of December 31, 2008.
 
Loans to Members.  At September 30, 2009, total loans to members reflected balances of $41.4 billion to 220 borrowing members, compared to $62.2 billion of loans to 249 borrowing members at year-end 2008, a 33.4% decrease in the portfolio balance. A significant concentration of the loans continued to be generated from the Bank’s five largest borrowers, generally reflecting the asset concentration mix of the Bank’s membership base. Total loans outstanding to the Bank’s five largest members were $25.1 billion and $37.6 billion at September 30, 2009 and December 31, 2008, respectively.
 
The following table provides a distribution of the number of members, categorized by individual member asset size, that had an outstanding average balance during the nine months ended September 30, 2009 and the year ended December 31, 2008.
 
                   
Member Asset Size     2009     2008  
Less than $100 million
      40       51  
Between $100 million and $500 million
      131       142  
Between $500 million and $1 billion
      39       39  
Between $1 billion and $5 billion
      30       26  
Greater than $5 billion
      16       16  
                   
Total borrowing members during the year
      256       274  
                   
                   
Total membership
      317       323  
Percent of members borrowing during the period
      80.8 %     84.8 %
Total borrowing members with outstanding loan balances at period-end
      220       249  
Percent of member borrowing at period-end
      69.4 %     77.1 %
                   
 
As of September 30, 2009, the par value of the combined mid-term (Mid-Term RepoPlus) and short-term (RepoPlus) products decreased $14.1 billion, or 42.1%, to $19.4 billion, compared to $33.5 billion at December 31, 2008. These products represented 49.0% and 56.3% of the par value of the Bank’s total loans to members portfolio at September 30, 2009 and December 31, 2008, respectively. The Bank’s shorter-term loans to members decreased as a result of members having less need for liquidity from the Bank as they have taken actions during the credit crisis, such as raising core deposits, reducing their balance sheets, and identifying alternative sources of funds. Also, many of the


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Bank’s members have reacted to the Bank’s temporary actions of not paying dividends and not repurchasing excess capital stock by limiting their use of the Bank’s loans to members products. All of this has resulted in only 69.4% of current members having outstanding borrowings with the Bank at September 30, 2009. The short-term portion of the loans to members portfolio is volatile; as market conditions change rapidly, the short-term nature of these lending products could materially impact the Bank’s outstanding loan balance. See Item 1. Business in the Bank’s 2008 Annual Report filed on Form 10-K for details regarding the Bank’s various loan products.
 
The Bank’s longer-term loans to members, referred to as Term Loans, decreased $1.9 billion, or 13.0%, to $13.0 billion at September 30, 2009 down from $14.9 billion at December 31, 2008. These balances represented 32.7% and 25.0% of the Bank’s loans to members portfolio at September 30, 2009 and December 31, 2008, respectively. The loans to members continue to represent a good value for the Bank’s members based on the interest rate environment. While term loan balances have declined, the decrease has been at a slower rate than the remaining products and the Term Loans portfolio now represent a larger percentage of the total loans to members portfolio. A number of the Bank’s members have a high percentage of long-term mortgage assets on their balance sheets; these members generally fund these assets through these longer-term borrowings with the Bank to mitigate interest rate risk. Meeting the needs of such members has been, and will continue to be, an important part of the Bank’s loans to members business.
 
As of September 30, 2009, the Bank’s longer-term option embedded loans to members decreased $3.9 billion to $7.2 billion as of September 30, 2009, down from $11.1 billion as of December 31, 2008. These products represented 18.3% and 18.7% of the Bank’s loans to members portfolio on September 30, 2009 and December 31, 2008, respectively.
 
Mortgage Loans Held for Portfolio.  Net mortgage loans held for portfolio decreased 13.4% to $5.3 billion at September 30, 2009, compared to $6.2 billion at December 31, 2008. This decrease was primarily due to the continued run-off of the portfolio, due primarily to paydowns resulting from an increase in refinancings in the low interest rate environment. This run-off more than offset new funding activity.
 
Loan Portfolio Analysis.  The Bank’s outstanding loans, nonaccrual loans and loans 90 days or more past due and accruing interest are as presented in the following table.
 
                   
      September 30,
    December 31,
 
(in millions)     2009     2008  
Loans to members(1)
    $ 41,363.4     $ 62,153.4  
Mortgage loans held for portfolio, net(2)
      5,339.1       6,165.3  
Nonaccrual mortgage loans, net(3)
      62.8       38.3  
Mortgage loans past due 90 days or
more and still accruing interest(4)
      17.9       12.6  
BOB loans, net(5)
      11.9       11.4  
                   
Notes:
 
(1) There are no loans to members balances which are past due or on nonaccrual status.
(2) All of the real estate mortgages held in portfolio by the Bank are fixed-rate. Balances are reflected net of allowance for credit losses.
(3) All nonaccrual mortgage loans are reported net of interest applied to principal.
(4) Government-insured or -guaranteed loans (e.g., FHA, VA, HUD or RHS) continue to accrue interest after becoming 90 days or more delinquent.
(5) Due to the nature of the program, all BOB loans are considered nonaccrual loans. Balances are reflected net of allowance for credit losses.
 
The Bank has experienced an increase in its nonaccrual mortgage loans held for portfolio. Nonaccrual mortgage loans increased approximately $24.5 million, or 64.2%, from December 31, 2008 to September 30, 2009. This increase was driven by general economic conditions. The Bank increased its allowance for credit losses on these loans from $4.3 million at December 31, 2008 to $7.5 million at September 30, 2009.
 
Interest-Earning Deposits and Federal Funds Sold.  At September 30, 2009, these short-term investments totaled $4.1 billion, a net decrease of $2.3 billion, or 35.9%, from December 31, 2008. The Bank maintains these types of balances in order to meet member’s loan demand under conditions of market stress and maintain adequate liquidity in accordance with Finance Agency guidance and Bank policies.


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Investment Securities.  Investment securities decreased $508.1 million, or 3.3%, from December 31, 2008 to September 30, 2009, primarily due to a decrease in MBS. MBS are collateralized and are typically expected to provide a return that exceeds the return on other types of investments. The decrease in MBS was driven by paydowns and/or maturities of principal as well as OTTI losses recorded against the portfolio. The increase in trading securities was driven primarily by an increase in Treasury bills and TLGP investments as the Bank continues to increase its liquidity position. The Bank also uses these securities to pledge as collateral on interest rate swap agreements. During 2009, the Bank did offset some of the MBS portfolio run-off with the purchase of U.S. agency MBS. During the third quarter of 2009, Taylor, Bean & Whitaker (TBW), a servicer on one of the Bank’s private label MBS filed for bankruptcy. Due to TBW’s bankruptcy filing, normal monthly remittances on the loans securing the security have been delayed. All other securities are receiving cash payments.
 
During 2009, the Bank transferred certain private label MBS with an amortized cost of $3.1 billion from its held-to-maturity investment portfolio to its available-for-sale investment portfolio. The securities transferred had OTTI credit losses recognized during the second or third quarters of 2009. The Bank transferred the securities to the available-for-sale portfolio to increase financial flexibility to sell these securities if management determines it is prudent to do so. The Bank has no current plans to sell these securities nor is the Bank under any requirements to sell the securities. See Note 4 to the unaudited financial statements in this report filed on Form 10-Q for additional information.
 
Historically, the amount that the Bank can invest in MBS is limited by regulation to 300% of regulatory capital. However, on March 24, 2008, the Finance Agency passed a resolution that authorized a temporary increase in the amount of MBS the FHLBanks are permitted to purchase. This resolution increased the MBS investment limit to 600% of regulatory capital for two years, subject to Board approval and filing of required documentation with the Finance Agency. This temporary resolution expires March 31, 2010. The Bank will continue to monitor its MBS position and determine the proper portfolio level. At the current time, the Bank does not expect to exceed the original 300% limit.
 
The following tables summarize key investment securities portfolio statistics.
 
