UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

 

 

Commission File Number: 000-51395

 

FEDERAL HOME LOAN BANK OF PITTSBURGH

(Exact name of registrant as specified in its charter)

 

 

(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.  xYes  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):

 

(Do not check if a 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 40,076,009 shares of common stock with a par value of $100 per share outstanding at April 30, 2010.

 

FEDERAL HOME LOAN BANK OF PITTSBURGH

 

TABLE OF CONTENTS

 

 

This Overview should be read in conjunction with the Bank’s unaudited financial statements and footnotes to financial statements in the quarterly report filed on this Form 10-Q as well as the Bank’s 2009 Annual Report filed on Form 10-K.

 

Overview

 

The Federal Home Loan Bank of Pittsburgh’s (the Bank) mission is to provide a readily available, low-cost source of funds for housing and community lenders. The Bank strives to enhance the availability of credit for residential mortgages and targeted community development. The Bank manages its own liquidity so that funds are available to meet members’ demand. By providing needed liquidity and enhancing competition in the mortgage market, the Bank’s lending programs benefit homebuyers and communities.

 

Financial and housing markets have been in turmoil for the last two years, both here in the U.S. and worldwide, as failure to adhere to sound underwriting standards, an increase in mortgage delinquencies and higher foreclosures impacted the economy. As a result of the extensive efforts of the U.S. government and other governments around the world to stimulate economic activity and provide liquidity to the capital markets, the economic environment remains uncertain. Unemployment and underemployment remain at higher levels. In addition, many government programs that support the financial and housing markets are beginning to wind down in 2010. There may be risks to the economy as these programs wind down and the government withdraws its support.

 

Housing prices are still low and falling in some areas. Delinquency and foreclosure rates continue to run at high levels. While the agency mortgage-backed securities (MBS) market is active in funding new mortgage originations, the private label MBS market has not yet recovered. In addition, the commercial real estate market continues to trend downward.

 

The conditions noted above continued to affect the Bank’s business, results of operations and financial condition, as well as that of the Bank’s members, in the first quarter of 2010, and are expected to continue to exert a significant negative effect in the future.

 

General

 

The 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 amended 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 regulation was effective February 4, 2010 and sets out the eligibility and procedural requirements for CDFIs that wish to become members of an FHLBank. 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 and U.S. Treasury debt widened, making it more difficult for the Bank to provide term funding to members at attractive rates in the beginning of 2009. However, during the last part of the first 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 a dividend on the capital investment.

 

Second, because the Bank’s customers and shareholders are predominantly the same group of 318, 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, in an effort to build retained earnings the Bank, on a voluntary basis, temporarily has suspended its dividend payments until the Bank believes it is prudent to restore them.

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 community development 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 (RBC) requirements due to deterioration in the market values of the Bank’s private label MBS. The Bank was narrowly in compliance with its RBC requirement. As a result, the Bank submitted an initial Capital Stabilization Plan (CSP) to the Finance Agency on February 27, 2009. During 2009, there were numerous changes in the economic environment affecting the Bank, including a change in Financial Accounting Standards Board (FASB) guidance regarding other-than-temporary impairment (OTTI), significant downgrades of the Bank’s private label MBS securities, and a larger than expected decrease in advances. Collectively, these developments merited an update of the CSP in late 2009. The CSP 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 and has begun to make certain enhancements. The most recent CSP was accepted by the Finance Agency.

 

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. On March 31, 2010, the Bank received final notification from the Finance Agency that it was considered adequately capitalized for the quarter ended December 31, 2009. In its determination, the Finance Agency expressed concerns regarding the Bank’s capital position and earnings prospects. Retained earnings levels and poor quality of the Bank’s private label MBS portfolio have created uncertainties about the Bank’s ability to maintain permanent capital above RBC requirements. As of the date of this filing, the Bank has not received notice from the Finance Agency regarding its capital classification for the quarter ended March 31, 2010. The Bank was in compliance with its risk-based, total and leverage capital requirements at March 31, 2010, as discussed in detail in the Capital Resources section of this Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (Management’s Discussion and Analysis) in the quarterly report filed on this Form 10-Q.