                   
      September 30,
    December 31,
 
(in millions)     2009     2008  
Trading securities:
                 
Mutual funds offsetting deferred compensation
    $ 6.5     $ 6.2  
Treasury bills
      1,028.8       -  
Certificates of deposit
      -       500.6  
TLGP investments
      250.0       -  
                   
Total trading securities
    $ 1,285.3     $ 506.8  
                   
                   
Available-for-sale securities:
                 
Mututal funds offsetting deferred compensation
    $ 2.2     $ -  
MBS
      2,131.0       19.7  
                   
Total available-for-sale securities
    $ 2,133.2     $ 19.7  
                   
                   
Held-to-maturity securities:
                 
Certificates of deposit
    $ 4,150.0     $ 2,700.0  
State or local agency obligations
      627.8       636.8  
U.S. government-sponsored enterprises
      181.5       955.0  
MBS
      6,558.6       10,626.2  
                   
Total held-to-maturity securities
    $ 11,517.9     $ 14,918.0  
                   
Total investment securities
    $ 14,936.4     $ 15,444.5  
                   
                   


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As of September 30, 2009, investment securities had the following maturity and yield characteristics.
 
                     
(dollars in millions)     Carrying Value     Yield  
Trading securities:
                   
Mutual funds offsetting deferred compensation
    $ 6 .5       n/a  
Treasury bills
      1,028 .8       0.37 %
TLGP investments
      250 .0       0.30  
                     
Total trading securities
    $ 1,285 .3       0.35  
                     
                     
Available-for-sale securities:
                   
Mutual funds offsetting deferred compensation
    $ 2 .2       n/a  
MBS
      2,131 .0       5.41  
                     
Total available-for-sale securities
    $ 2,133 .2       5.41  
                     
                     
Held-to-maturity securities:
                   
Certificates of deposit
    $ 4,150 .0       0.45  
State or local agency obligations:
                   
Within one year
      56 .2       5.86  
After one but within five years
      78 .5       5.73  
After five years
      493 .1       2.75  
                     
Total state or local agency obligations
      627 .8       3.41  
                     
U.S. government-sponsored enterprises:
                   
Within one year
    $ 99 .9       0.40  
After five years
      81 .6       4.05  
                     
Total U.S. government-sponsored enterprises
      181 .5       2.05  
MBS
      6,558 .6       3.86  
                     
Total held-to-maturity securities
    $ 11,517 .9       2.59  
                     
                     
Total investment securities
    $ 14,936 .4       2.96  
                     
                     
n/a - not applicable
 
As of September 30, 2009, the Bank’s available-for-sale and held-to-maturity portfolios included combined gross unrealized losses of $1.4 billion. As of December 31, 2008, the available-for-sale and held-to-maturity securities portfolios included gross unrealized losses of $2.1 billion. The gross unrealized losses on these portfolios resulted from ongoing market volatility, illiquidity in certain market sectors, widening credit spreads and deterioration in credit quality. In conjunction with the adoption of the amended OTTI guidance, the Bank recorded a $255.9 million cumulative effect adjustment to AOCI. This amount represented the noncredit loss portion of OTTI recorded in fourth quarter 2008. In addition, the Bank recorded OTTI charges representing the noncredit portion of impairment to AOCI on its investment securities portfolio of $97.2 million and $812.4 million for the three and nine months ended September 30, 2009, respectively. See Critical Accounting Policies and “Credit and Counterparty Risk – Investments” in the Risk Management section, both in this Item 2. Management’s Discussion and Analysis in this report filed on Form 10-Q for additional details.


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As of September 30, 2009, the Bank held securities from the following issuers with a book value greater than 10% of Bank total capital.
 
                     
      Total
    Total
 
(in millions)     Carrying Value     Fair Value  
JP Morgan Mortgage Trust
    $ 1,333 .6     $ 1,288.4  
Freddie Mac 
      1,072 .9       1,072.9  
U.S. Treasury
      1,028 .7       1,028.7  
Government National Mortgage Association
      985 .6       984.7  
Wells Fargo Mortgage Backed Securities Trust
      878 .7       775.2  
Fannie Mae
      535 .0       548.9  
Structured Adjustable Rate Mortgage Loan Trust
      445 .7       421.5  
Pennsylvania Housing Finance Agency
      419 .1       404.6  
                     
Total
    $ 6,699 .3     $ 6,524.9  
                     
                     
 
For additional information on the credit risk of the investment portfolio, see the “Credit and Counterparty Risk — Investments” discussion in the Risk Management section of this Item 2. Management’s Discussion and Analysis in this report filed on Form 10-Q.
 
Deposits.  At September 30, 2009, time deposits in denominations of $100 thousand or more totaled $13.8 million. The table below presents the maturities for time deposits in denominations of $100 thousand or more.
 
                                                 
            Over 3
      Over 6
                 
(in millions)           Months but
      Months but
                 
      3 Months
    Within
      Within
                 
By Remaining Maturity at September 30, 2009     or Less     6 Months       12 Months       Thereafter       Total  
Time certificates of deposit ($100,000 or more)
    $ 2.8     $ 6.0       $ 4.5       $ 0.5       $ 13.8  
                                                 
                                                 
 
Commitment and Off-balance Sheet Items.  At September 30, 2009, the Bank was obligated to fund approximately $0.9 million in additional loans to members, $12.7 million of mortgage loans and $9.8 billion in outstanding standby letters of credit, and was obligated to issue $210.8 million in consolidated obligations. The Bank does not have any off-balance sheet special purpose entities or any other type of off-balance sheet conduits.
 
Retained Earnings.  The Finance Agency has issued regulatory guidance to the FHLBanks relating to capital management and retained earnings. The guidance directs each FHLBank to assess, at least annually, the adequacy of its retained earnings with consideration given to future possible financial and economic scenarios. The guidance also outlines the considerations that each FHLBank should undertake in assessing the adequacy of its retained earnings.
 
                   
      Nine Months Ended September 30,  
(in millions)     2009     2008  
Balance, beginning of the year
    $ 170.5     $ 296.3  
Cumulative effect of adoption of the amended OTTI guidance
      255.9       -  
Net income
      (31.9)       207.3  
Dividends
      -       (121.6)  
                   
Balance, end of the period
    $ 394.5     $ 382.0  
                   
                   
Payout ratio (dividends/net income)
      -       58.7%  
                   
n/a - not applicable
 
At September 30, 2009, retained earnings were $394.5 million, representing an increase of $224.0 million, or 131.4%, from December 31, 2008. The Bank adopted the amended OTTI guidance effective January 1, 2009. This adoption resulted in a $255.9 million increase in retained earnings due to the cumulative effect adjustment recorded as of January 1, 2009. This cumulative effect adjustment did not impact the Bank’s REFCORP or AHP assessment expenses or liabilities, as these assessments are based on GAAP net income.


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Additional information regarding the amended OTTI guidance is available in the “Critical Accounting Policies” discussion in this Item 2. Management’s Discussion and Analysis and Note 2 to the unaudited financial statements, both in this report filed on Form 10-Q. Further details of the components of required risk-based capital are presented in the “Capital Resources” discussion in Management’s Discussion and Analysis in this report filed on Form 10-Q. See Note 11 to the unaudited financial statements in this report filed on Form 10-Q for further discussion of AOCI, risk-based capital and the Bank’s policy on capital stock requirements.
 
Capital Resources
 
The following is Management’s Discussion and Analysis of the Bank’s capital resources as of September 30, 2009, which should be read in conjunction with the unaudited interim financial statements and notes included in this report filed on Form 10-Q and the audited financial statements in the Bank’s 2008 Annual Report filed on Form 10-K.
 
Risk-Based Capital (RBC)
 
The Bank became subject to the Finance Agency’s risk-based capital (RBC) regulations upon implementation of its capital plan on December 16, 2002. This regulatory framework requires the Bank to maintain sufficient permanent capital, defined as retained earnings plus capital stock, to meet its combined credit risk, market risk and operational risk. Each of these components is computed as specified in regulations and directives issued by the Finance Agency.
 