 

Advances and Collateral

 

The Bank makes advances (loans to members and eligible nonmember housing associates) on the security of pledged mortgage loans 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.

 

Advance Products. The Bank offers a number of various loan products to its members. These products are discussed in detail in the “Advances” discussion in Item 1. Business in the Bank’s 2009 Annual Report filed on Form 10-K.

 

Collateral. The Bank provides members with two options regarding collateral agreements: a blanket collateral pledge agreement or a specific collateral pledge agreement. Under a blanket agreement, the Bank obtains a lien against all of the member’s unencumbered eligible collateral assets and most ineligible collateral assets, to secure the member’s obligations with the Bank. Under a specific agreement, the Bank obtains a lien against the specific eligible collateral assets of a member, to secure the member’s obligations with the Bank. These agreements require one of three types of collateral status: undelivered, detailed listing or delivered status. Partial listing or delivery requirements may also be assigned at the Bank’s discretion. A member is assigned a collateral status based on the Bank’s determination of the member’s current financial condition and credit product usage, as well as other information that may have been obtained. All collateral securing advances is discounted to help protect the Bank from losses resulting from a decline in the values of the collateral in adverse market conditions and if the Bank had to take title to the collateral and liquidate in a worst case scenario. 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. The Bank reviews the collateral weightings periodically and may adjust them for individual borrowers on a case-by-case basis. The Bank may also require different levels of collateral reporting depending on the member’s current financial condition, types of collateral pledged and credit product usage. The reporting may take the form of detailed loan level listings and/or a Qualifying Collateral Report (QCR) filed on a quarterly or monthly basis. A summary of the collateral weightings is presented in detail in the tables entitled “Lending Value Assigned to the Collateral as a Percentage of Value” in Item 1. Business in the Bank’s 2009 Annual Report filed on Form 10-K. As additional security for each member’s indebtedness, the Bank has a statutory lien on the member’s capital stock in the Bank.

 

The least restrictive collateral status, and the most widely used by the Bank’s members, is the undelivered collateral status. This status is generally assigned to lower risk institutions pledging collateral. Under undelivered collateral status, the Bank calculates and monitors the eligible collateral using regulatory financial reports or QCRs, which are typically submitted quarterly along with collateral certifications. At March 31, 2010, nine of the Bank’s top ten borrowers were in an undelivered collateral status and one was in a delivery collateral status. The Bank also obtains detailed listings on some of the pledged loan collateral on five of the top ten borrowers.

 

Under the Bank’s policy, the Bank may require members to provide a detailed listing of eligible advance collateral being pledged to the Bank due to their high usage of Bank credit products, the type of assets being pledged or the credit condition of the member. This is referred to as detailed listing collateral status. In this case, the member typically retains physical possession of collateral pledged to the Bank but provides a loan level listing of assets pledged. The loan level listing includes the reporting characteristics on the individual loan. Examples include loan amount, zip code, appraised amount and FICO score. In some cases, the member may benefit by listing collateral, in lieu of undelivered status, since it may result in a higher collateral weighting being applied to the collateral. The Bank benefits from listing collateral status because it provides more loan information to calculate a more precise valuation on the collateral. Typically, those members with large, frequent borrowings are covered under listing status with a blanket agreement.

 

The third collateral status used by the Bank’s members is delivered, or in possession collateral status. In this case, the Bank requires the member to physically deliver, or grant control of, eligible collateral to the Bank, including through a third party custodian for the Bank to sufficiently secure all outstanding member obligations. Typically, the Bank would take physical possession/control of collateral if the financial condition of the member was deteriorating or if the member exceeded certain credit product usage triggers. Delivery of collateral may also be required if there is a regulatory action taken against the member by its regulator that would indicate inadequate controls or other conditions that would be of concern to the Bank. Delivery collateral status may apply to both blanket lien and specific agreements. The Bank requires delivery to a restricted account of all securities pledged as collateral. The Bank also requires delivery of collateral from de novo institution members at least during their first two years of operation.

 

With respect to specific collateral agreement borrowers (typically housing finance agencies (HFAs) and insurance companies), the Bank takes control of all collateral pledged at the time the loan is made through the delivery of securities or mortgage loans to the Bank or its custodian.

 

The Bank determines the type and amount of collateral each member has available to pledge as security for Bank advances by reviewing, on a quarterly basis, 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 QCR on a quarterly or monthly basis. The resulting total value of collateral available to be pledged to the Bank after any collateral weighting is referred to as a member’s maximum borrowing capacity (MBC).

 

At March 31, 2010, 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. High-quality

securities, including U.S. Treasuries, U.S. agency securities, GSE MBS, and select private label MBS, were also accepted as collateral. FHLBank deposits and multi-family residential mortgages, as well as other real estate related collateral (ORERC), comprised the remaining 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 the quarterly report filed on this Form 10-Q for further information on collateral policies and practices and details regarding eligible collateral, including amounts and percentages of eligible collateral securing member advances as of March 31, 2010.

 

At March 31, 2010 and December 31, 2009, respectively, on a borrower-by-borrower basis, the Bank had a perfected interest in eligible collateral with an eligible collateral value (after collateral weightings) in excess of the book value of all advances. 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.

 

Although subprime mortgages are no longer 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.

 

Nationally, during the first three months of 2010, 41 Federal Deposit Insurance Corporation (FDIC)−insured institutions have failed. None of the FHLBanks have incurred any losses on advances outstanding to these institutions. Although many of these institutions were members of the System, none was a member of the Bank.

 

Investments

 

The Bank maintains a portfolio of investments for three main purposes: liquidity, collateral for derivative counterparties and additional earnings. For liquidity purposes, the Bank invests in shorter-term instruments, including overnight Federal funds, to ensure the availability of funds to meet member requests. In addition, the Bank invests in other short-term instruments, including term Federal funds, interest-bearing certificates of deposit and commercial paper. The Bank also maintains a secondary liquidity portfolio, which includes FDIC-guaranteed Temporary Liquidity Guarantee Program (TLGP) investments, U.S. Treasury and agency securities that can be financed under normal market conditions in securities repurchase agreement transactions to raise additional funds. U.S. Treasury securities are the primary source for derivative counterparty collateral.

 

The Bank further enhances interest income by maintaining a long-term investment portfolio, including securities issued by GSEs and state and local government agencies as well as agency and private label MBS. All private label MBS currently in the portfolio, excluding the Shared Funding securities, were required to carry the top rating from Moody’s Investors Service, Inc. (Moody’s), Standard & Poor’s (S&P) or Fitch Ratings (Fitch) at the time of purchase. The long-term investment portfolio is intended to provide the Bank with higher returns than those available in the short-term money markets. Investment income also bolsters the Bank’s capacity to meet its commitment to affordable housing and community investment, to cover operating expenses, and to satisfy its statutory Resolution Funding Corporation (REFCORP) assessment.

 

See the “Credit and Counterparty Risk – Investments” discussion in Risk Management in this Item 2. Management’s Discussion and Analysis in the quarterly report filed on this Form 10-Q for discussion of the credit risk of the investment portfolio, including OTTI charges, and further information on these securities’ current ratings.

 

The Bank does not consolidate any off-balance sheet special-purpose entities or other conduits.

 

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 three products under the MPF Program to Participating Financial Institutions (PFIs): Original MPF, MPF Government and MPF Xtra. 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 2009 Annual Report filed on Form 10-K.