                                     
      September 30,
    June 30,
      March 31,
    December 31,
 
(in millions)     2009     2009       2009     2008  
Permanent capital:
                                   
Capital stock(1)
    $ 4,021.3     $ 4,015.3       $ 4,007.2     $ 3,986.4  
Retained earnings
      394.5       434.9         402.8       170.5  
                                     
Total permanent capital
    $ 4,415.8     $ 4,450.2       $ 4,410.0     $ 4,156.9  
                                     
                                     
Risk-based capital requirement:
                                   
Credit risk capital
    $ 922.7     $ 530.6       $ 432.8     $ 278.7  
Market risk capital
      1,525.1       2,218.7         2,685.7       2,739.1  
Operations risk capital
      734.3       824.8         935.5       905.3  
                                     
Total risk-based capital requirement
    $ 3,182.1     $ 3,574.1       $ 4,054.0     $ 3,923.1  
                                     
                                     
Note:
(1) Capital stock includes mandatorily redeemable capital stock.
 
The Bank held excess permanent capital over RBC requirements of $1.2 billion, $876.1 million, $356.0 million and $233.8 million at September 30, 2009, June 30, 2009, March 31, 2009 and December 31, 2008, respectively.
 
On August 4, 2009, the Finance Agency issued its final Prompt Corrective Action Regulation (PCA Regulation) incorporating the terms of the Interim Final Regulation issued on January 30, 2009. See the “Legislative and Regulatory Developments” discussion in this Item 2. Management’s Discussion and Analysis in this report filed on Form 10-Q for additional information regarding this Interim Final Regulation. See also Item 7. Management’s Discussion and Analysis in the Bank’s 2008 Annual Report filed on Form 10-K for additional discussion. On September 30, 2009, the Bank received final notification that it was considered adequately capitalized for the quarter ended June 30, 2009; however, the Finance Agency did express concern regarding the ratio of the Bank’s level of AOCI to retained earnings, the decline in excess permanent capital over risk-based capital requirements and the potential impact of redemption of excess capital stock.


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Capital and Leverage Ratios
 
In addition to the requirements for RBC, the Finance Agency has mandated maintenance of certain capital and leverage ratios. The Bank must maintain total regulatory capital and leverage ratios of at least 4.0% and 5.0% of total assets, respectively. Management has an ongoing program to measure and monitor compliance with the ratio requirements. As a matter of policy, the Board has established an operating range for capitalization that calls for the capital ratio to be maintained between 4.08% and 5.0%. To enhance overall returns, it has been the Bank’s practice to utilize leverage within this operating range when market conditions permit, while maintaining compliance with statutory, regulatory and Bank policy limits.
 
                   
      September 30,
    December 31,
 
(dollars in millions)     2009     2008  
Capital Ratio
                 
Minimum capital (4.0% of total assets)
    $ 2,660.4     $ 3,632.2  
Actual capital (permanent capital plus reserves for off-balance sheet credit risk)
      4,416.4       4,170.9  
Total assets
      66,510.5       90,805.9  
Capital ratio (actual capital as a percent of total assets)
      6.6 %     4.6 %
                   
Leverage Ratio
                 
Minimum leverage capital (5.0% of total assets)
    $ 3,325.5     $ 4,540.3  
Leverage capital (permanent capital multiplied by a 1.5 weighting factor plus reserves for off-balance sheet credit risk)
      6,624.3       6,249.3  
Leverage ratio (leverage capital as a percent of total assets)
      10.0 %     6.9 %
 
Management reviews, on a routine basis, projections of capital leverage that incorporate anticipated changes in assets, liabilities, and capital stock levels as a tool to manage overall balance sheet leverage within the Board’s operating ranges. In connection with this review, when management believes that adjustments to the current member stock purchase requirements within the ranges established in the capital plan are warranted, a recommendation is presented for Board consideration. The member stock purchase requirements have been adjusted several times since the implementation of the capital plan in December 2002. Members are currently required to purchase Bank stock in an amount equal to 4.75% of member loans outstanding, 4.0% on AMA activity (for Master Commitments executed on or after May 1, 2009), and 0.75% of unused borrowing capacity.
 
The Bank has initiated the process of amending its capital plan. The goal of this capital plan amendment is to provide members with a stable membership capital stock calculation that would replace the Unused Borrowing Capacity calculation. Additionally, the proposed amendment would expand the AMA stock purchase requirement range and prospectively establish a capital stock purchase requirement for letters of credit. As required by Finance Agency regulation and the terms of the capital plan, any amendment must be approved by the Finance Agency prior to becoming effective.
 
On November 10, 2008, the Bank first changed its excess capital stock repurchase practice, stating that the Bank would no longer make excess capital stock repurchases at a member’s request and noting that the previous practice of repurchasing excess capital stock from all members on a periodic basis was revised. Subsequently, as announced on December 23, 2008, the Bank suspended excess capital stock repurchases until further notice. At September 30, 2009 and December 31, 2008, excess capital stock totaled $1.3 billion and $479.7 million, respectively. The Bank’s prior practice was to promptly repurchase the excess capital stock of its members upon their request (except with respect to directors’ institutions during standard blackout periods). As long as it is not repurchasing excess capital stock, the Bank’s capital and leverage ratios may continue to increase outside of normal ranges as evidenced by the increases from December 31, 2008 to September 30, 2009. This may result in lower earnings per share and return on capital.


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Critical Accounting Policies
 
The Bank’s financial statements are prepared in accordance with U.S. Generally Accepted Accounting Principles (GAAP). Application of these principles requires management to make estimates, assumptions or judgments that affect the amounts reported in the financial statements and accompanying notes. The use of estimates, assumptions and judgments is necessary when financial assets and liabilities are required to be recorded at, or adjusted to reflect, fair value. Assets and liabilities carried at fair value inherently result in more financial statement volatility. The fair values and the information used to record valuation adjustments for certain assets and liabilities are based on quoted market prices when available. When quoted market prices are not available, fair values may be obtained from third-party sources or are estimated in good faith by management, primarily through the use of internal cash flow and other financial modeling techniques.
 
The most significant accounting policies followed by the Bank are presented in Note 2 to the audited financial statements in the Bank’s 2008 Annual Report filed on Form 10-K. These policies, along with the disclosures presented in the other notes to the financial statements and in this financial review, provide information on how significant assets and liabilities are valued in the financial statements and how those values are determined. Management views critical accounting policies to be those which are highly dependent on subjective or complex judgments, estimates or assumptions, and those for which changes in those estimates or assumptions could have a significant impact on the financial statements.
 
The following critical accounting policies are discussed in more detail under this same heading in the Bank’s 2008 Annual Report filed on Form 10-K:
 
  •   Other-Than-Temporary Impairment for Investment Securities
  •   Fair Value Calculations and Methodologies
  •   Accounting for Derivatives
  •   Loans to Members and Related Allowance for Credit Losses
  •   Guarantees and Consolidated Obligations
  •   Accounting for Premiums and Discounts on Mortgage Loans and Mortgage-Backed Securities
  •   Allowance for Credit Losses on Banking on Business Loans
  •   Allowance for Credit Losses on Mortgage Loans Held for Portfolio
  •   Future REFCORP Payments
 
Since January 1, 2009, the Bank has made changes to two of its critical accounting policies as a result of adopting newly issued accounting standards and changes in methods. The impact of the changes on the Bank’s Critical Accounting Policies is discussed below.
 
Other-Than-Temporary Impairment Assessments for Investment Securities.  Effective January 1, 2009, the Bank adopted the amended OTTI guidance issued by the Financial Accounting Standards Board (FASB). Among other things, the amended OTTI guidance revises the recognition and reporting requirements for OTTI of debt securities classified as available-for-sale and held-to-maturity.
 
For debt securities, the “ability and intent to hold” provision was eliminated in this guidance, and impairment is now considered to be other than temporary if an entity (1) intends to sell the security, (2) more likely than not will be required to sell the security before recovering its amortized cost basis, or (3) does not expect to recover the security’s entire amortized cost basis (even if the entity does not intend to sell the security). In addition, the probability standard relating to the collectibility of cash flows was eliminated in this guidance, and impairment is now considered to be other than temporary if the present value of cash flows expected to be collected from the debt security is less than the amortized cost basis of the security (any such shortfall is referred to in the guidance as a credit loss).
 