 

The Bank held approximately $5.0 billion and $5.1 billion in mortgage loans at par under the MPF Program at March 31, 2010 and December 31, 2009, respectively. These balances represented approximately 8.4% and 7.8% of total assets at March 31, 2010 and December 31, 2009, respectively. Mortgage loans contributed approximately 25.9% and 16.1% of total interest income for first quarter 2010 and 2009, respectively. While interest income on mortgage loans dropped 17.1% in the quarter-over-quarter comparison, the Bank’s total interest income decreased 48.5%. Total interest income decreased more rapidly than interest income on mortgage loans as the Bank had significant funds invested in short-term assets, which experienced sharp rate declines in the quarter-over-quarter comparison.

 

As of March 31, 2010, 35 PFIs were eligible to participate in the MPF Xtra program. Of these, 10 have sold $12.4 million of mortgage loans through the MPF Xtra program year-to-date.

 

Effective July 15, 2009, the Bank introduced a temporary loan payment modification plan (loan 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 loan modification plan. This 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 loan modification plan. Applicants are initially under a 90-day trial period prior to final approval of the loan modification. As of March 31, 2010, there have been minimal requests for loan modifications under this loan modification plan; these modifications are still in the 90-day trial period.

 

The FHLBank of Chicago, in its role as MPF Provider, provides the programmatic and operational support for the MPF Program and is responsible for the development and maintenance of the origination, underwriting and servicing guides.

 

“Mortgage Partnership Finance,” “MPF” and “MPF Extra” 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 advances. 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 Management’s Discussion and Analysis in the quarterly report filed on this 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

 

Conditions in the Financial Markets. Government programs put in place in 2008 worked throughout 2009 to create more confidence in the credit markets and helped to get capital flowing once again. As financial conditions have shown some improvement and as further evidence of the stabilization of the credit markets, the Federal Reserve has substantially phased out the lending programs activated during the crisis without significant effect on the markets. Some were closed over the course of 2009, and most others expired on February 1, 2010. Total credit outstanding under all programs, including the regular discount window, has fallen sharply from a peak of approximately $1.5 trillion at year-end 2008 to approximately $71 billion at mid-March 2010. The Term Auction Facility, under which fixed amounts of discount window credit were auctioned to depository institutions, was discontinued in March 2010. Reflecting notably better conditions in many markets for ABS, the Term Asset-Backed Securities Loan Facility (TALF) closed on March 31, 2010 for securities backed by all types of collateral except newly issued commercial MBS (CMBS) and will close on June 30, 2010 for securities backed by newly issued CMBS. The later scheduled closing of the CMBS portion of the facility reflects the Federal Reserve Board’s (Federal Reserve’s) assessment that conditions in that sector remain highly stressed, as well as the fact that CMBS securitizations are more complex and take longer to complete than other types of arrangements.

 

Renewed economic growth, particularly employment growth, remains uncertain. The unemployment rate remained at 9.7% in March 2010, but the nation added 162,000 nonfarm jobs, the largest one-month gain in three years. The job growth was below what economists were predicting, but the government hired fewer census workers than expected and the economic recovery continues to be slow.

 

Given the current economic environment, the financial performance of the Bank has been significantly affected, mainly due to OTTI charges on the private label MBS portfolio. The Bank recognizes this will be an ongoing challenge throughout the remainder of 2010. Additional material credit-related OTTI charges have occurred in the first quarter and could be expected throughout the year. The specific amount of credit-related OTTI charges will depend on several factors, including economic, financial market and housing market conditions and the actual and projected performance of the loan collateral underlying the Bank’s MBS. If delinquency and/or loss rates on mortgages and/or home equity loans continue to increase, and/or there is a further decline in residential real estate values, the Bank could experience further material credit-related OTTI losses or reduced yields on these investment securities.

 

First Quarter 2010. Credit markets continued to trend toward stability through first quarter 2010. In addition, the FHLBanks continued to have access to the capital markets. While GDP showed promising growth towards the end of 2009, first quarter 2010 may see a slowing of GDP growth.