The Bank evaluates outstanding available-for-sale and held-to-maturity securities in an unrealized loss position (i.e., impaired securities) for OTTI on at least a quarterly basis. In doing so, the Bank considers many factors including, but not limited to: the credit ratings assigned to the securities by the NRSROs; other indicators of the credit quality of the issuer; the strength of the provider of any guarantees; the length of time and extent that fair value has been less than amortized cost; and whether the Bank has the intent to sell the security or more likely than


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not will be required to sell the security before its anticipated recovery. In the case of its private label residential MBS, the Bank also considers prepayment speeds, the historical and projected performance of the underlying loans and the credit support provided by the subordinate securities. These evaluations are inherently subjective and consider a number of quantitative and qualitative factors.
 
In the case of its private label residential MBS, the Bank employs models or alternative procedures to determine the cash flows that it is likely to collect from all of its securities. These models consider borrower characteristics and the particular attributes of the loans underlying the securities, in conjunction with assumptions about future changes in home prices and interest rates, to predict the likelihood a loan will default and the impact on default frequency, loss severity and remaining credit enhancement. A significant input to these models is the forecast of future housing price changes for the relevant states and metropolitan statistical areas, which are based upon an assessment of the various housing markets. In general, since the ultimate receipt of contractual payments on these securities will depend upon the credit and prepayment performance of the underlying loans and, if needed, the credit enhancements for the senior securities owned by the Bank, the Bank uses these models to assess whether the credit enhancement associated with each security is sufficient to protect against likely losses of principal and interest on the underlying mortgage loans. The development of the modeling assumptions requires significant judgment.
 
During the first quarter of 2009, the Finance Agency required the FHLBanks to develop and utilize FHLBank System-wide modeling assumptions for purposes of producing cash flow analyses used in the OTTI assessment for private label residential MBS. During the second quarter of 2009, the FHLBanks, enhanced the overall OTTI process by creating an OTTI Governance Committee. The OTTI Governance Committee provides a formal process by which the FHLBanks can provide input on and approve assumptions. The OTTI Governance Committee is responsible for reviewing and approving the key assumptions including interest rate and housing prices along with related modeling inputs and methodologies to be used to generate cash flow projections. The OTTI Governance Committee requires the FHLBanks to run the OTTI analysis on a common platform. The Bank utilized the FHLBank of Indianapolis to run its OTTI analysis of its private label residential MBS classified as prime and Alt-A (except for common CUSIPs, which are those held by two or more FHLBanks), the FHLBank of Chicago to run its private label residential MBS classified as subprime, and the FHLBank of San Francisco to run its common CUSIPs. The Bank performed its OTTI analysis on monoline in a manner consistent with other FHLBanks with similar instruments. For certain private label residential MBS where underlying loan level collateral data is not available, alternative procedures are used to assess these securities for OTTI. The OTTI Governance Committee requires the FHLBanks to perform OTTI analysis on sample securities to ensure that the OTTI analysis produces consistent results, among the Banks.
 
The Bank reviewed the FHLBank System-wide assumptions used in the 2009 OTTI process. Based on the results of this review, the Bank deemed the FHLBank System-wide assumptions to be reasonable and adopted them. However, different assumptions could produce materially different results, which could impact the Bank’s conclusions as to whether an impairment is considered other-than-temporary and the magnitude of the credit loss.
 
If the Bank intends to sell an impaired debt security, or more likely than not will be required to sell the security before recovery of its amortized cost basis, the impairment is other-than-temporary and is recognized currently in earnings in an amount equal to the entire difference between fair value and amortized cost. To date, the Bank has not met either of these conditions.
 
In instances in which the Bank determines that a credit loss exists but the Bank does not intend to sell the security and it is not more likely than not that the Bank will be required to sell the security before the anticipated recovery of its remaining amortized cost basis, the OTTI is separated into (1) the amount of the total impairment related to the credit loss and (2) the amount of the total impairment related to all other factors (i.e., the noncredit portion). The amount of the total OTTI related to the credit loss is recognized in earnings and the amount of the total OTTI related to all other factors is recognized in AOCI. The total OTTI is presented in the Statement of Operations with an offset for the amount of the total OTTI that is recognized in AOCI. Absent the intent or requirement to sell a security, if a credit loss does not exist, any impairment is considered to be temporary. If the Bank determines that a common security is other-than-temporarily impaired, the FHLBanks that jointly own the common security are required to consult with each other to arrive at the same financial results.


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Regardless of whether an OTTI is recognized in its entirety in earnings or if the credit portion is recognized in earnings and the noncredit portion is recognized in other comprehensive income (loss), the estimation of fair values has a significant impact on the amount(s) of any impairment that is recorded.
 
The noncredit portion of any OTTI losses on securities classified as available-for-sale is adjusted to fair value with an offsetting adjustment to the carrying value of the security. The fair value adjustment could increase or decrease the carrying value of the security. The noncredit portion of any OTTI losses recognized in AOCI for debt securities classified as held-to-maturity is accreted over the remaining life of the debt security (using a level-yield method) as an increase in the carrying value of the security until the security is sold, the security matures, or there is an additional OTTI that is recognized in earnings.
 
In periods subsequent to the recognition of an OTTI loss, the other-than-temporarily impaired debt security is accounted for as if it had been purchased on the measurement date of the OTTI at an amount equal to the previous amortized cost basis less the credit-related OTTI recognized in earnings. For debt securities for which credit-related OTTI is recognized in earnings, the difference between the new cost basis and the cash flows expected to be collected is accreted into interest income over the remaining life of the security in a prospective manner based on the amount and timing of future estimated cash flows.
 
The adoption of the amended OTTI guidance required a cumulative effect adjustment as of January 1, 2009, which increased the Bank’s retained earnings by $255.9 million with an offsetting decrease to AOCI. The Bank’s adoption of this guidance had a material impact on the Bank’s Statement of Condition, Statement of Operations and Statement of Changes in Capital. The adoption of this guidance had no material impact on the Bank’s Statement of Cash Flows.
 
Fair Value Calculations and Methodologies.  On January 1, 2009, the Bank adopted guidance issued by the FASB regarding the determination of fair value when the volume and level of activity for an asset or liability has significantly decreased as well as identifying transactions that are not considered orderly. This guidance affirms the objective that fair value is the price that would be received to sell an asset in an orderly transaction (that is not a forced liquidation or distressed sale) between market participants at the measurement date under current market conditions (that is, in the inactive market). This guidance also provides additional guidance to determine whether a market for a financial asset is inactive and determine if a transaction is distressed. The Bank’s adoption of this guidance did not have a material impact on the Bank’s financial statements, nor did it change the Bank’s fair value methodologies from those disclosed in the Bank’s 2008 Annual Report filed on Form 10-K.
 
In an effort to achieve consistency among all of the FHLBanks, the FHLBanks formed the MBS Pricing Governance Committee which was responsible for developing a fair value methodology for MBS that all FHLBanks could adopt. In this regard, the Bank changed the methodology used to estimate the fair value of MBS during the quarter ended September 30, 2009. Under the methodology approved by the MBS Pricing Governance Committee, the Bank requests prices for all MBS from four specific third-party vendors, and, depending on the number of prices received for each security, selects a median or average price as defined by the methodology. The methodology also incorporates variance thresholds to assist in identifying median or average prices that may require further review. In certain limited instances (i.e., prices are outside of variance thresholds or the third-party services do not provide a price), the Bank will obtain a price from securities dealers or internally model a price that is deemed most appropriate after consideration of all relevant facts and circumstances that would be considered by market participants. Prices for CUSIPs held in common with other FHLBanks are reviewed for consistency. In adopting this common methodology, each FHLBank remains responsible for the selection and application of its fair value methodology and the reasonableness of assumptions and inputs used. Prior to the adoption of the new pricing methodology, the Bank used a similar process that utilized three third-party vendors and similar variance thresholds. This change in pricing methodology did not have a significant impact on the Bank’s estimated fair values of its MBS.
 
The Bank did not implement any other material changes to its accounting policies or estimates during the nine months ended September 30, 2009.


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Recently Issued Accounting Standards and Interpretations.  See Note 2 to the unaudited interim financial statements included in this report filed on Form 10-Q for a discussion of recent accounting pronouncements that are relevant to the Bank’s businesses.
 
Legislative and Regulatory Developments
 
Finance Agency Final Regulation on Capital Classifications and Critical Capital Levels for the FHLBanks.  On August 4, 2009, the Finance Agency issued its final Prompt Corrective Action Regulation (PCA Regulation) incorporating the terms of the interim Final Regulation issued on January 30, 2009. The final PCA Regulation (like the Interim Final Regulation): (1) provides for the Finance Agency to classify an FHLBank’s capital status at least once per quarter; (2) provides the Finance Agency with discretionary authority (under certain conditions) to reclassify an FHLBank down one lower capital classification level, including reclassifying an FHLBank as “undercapitalized” that otherwise meets its regulatory capital compliance measures; and (3) establishes the mandatory and discretionary actions and limitations that apply to an FHLBank that is classified as less than adequately capitalized. These actions and limitations include without limitation: (1) the requirement to submit a capital restoration plan; (2) restrictions on dividend payments, capital stock repurchases and redemptions; and (3) restrictions on the growth of average assets, which cannot exceed the previous quarter’s level of average assets without approval of the Finance Agency Director. See additional discussion regarding the mandatory and discretionary actions and limitations in the discussion of the Finance Agency Interim Final Regulation Regarding Minimum Capital Levels in the “Legislative and Regulatory Developments” section in Item 7. Management’s Discussion and Analysis in the Bank’s 2008 Annual Report filed on Form 10-K.
 
Proposed Regulation on Restructuring the FHLBanks Office of Finance.  On July 30, 2009, the Finance Agency announced that a proposed regulation regarding restructuring the board of directors of the Office of Finance (OF) would be issued for a 60-day comment period. The Finance Agency extended the period for comment submission on the proposed regulation until November 4, 2009. The OF is governed by a board of directors, the composition and functions of which are determined by FHFA’s regulations. In its announcement, the Finance Agency stated that its experience with the FHLBank System and with the combined financial reports prepared for the System by the OF during the recent period of market stress suggests that the OF and the FHLBank System could benefit from a reconstituted and strengthened board. The proposed regulation is intended to achieve that by the following: (1) increasing the size of the board and having it comprised of the twelve FHLBank presidents and three to five independent directors; (2) creating an audit committee; (3) providing for the creation of other committees; and (4) setting a method for electing independent directors along with setting qualification for these directors. Under the proposed rule, the audit committee would be charged with oversight of greater consistency in accounting policies and procedures by the FHLBanks which the Finance Agency has stated is intended to enhance the value of the combined financial reports of the OF.
 
Final Finance Agency Regulation on FHLBank Board of Director Elections and Director Eligibility.  On October 7, 2009, the Finance Agency issued a final regulation on FHLBank director elections and director eligibility. The final regulation largely codifies the interim final regulation previously issued by the Finance Agency on September 28, 2008. Changes in the final regulation included provisions: (1) requiring each FHLBank’s board of directors to annually determine how many of its independent directors should be designated public interest directors (provided that each FHLBank at all times has at least 2 public interest directors); (2) stating that where an FHLBank’s board acts to fill a member director vacancy that occurs mid-term that eligible candidates for such a position must be officers or directors of a member institution at the time the FHLBank board acts, not as of the prior year-end; and (3) permitting an FLHBank that nominates more than one nominee for each open independent director position to declare elected the nominee who receives the highest number of votes. This is true even if the total votes received is less than 20 percent of the eligible votes.
 
Collateral for Advances and Interagency Guidance on Nontraditional Mortgage Products.  On August 4, 2009, the Finance Agency published a notice for comment on a study it was required to undertake under the Housing and Economic Recovery Act to review the extent to which loans and securities used as collateral to support FHLBank advances are consistent with the federal banking agencies’ guidance on nontraditional mortgage products. In the notice, the Finance Agency requested comments on whether it should take any additional


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regulatory actions to ensure that FHLBanks are not supporting predatory practices. The Finance Agency also issued its notice of intent to revise previously published guidelines for subprime and nontraditional loans pledged as collateral. This proposed revision would require members pledging private label residential MBS and residential loans acquired after July 10, 2007 to comply with the federal interagency guidance regardless of the origination date of the loans in the security or of the loans pledged. At this time, we are uncertain whether the Finance Agency will implement this revision or impose other restrictions on FHLBank collateral practices as a result of this notice for comment.
 
U.S. Treasury Department’s Financial Stability Plan.  On March 23, 2009, in accordance with the U.S. Treasury Department’s announced Financial Stability Plan’s initiative to purchase illiquid assets, the U.S. Treasury announced the Public-Private Investment Program (PPIP), which is a program designed to attract private investors to purchase certain real estate loans and illiquid MBS (originally AAA-rated) owned by financial institutions using up to $100 billion in TARP capital funds. These funds could be levered with debt funding also provided by the U.S. Treasury to expand the capacity of the program. On July 8, 2009, the U.S. Treasury announced that it had selected the initial nine PPIP fund managers to purchase legacy securities including commercial and residential MBS originally issued prior to 2009 that were originally rated AAA by two or more NRSROs. On September 30, 2009, the Treasury Department announced the initial closings of two Public Private Investment Funds established under PPIP to purchase legacy securities. The PPIP’s activities in purchasing such residential MBS could affect the values of residential MBS. On September 18, 2009, the Treasury Department ended its temporary program to sustain money market funds at stable net asset values.
 
Helping Families Save Their Homes Act of 2009 and Other Mortgage Modification Legislation.  On May 20, 2009, the Helping Families Save Their Home Act of 2009 was enacted to encourage loan modifications in order to prevent mortgage foreclosures and to support the federal deposit insurance system. One provision in the act provides a safe harbor from liability for mortgage servicers who modify the terms of a mortgage consistent with certain qualified loan modification plans. At this time it is uncertain what effect the provisions regarding loan modifications will have on the value of the Bank’s mortgage asset portfolio, the mortgage loan collateral pledged by members to secure their loans to members from the Bank or the value of the Bank’s MBS. As mortgage servicers modify mortgages under the various government incentive programs and otherwise, the value of the Bank’s MBS and mortgage loans held for investment and mortgage assets pledged as collateral for member advances may be reduced. At this point, legislation to allow bankruptcy cramdowns on mortgages secured by owner-occupied homes has been defeated in the U.S. Senate; however, similar legislation could be re-introduced. With this potential change in the law, the risk of losses on mortgages due to borrower bankruptcy filings could become material. The previously proposed legislation permitted a bankruptcy judge, in specified circumstances, to reduce the mortgage amount to today’s market value of the property, reduce the interest rate paid by the debtor, and/or extend the repayment period. In the event that this legislation would again be proposed, passed and applied to existing mortgage debt (including residential MBS), the Bank could face increased risk of credit losses on its private label MBS that include bankruptcy carve-out provisions and allocate bankruptcy losses over a specified dollar amount on a pro-rata basis across all classes of a security. As of September 30, 2009, the Bank has 73 private label MBS with a par value of $4.0 billion that include bankruptcy carve-out language that could be affected by cramdown legislation. The effect on the Bank will depend on the actual version of the legislation that would be passed (if any) and whether mortgages held by the Bank, either within the MPF Program or as collateral for MBS held by the Bank, would be subject to bankruptcy proceedings under the new legislation. Other Bankruptcy Reform Act Amendments also continue to be discussed.
 