 

Specific Program Activity

 

Federal Reserve Bank of New York (FRBNY). In early February 2010, the Federal Reserve Bank of New York (FRBNY) announced the scheduled expiration of several lending programs. These programs included the Commercial Paper Funding Facility (CPFF), the Primary Dealer Credit Facility (PDCF), and the Term Securities Lending Facility (TSLF), each of which expired on February 1, 2010. The expiration of these programs does not appear to have had a major effect on the agency debt markets.

 

Furthermore, the Federal Reserve’s purchasing of agency debt and agency mortgage-backed securities ended during the first quarter of 2010. During the quarter, the Federal Reserve purchased $12.2 billion in debt issued by the housing GSEs, including $3.2 billion in FHLBank mandated Global bullet bonds. The Federal Reserve purchased a total of $172.1 billion in agency debt securities while the program was in effect; this was just shy of the $175 billion committed to the purchase of agency debt under the program. The Federal Reserve also purchased $207 billion in gross agency MBS during the first quarter of 2010. From the program’s inception to its expiration, the Federal Reserve’s total net purchases of agency MBS equaled $1.25 trillion, the amount originally committed to the purchase of MBS under the program.

Fannie Mae and Freddie Mac. On December 24, 2009, the U.S. Treasury had announced modifications to the Preferred Stock Purchase Agreements with Fannie Mae and Freddie Mac, including an increased capacity to absorb losses from the housing GSEs beyond the original $200 billion per agency and a portfolio cap of $900 billion for each institution which will shrink by 10 percent each year. These modifications replaced the requirement to reduce the actual portfolio amounts by 10 percent each year starting in 2010. These modifications were fully implemented in first quarter 2010.

 

Also during the first quarter of 2010, Fannie Mae and Freddie Mac announced plans to purchase loans that are at least 120 days delinquent out of mortgage pools. The initial purchases are slated to occur from February 2010 through May 2010, with additional delinquency purchases as needed thereafter. As Fannie Mae and Freddie Mac may need to raise additional funds to complete these loan purchases, funding costs in the short-end of the agency debt market may continue to be affected.

 

Consolidated Obligations of the FHLBanks. During the first quarter of 2010, the FHLBanks issued $154 billion of consolidated bonds, just $2.4 billion more than during the fourth quarter of 2009. However, weighted-average bond funding costs decreased significantly during the first quarter of 2010, with March 2010 witnessing the lowest weighted-average monthly spreads to London Interbank Offered Rate (LIBOR) since February 2009. Swapped funding levels have been driven lower by a variety of factors, including recent spread compression of the swap curve. During the first quarter of 2010, the FHLBanks relied heavily on swapped negotiated callable bonds, floating-rate bonds and step-up callable bonds. In 2010, the FHLBanks continued to use an issuance calendar for FHLBank mandated Global bullet bond pricing; as such, the FHLBanks issued a $1 billion reopening of the most recent two-year mandated Global bullet bond in January 2010, issued $3 billion of a new, three-year mandated Global bullet bond in February 2010, and issued $3 billion of a new, two-year mandated Global bond in March 2010.

 

The FHLBanks’ consolidated obligations outstanding continued to shrink during the first quarter of 2010. Although consolidated obligations outstanding increased slightly in early January 2010, they soon reversed course, and through the first quarter of 2010, have decreased approximately $60 billion since year-end 2009, to $871 billion at March 31, 2010. Contrary to the fourth quarter of 2009, this decline was caused primarily by a decline in consolidated bonds outstanding, which fell $49 billion, while consolidated discount notes dropped $10 billion. The drop in consolidated bonds outstanding may be attributed in part to increased consolidated bond redemptions during the first quarter of 2010. During this period, consolidated bond maturities were $127 billion and consolidated bond calls were $70.5 billion.

 

Primary dealer inventories of agency discount notes and bonds increased during the first quarter of 2010, compared to year-end 2009. During the first quarter of 2010, agency discount note inventories increased $4 billion, to $16 billion, and agency bond inventories increased $6 billion, to $62 billion. However, similar to the previous two calendar quarters, dealer inventories increased during the quarter and then decreased toward the end of the quarter. During the first quarter of 2010, dealer inventories of agency discount notes were as high as $38 billion in early March 2010 and dealer inventories of agency bonds were as high as $83 billion in mid-February 2010.

 

On a stand-alone basis, the Bank’s total consolidated obligations declined $6.8 billion or 11.5% since year end 2009. Discount notes accounted for 19.0% and 17.2% of the Bank’s total consolidated obligations at March 31, 2010 and December 31, 2009, respectively. Total bonds decreased 13.4% in the same comparison, but comprised a smaller percentage of the total debt portfolio, decreasing from 82.8% at December 31, 2009 to 81.0% at March 31, 2010.

 

Foreign Official Holdings and Money Fund Assets. Overall, foreign investor holdings of agencies (both debt and MBS), as reported by the Federal Reserve System, were flat to lower for much of the first quarter of 2010, but started to increase in late February 2010, closing the quarter up $10 billion compared to year-end 2009.

 

On March 4, 2010, in the Federal Register, the SEC published its final rule on money market fund reform. The rule became effective on May 5, 2010, with certain aspects of the rule phased in over the remainder of 2010. In its

final rule, the SEC included FHLBank consolidated discount notes with remaining maturities of 60 days or less in its definition of weekly liquid assets, which should help maintain investor demand for shorter-term FHLBank consolidated discount notes. However, this new rule, combined with shrinking yields in the money market sector, have driven investors to seek riskier investment categories that offer a higher rate of return. As such, taxable money market fund assets declined $276 billion during the first quarter of 2010. As a subset of those assets, taxable money market fund investments allocated to the U.S. Other Agency category have also declined, dropping an additional $68 billion since year-end 2009.

 

Interest Rate Trends. 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. A portion of the Bank’s advances have 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.).

 

Note:

 

⁽¹⁾LIBOR - London Interbank Offered Rate

⁽²⁾Simple average of Fannie Mae and Freddie Mac mortgage-backed securities current coupon rates.

 

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 to return the cash collateral posted by the Bank associated with the derivative contracts. In 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. Continuing developments in the adversary proceeding occurred during 2009. The discovery phase of the adversary proceeding began, which has provided management information related to its claim. Based on this information, management’s most probable estimated loss was $35.3 million and a reserve was recorded in the first quarter of 2009. As of March 31, 2010, 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 the Bank’s 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.

 

The Bank filed a 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 March 31, 2010.

 

See Item 3. Legal Proceedings in the Bank’s 2009 Annual Report filed on Form 10-K for additional information concerning the adversary proceedings discussed above.

 

Mortgage-Based Assets and Related Trends. 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 March 31, 2010, 55.7% 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 56.1% at December 31, 2009. The remaining 44.3% at March 31, 2010 was concentrated in other real estate-related collateral and high quality investment securities, compared to 43.9% at December 31, 2009. For the top ten borrowers, 1-4 single family residential mortgage loans or multi-family residential mortgage loans accounted for 59.2% of total eligible collateral, after collateral weightings, at March 31, 2010, compared to 59.3% at December 31, 2009. The remaining 40.8% at March 31, 2010 was concentrated in other real estate-related collateral and high quality investment securities, compared to 40.7% at December 31, 2009. Due to collateral policy changes implemented in third quarter 2009, the mix of collateral types within the total portfolio shifted. The requirement to deliver all securities pledged as collateral, as well as refinements in collateral reporting and tracking made through the Qualifying Collateral Report (QCR) process, impacted the concentration of collateral types by category.

 

With respect to the investment portfolio, as of March 31, 2010 the Bank’s private label MBS portfolio represented 9.6% of total assets, while net mortgage loans held for portfolio represented 8.5% of total assets. At December 31, 2009, the comparable percentages were 9.1% and 7.9%, respectively.