Federal Reserve Board GSE Debt and MBS Purchases Initiative.  On November 25, 2008, the Federal Reserve Board (FRB) announced an initiative for the Federal Reserve Bank of New York (FRBNY) to purchase up to $100 billion of the debt of Freddie Mac, Fannie Mae, and the FHLBanks. On March 18, 2009, the FRB committed to purchase up to an additional $100 billion of such debt. Through September 30, 2009, the FRBNY has purchased approximately $131.2 billion in such term debt, of which approximately $28.0 billion was FHLBank term debt. On November 25, 2008, the FRB also announced a program to purchase up to $500 billion in MBS backed by Fannie Mae, Freddie Mac, and the Government National Mortgage Association (Ginnie Mae) to reduce the cost and increase the availability of credit for the purchase of houses. On March 18, 2009, the FRB committed to purchase up to an additional $750 billion of such MBS increasing the total purchase authority to $1.25 trillion since inception of the program. In the third quarter of 2009, the FRBNY purchased approximately $330.4 billion in GSE MBS,


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including approximately $47.2 billion in purchases related to dollar rolls which provide holders of MBS with a form of short-term financing, similar to repurchase agreements. This program, initiated to drive mortgage rates lower, make housing more affordable, and help stabilize home prices, may lead to continued artificially low agency-mortgage pricing. Comparative MPF Program price execution, which is a function of the FHLBank debt issuance costs, may not be competitive as a result. This trend could continue and member demand for MPF Program products could diminish.
 
Additional Federal Reserve Bank Actions.  On November 25, 2008, the FRB announced the creation of the Term Asset-Backed Securities Loan Facility (TALF). The TALF is a funding facility that will issue loans with a term of up to three years to U.S. persons that own eligible asset-backed security (ABS) collateral. The TALF is intended to (1) assist the financial markets in accommodating the credit needs of consumers and small businesses by facilitating the issuance of ABS collateralized by student loans, auto loans, credit card loans, and loans guaranteed by the Small Business Administration (SBA) and (2) improve the market conditions for ABS more generally. TALF loans are non-recourse loans, meaning that the borrower’s obligation to repay the loan can be fulfilled by surrendering the collateral. The U.S. Treasury is providing credit protection to the FRBNY using funds authorized under the TARP. The loan from the FRBNY is senior to the TARP funds. On February 10, 2009, the FRB announced that it is prepared to expand the size of the TALF to as much as $1.0 trillion and potentially to broaden the eligible collateral to encompass other types of newly issued AAA-rated asset-backed securities, such as ABS backed by commercial mortgages or private label MBS backed by residential mortgages. Any expansion of the TALF would be supported by the Treasury providing additional funds from the TARP. In May 2009, the Federal Reserve Board announced the expansion of the TALF to include commercial MBS, including legacy assets. On August 17, 2009, the Federal Reserve Board and Treasury Department announced that the TALF would be extended until March 31, 2010. The eligible collateral for the TALF program remains the same.
 
FDIC Temporary Liquidity Guarantee Program (TLGP) and Other FDIC Actions.  On August 26, 2009, the FDIC approved the extension of its guarantee for noninterest bearing transaction accounts through June 30, 2010 for those participating institutions that do not opt-out of the program. On February 10, 2009, the FDIC extended the guarantee of eligible debt under the TLGP from June 30, 2009 to October 31, 2009, in exchange for an additional premium for the guarantee. On May 19, 2009, Congress passed legislation continuing the FDIC-insured deposit limit of $250 thousand through 2013.
 
FDIC Deposit Insurance Assessments.  On September 29, 2009, the FDIC approved a proposed regulation that would require insured institutions to prepay their estimated quarterly risk-based assessments for the fourth quarter of 2009 and for all of 2010, 2011 and 2012. The FDIC estimates that the total prepaid assessments collected would be approximately $45 billion. On May 29, 2009, the FDIC published a final rule to impose a five basis point special assessment on an insured depository institution’s assets minus Tier 1 capital as of June 30, 2009, subject to certain caps. Past FDIC assessments have been based on the amount of deposits held by an institution. Previously, on February 27, 2009, the FDIC approved a final regulation that would increase the deposit insurance assessment for those FDIC-insured institutions that have outstanding FHLBank advances and other secured liabilities to the extent that the institution’s ratio of secured liabilities to domestic deposits exceeds 25 percent. The FDIC’s risk-based assessment and special assessment on assets may provide incentive for some of the Bank’s members to hold more deposits vis-à-vis other liabilities, such as advances, than they would if non-deposit liabilities were not a factor in determining an institution’s deposit insurance assessments.
 
Proposed Financial Regulatory System Reorganization.  On June 17, 2009, President Barack Obama issued a proposal to improve the effectiveness of the federal regulatory structure that would, among other things, cause a restructuring of the current bank regulatory system. One provision of the plan would require the Treasury Department and the Department of Housing and Urban Development to analyze the future of the FHLBanks, along with Fannie Mae and Freddie Mac with a goal of developing such recommendations in time for the 2011 U.S. fiscal budget. Since June, various versions of proposed regulatory restructuring for the federal financial institution regulators (Federal Reserve, FDIC, OTS and OCC) have been introduced in the House and Senate as well as legislation addressing matters such as: (1) establishment of a consumer financial products safety commission; (2) regulatory requirements for derivatives transactions; (3) systemic risk regulation; (4) regulatory consolidation; (5) GSE reform; and (6) executive compensation. The Bank is unable to predict what versions of such legislation


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will ultimately be passed and therefore is unable to predict the impact of such legislation on the Bank or its members’ activity with the Bank.
 
Money Market Fund Reform.  On July 8, 2009, the Securities and Exchange Commission published a proposed rule on money market fund reform. One of the reforms proposed in the rule is the imposition of new liquidity requirements on money market funds. As proposed, treasury securities, but not FHLBank securities, would be considered liquid assets for purposes of meeting the new liquidity requirements. If the liquidity requirements were adopted as proposed, money market fund demand for FHLBank debt could decrease.
 
Finance Agency Advisory Bulletin on Executive Compensation Principles.  Under the Housing Act, the Finance Agency has the authority to prohibit executive compensation that is not reasonable and comparable to compensation paid to executives at other financial institutions. On October 27, 2009, the Finance Agency issued an Advisory Bulletin establishing the following standards against which the Finance Agency will evaluate each FHLBank’s executive compensation: (1) that each individual executive’s compensation should be reasonable and comparable to that offered to executives in similar positions at comparable financial institutions; (2) such compensation should be consistent with sound risk management and preservation of the par value of FHLBank stock; and (3) a significant percentage of incentive-based compensation should be tied to longer-term performance and outcome-indicators.
 
Proposed Rule on FHLBank Director Compensation.  On October 23, 2009, the Finance Agency issued a proposed rule that would implement Section 1202 of the Housing Act. The proposed rule would allow each FHLBank to pay its directors reasonable compensation and expenses, subject to the authority of the Director of the Finance Agency to object to, and to prohibit prospectively, compensation and/or expenses that the Director determines are not reasonable. The Finance Agency will accept written comments on this proposed rule on or before December 7, 2009.
 
Risk Management
 
Housing and financial markets have been in tremendous turmoil since the middle of 2007, with repercussions throughout the U.S. and global economies, and the U.S. economy is in a recession. Limited liquidity in the credit markets, increasing mortgage delinquencies and foreclosures, falling real estate values, the collapse of the secondary market for MBS, loss of investor confidence, a highly volatile stock market, interest rate fluctuations, and the failure of a number of large and small financial institutions are all indicators of the severe economic crisis facing the U.S. and the rest of the world. These economic conditions, particularly in the housing and financial markets, combined with ongoing uncertainty about the depth and duration of the financial crisis and the recession, continued to affect the Bank’s business and results of operations, as well as its members, during the first nine months of 2009 and may continue to have adverse effects.
 
While the significant deterioration in economic conditions that followed the disruptive financial market events of September 2008 has not reversed, and the economy has remained weak since that time, there are some indications that the pace of economic decline may have started to slow. There have been signs that the financial condition of large financial institutions has begun to stabilize. However, despite these early signs of improvement, the prospects for and potential timing of renewed economic growth (employment growth in particular) remain very uncertain. The ongoing weak economic outlook, along with continued uncertainty regarding the extent that weak economic conditions will extend future losses at large financial institutions to a wider range of asset classes, and the nature and extent of the ongoing need for the government to support the banking industry, have combined to maintain market participants’ somewhat cautious approach to the credit markets.
 
The Bank is heavily dependent on the residential mortgage market through the collateral securing member loans and holdings of mortgage-related assets. The Bank’s member collateral policies, practices and secured status are discussed in more detail below as well as in Item 1. Business in the Bank’s 2008 Annual Report filed on Form 10-K. Additionally, the Bank has outstanding credit exposures related to the MPF Program and investments in private label MBS, which are affected by the continuing mortgage market deterioration. All of these risk exposures are continually monitored and are discussed in more detail in the following sections.


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For further information regarding the financial and residential markets in the third quarter and first nine months of 2009, see the “Current Financial and Mortgage Markets and Trends” discussion in the Overview section of this Item 2. Management’s Discussion and Analysis in this report filed on Form 10-Q.
 
Risk Governance
 
The Bank’s lending, investment and funding activities and use of derivative hedging instruments expose the Bank to a number of risks that include market and interest rate risk, credit and counterparty risk, liquidity and funding risk, and operating and business risk, among others, including those described in Item 1A. Risk Factors in the Bank’s 2008 Annual Report filed on Form 10-K.
 
Subprime and Nontraditional Loan Exposure.  In October 2009, the Board approved various policy revisions, which were effective immediately, pertaining to subprime and nontraditional loan exposure. These revisions included establishment of a Bankwide limit on these types of exposures and affected policies related to collateral, MBS investments and the MPF Program mortgage loan portfolio.
 
First, the definitions of subprime and nontraditional residential mortgage loans and MBS were updated to be consistent with Federal Financial Institutions Examination Council (FFIEC) and Finance Agency Guidance. Second, the overall risk limits were established with respect to exposure to subprime and nontraditional exposure. Currently, subprime exposure limits are essentially established at zero. With respect to nontraditional exposure, the Bank has established overall limits and portfolio sublimits. The overall risk limit for nontraditional exposure is 25%, that is, the total overall nontraditional exposure cannot exceed 25% of the sum of the collateral pool plus MBS investments plus MPF mortgage loans. The collateral sublimit has been set at 20%, the MBS investment sublimit at 10% and the MPF mortgage loan sublimit at 5%. The MBS investment sublimit of 10% excludes legacy private label MBS and any securities issued, guaranteed or fully insured by Ginnie Mae. Third, an enhanced reporting process has been established to aggregate the volume of subprime and nontraditional loans and MBS investments. Lastly, with respect to collateral, all members are required to identify subprime and nontraditional loans and MBS and provide periodic certification that they comply with the FFIEC guidance.
 
Capital Adequacy and the Alternative Risk Profile.  As discussed in the Bank’s 2008 Annual Report filed on Form 10-K, the Bank’s overarching capital adequacy metric is the Projected Capital Stock Price (PCSP). The PCSP begins by determining the market value of the capital stock as of the measurement date. The PCSP is calculated using risk components for interest rates, spread, credit, operating and accounting risk. The sum of these components represents an estimate of projected capital stock variability and is used in evaluating the adequacy of retained earnings and developing dividend payout recommendations to the Board. The Board has established a PCSP floor of 85% and a target of 95%. Management strives to manage the overall risk profile of the Bank in a manner that attempts to preserve the PCSP at or near the target ratio of 95%. The difference between the actual PCSP and the floor or target, if any, represents a range of additional retained earnings that, in the absence of a reduction in the aforementioned risk components, would need to be accumulated over time to restore the PCSP and retained earnings to an adequate level. During third quarter 2009 and at September 30, 2009, the Bank was out of compliance with the capital adequacy policy metric. The Bank made no dividend payments during the third quarter, which conserved retained earnings.
 
Mortgage spreads, particularly spreads on private label MBS, expanded to historically wide levels over the last two years, reflecting increased credit risk and an illiquid market environment. Due to these unprecedented market developments, the Bank’s market risk metrics began to deteriorate in early 2008, including a decline in the Bank’s market value of equity and an increase in the duration of equity. At that time, management developed an Alternative Risk Profile to exclude the effects of further increases in certain mortgage-related asset credit spreads to better reflect the underlying interest rate risk and accommodate prudent management of the Bank’s balance sheet. During the third quarter of 2009, the Alternative Risk Profile calculation was refined to revalue private label MBS using market implied discount spreads from the period of acquisition. This revision had the impact of increasing the PCSP calculated under the Alternative Risk Profile by 8.2%. This refinement is also discussed in the Duration of Equity section. See the Risk Management section in Item 7. Management’s Discussion and Analysis in the Bank’s 2008 Annual Report filed on Form 10-K for additional information on the Alternative Risk Profile.


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The following table presents the Bank’s PCSP calculation under the provisions of the revised Risk Governance Policy. Under both the Actual and Alternative Risk Profile calculations, the Bank was out of compliance with the PCSP limits for all periods presented.
 
                                         
      Projected Capital Stock Price (PCSP)  
      Actual       Alternative Risk Profile       Floor       Target  
September 30, 2009
      25.5%         67.8%         85%         95%  
                                         
June 30, 2009
      21.2%         71.6%         85%         95%  
                                         
March 31, 2009
      11.6%         73.2%         85%         95%  
                                         
December 31, 2008
      9.9%         74.2%         85%         95%  
                                         
September 30, 2008
      57.1%         83.7%         85%         95%  
                                         
 
Declines in the market value of equity due to further private label MBS credit spread widening in the fourth quarter of 2008 reduced the current capital stock price from which the PCSP is projected and significantly increased the differential between the Actual and Alternative Risk Profile calculations.
 
During the first quarter of 2009, the PCSP stabilized at a level just above the low price established in December 2008 for the Actual PCSP. The interest rate and spread risk components of PCSP were relatively stable at low levels during the first quarter of 2009. The credit risk component, however, increased and was a primary driver of keeping the PCSP at such a low level during the first quarter of 2009 for both the Actual and Alternate Risk Profile PCSP, despite an improved current capital stock price from which the PCSP is projected. The increase in the credit risk component was driven primarily by credit ratings downgrades on private label MBS.
 
The market value of the capital stock as of the measurement date has increased due to narrowing private label MBS spreads in the Actual calculation. This increase was partially offset by credit rating downgrades on certain private label MBS.
 
The market value of capital stock component of the PCSP in the Alternative Risk Profile increased in both the second and third quarters of 2009. The primary increase in the market value component in the third quarter was driven by a methodology change, as discussed above. However, more than offsetting this increase was the credit rating downgrades on certain private label MBS, which caused the PCSP in the Alternative Risk Profile to decrease.
 
Actual PCSP is impacted by increases in private label MBS pricing. Conversely, in the Alternative Risk Profile, private label MBS pricing is converted to acquisition spreads eliminating some of the price volatility.
 
Qualitative Disclosures Regarding Market Risk
 
Managing Market and Interest Rate Risk.  The Bank’s market and interest rate risk management objective is to protect member/shareholder and bondholder value consistent with the Bank’s housing mission and safe and sound operations in all interest-rate environments. Management believes that a disciplined approach to market and interest rate risk management is essential to maintaining a strong and durable capital base and uninterrupted access to the capital markets.
 
Market risk is defined as the risk of loss arising from adverse changes in market rates and prices and other relevant market rate or price changes, such as basis changes. Generally, the Bank manages basis risk through asset selection and pricing. However, the unprecedented private label mortgage credit spreads have significantly reduced the Bank’s net market value and Actual PCSP.
 
Interest rate risk is the risk that relative and absolute changes in prevailing market interest rates may adversely affect an institution’s financial performance or condition. Interest rate risk arises from a variety of sources, including repricing risk, yield curve risk and options risk. The Bank invests in mortgage assets, such as MPF Program mortgage loans and MBS, which together represent the primary source of option risk. As of September 30, 2009, mortgage assets totaled 21.1% of the Bank’s balance sheet. Management reviews the estimated market risk of the entire portfolio of mortgage assets and related funding and hedges on a monthly basis to assess the need for


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rebalancing strategies. These rebalancing strategies may include entering into new funding and hedging transactions, forgoing or modifying certain funding or hedging transactions normally executed with new mortgage purchases, or terminating certain funding and hedging transactions for the mortgage asset portfolio.
 
Earnings-at-Risk.  On March 27, 2009, the Board approved an earnings-at-risk framework for certain mark-to-market positions, including economic hedges. This framework established a forward-looking, scenario-based exposure limit based on parallel rate shocks that would apply to any existing or proposed transaction that is marked to market through the income statement without an offsetting mark arising from a qualifying hedge relationship. An earnings-at-risk policy based on the approved framework was implemented effective April 1, 2009.
 
The Board established an initial daily exposure limit of $2.5 million. The Asset/Liability Committee (ALCO) has implemented a more restrictive daily exposure operating guideline of $1.5 million. Throughout the second and third quarters of 2009, the daily forward-looking exposure was below the operating guidelines of $1.5 million and at September 30, 2009 measured $148 thousand. Capital Markets and Corporate Risk Management also monitor actual profit/loss change on a daily, monthly cumulative, and quarterly cumulative basis.
 
Quantitative Disclosures Regarding Market Risk
 
The Bank’s Market Risk Model.  Significant resources, both in analytical computer models and staff, are devoted to assuring that the level of interest rate risk in the balance sheet is accurately measured, thus allowing management to monitor the risk against policy and regulatory limits. The Bank uses an externally developed market risk model to evaluate its financial position. Management regularly reviews the major assumptions and methodologies used in the model, as well as available upgrades to the model. During second quarter 2009, the Bank upgraded the mortgage prepayment models used within the market risk model to more accurately reflect expected prepayment behavior. See the Risk Management discussion in Item 7. Management’s Discussion and Analysis in the Bank’s 2008 Annual Report filed on Form 10-K for additional information regarding the Bank’s market risk profile.
 
The duration of equity and return volatility metrics, as well as the PCSP discussed above, are the direct primary metrics used by the Bank to manage its interest rate risk exposure. The Bank’s asset/liability management policies specify acceptable ranges for duration of equity, return volatility and the PCSP metrics, and the Bank’s exposures are measured and managed against these limits. The duration of equity and return volatility metrics are described in more detail below.
 
Duration of Equity.  One key risk metric used by the Bank, and which is commonly used throughout the financial services industry, is duration. Duration is a measure of the sensitivity of a financial instrument’s value, or the value of a portfolio of instruments, to a parallel shift in interest rates. Duration (typically measured in months or years) is commonly used by investors throughout the fixed income securities market as a measure of financial instrument price sensitivity. Longer duration instruments generally exhibit greater price sensitivity to changes in market interest rates than shorter duration instruments. For example, the value of an instrument with a duration of five years is expected to change by approximately 5% in response to a one percentage point change in interest rates. Duration of equity, an extension of this conceptual framework, is a measure designed to capture the potential for the market value of the Bank’s equity base to change with movements in market interest rates. Higher duration numbers, whether positive or negative, indicate a greater potential exposure of market value of equity in response to changing interest rates.
 
The Bank’s asset/liability management policy approved by the Board calls for duration of equity to be maintained within a + 4.5 year range in the base case. In addition, the duration of equity exposure limit in an instantaneous parallel interest rate shock of + 200 basis points is + 7 years. Management analyzes the duration of equity exposure against this policy limit on a daily basis. Management continually evaluated its market risk management strategies throughout 2008. In March 2008, management determined that strict compliance with the actual duration of equity limit under the current severe market conditions would not be prudent. In November 2008 and in connection with the Alternative Risk Profile discussed above, management requested and was approved to use the alternate calculation of duration of equity for the calculation and monitoring of duration of equity through


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December 31, 2009. The Board did not adjust the existing market risk limits; therefore, compliance with those limits is now measured using the alternative calculation.
 
The following table presents the Bank’s duration of equity exposure in accordance with the actual and Alternative Risk Profile duration of equity calculation by quarter.
 
                           
      Down 200
  Down 100
    Base
    Up 100
  Up 200
(in years)     basis points   basis points     Case     basis points   basis points
Alternative duration of equity
                         
                           
September 30, 2009
    (1)   (1)     0.2     2.2   2.8
                           
June 30, 2009
    (1)   (1)     2.3     3.2   3.3
                           
March 31, 2009
    (1)   (1)     (2.7)     0.2   1.1
                           
December 31, 2008
    (1)   (1)     (0.1)     1.5   1.7
                           
Actual duration of equity
                         
                           
September 30, 2009
    (1)   (1)     15.3     10.5   6.2
                           
June 30, 2009
    (1)   (1)     22.1     11.7   6.2
                           
March 31, 2009
    (1)   (1)     13.9     2.2   (2.2)
                           
December 31, 2008
    (1)   (1)     26.8     10.9   0.6
                           
September 30, 2008
    (1)   4.1     3.2     1.8   0.8
                           
June 30, 2008
    (1)   2.4     3.9     3.9   3.7
                           
March 31, 2008
    (1)   3.2     5.0     5.0   3.4
                           
December 31, 2007
    (2.8)   (0.6)     4.2     4.7   4.0
                           
Note:
 
(1) Given the low level of interest rates, an instantaneous parallel interest rate shock of “down 200 basis points” and “down 100 basis points” cannot be meaningfully measured for these periods.
 
During 2008 the Bank periodically took various hedging actions, including the issuance of a limited amount of fixed-rate debt, and was in compliance with the actual policy metric for the quarters ended June 30, 2008, and September 30, 2008. However, the Bank’s base case duration of equity exceeded the policy limit at times during the second, third and fourth quarters of 2008 until the Alternative Risk Profile was adopted in November 2008, as previously discussed. Subsequent to the adoption of the alternative duration of equity calculation, private label MBS spreads continued to widen significantly causing a substantial decline in the market value of equity and a substantial increase in the actual duration of equity levels as of December 31, 2008. The Bank’s low market value of equity in the fourth quarter 2008 had the effect of amplifying the volatility of the actual reported duration of equity metric. Therefore, the Bank was substantially out of compliance with the actual reported duration of equity as of December 31, 2008 and through the third quarter of 2009. However, under the Alternative Risk Profile, the Bank was in compliance with the duration of equity policy metric for all periods presented.
 
During the first quarter of 2009, the decrease in the alternate base case duration of equity of 2.6 years from December 31, 2008 to March 31, 2009 was primarily due to narrower agency mortgage spreads and issuance of fixed-rate debt. Increases in the alternate duration of equity for the second quarter of 2009 were primarily a result of the prepayment model changes made during the quarter, which more accurately reflect actual prepayment activity, as well as higher longer term rates. These model changes are made periodically to maintain adequate model performance. Decreases in the alternative duration of equity during the third quarter of 2009 were primarily a result of a lower, flatter yield curve and a change to the Alternative Risk Profile calculation to revalue private label MBS using market implied discount spreads from the period of acquisition. This change in the Alternative Risk Profile calculation had an impact of decreasing the duration of equity by 1.2 years in the base case. This change is discussed in the Capital Adequacy and Alternative Risk Profile section. Fixed-rate debt was also issued during the quarter to reduce the duration levels.


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The Bank continues to monitor the mortgage and related fixed income markets and the impact that changes in the market may have on duration of equity and other market risk measures and may take actions to reduce market risk exposures as needed. Management believes that the Bank’s current market risk profile is reasonable given these market conditions.
 
Return Volatility.  The Bank’s asset/liability management policy specifies a return volatility metric to manage the impact of market risk on the Bank’s average return on average capital stock compared to a dividend benchmark interest rate over multiple interest rate shock scenarios over a rolling forward one to 12 month time period. Effective September 2008, the Board approved an expansion of this metric to include a similar metric over the 13 to 24 month time period. The Board selected the dividend benchmark of three-month LIBOR and approved related spread limits for both time periods. This risk metric is calculated and reported to the Board on a monthly basis.
 
The following table presents the Bank’s return volatility metric for the periods in which the policy was applicable. The metric is presented as spreads over 3-month LIBOR. The steeper and flatter yield curve shift scenarios shown below are represented by appropriate increases and decreases in short-term and long-term interest rates using the three-year point on the yield curve as the pivot point. The Bank was in compliance with these return volatility metrics across all selected interest rate shock scenarios as of September 30, 2009.
 
                                           
      Yield Curve Shifts(1)  
      Down 200 bps