 

The Bank continues to have high concentrations of its advance portfolio outstanding to its top ten borrowers. The Bank’s advance portfolio declined $4.4 billion, or 10.6%, from December 31, 2009 to March 31, 2010, as members de-levered, increased deposits and utilized government programs aimed at improving liquidity. Also, many of the Bank’s members may 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 advance products.

 

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 the quarterly report filed on this Form 10-Q for information related to derivative counterparty risk and overall market risk of the Bank.

Financial Highlights

 

The Statement of Operations data for the three months ended March 31, 2010 and the Condensed Statement of Condition data as of March 31, 2010 are unaudited and were derived from the financial statements included in the quarterly report filed on this Form 10-Q . The Condensed Statement of Condition data as of December 31, 2009 was derived from the audited financial statements in the Bank’s 2009 Annual Report filed on Form 10-K. The Statement of Operations data for the three months ended December 31, 2009 is unaudited and was derived from the Bank’s 2009 Annual Report filed on Form 10-K. The Statement of Operations and Statement of Condition data for all other interim quarterly periods is unaudited and was derived from the applicable quarterly reports filed on Form 10-Q.

 

Statement of Operations

 

Notes:

 

Condensed Statement of Condition

 

Notes:

 

 

Because of the nature of (1) the contingency reserve resulting from the Lehman-related transactions and (2) the OTTI charges recorded during the three months ended March 31, 2010 and 2009, the Bank believes that the presentation of adjusted non-GAAP financial measures below provides a greater understanding of ongoing operations and enhances comparability of results with prior periods.

 

Statement of Operations
Reconciliation of GAAP Earnings to Adjusted Earnings to Exclude Impact of
Lehman-Related Transactions, Net OTTI Charges and Related Assessments

 

 

Notes:

 

 

 

For further information regarding the Lehman-related transactions, see the “Current Financial and Mortgage Market Events and Trends” discussion in Earnings Performance in Item 7. Management’s Discussion and Analysis in the Bank’s 2009 Annual Report filed on Form 10-K. For additional information on OTTI, see Critical Accounting Policies and Risk Management, both in Item 7. Management’s Discussion and Analysis, and Note 8 to the audited financial statements in Item 8. Financial Statements and Supplementary Financial Data, all in the Bank’s 2009 Annual Report filed on Form 10-K.

 

Forward-Looking Information

 

Statements contained in the quarterly report on this 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 advances; an increase in advances’ 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 of Financial Condition and Results of Operations 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 quarterly report filed on this Form 10-Q, as well as Risk Factors in Item 1A of the Bank’s 2009 Annual Report filed on Form 10-K.

 

Earnings Performance

 

The following is Management’s Discussion and Analysis of the Bank’s earnings performance for the three months ended March 31, 2010 compared to the three months ended March 31, 2009. This discussion should be read in conjunction with the unaudited interim financial statements and notes included in the quarterly report filed on this Form 10-Q as well as the audited financial statements and analysis for the year ended December 31, 2009, included in the Bank’s 2009 Annual Report filed on Form 10-K.

 

Summary of Financial Results

 

Net Income and Return on Equity. For the first quarter of 2010, the Bank’s net income totaled $9.9 million, an increase of $33.5 million from the first quarter 2009 loss of $23.6 million. This increase was primarily due to a $35.3 million reserve recorded in the first quarter of 2009 related to the collectibility of the LBSF receivable, as well as higher net interest income and slightly lower net OTTI losses. First quarter 2010 results also reflect slightly higher operating expenses from the prior year. Net OTTI losses for the three months ended March 31, 2010 and 2009 were $27.6 million and $30.5 million, respectively. Details of the Statement of Operations are presented more fully below. The Bank’s return on average equity was 1.07% in the first quarter of 2010, compared to (2.30)% in the same year-ago period.

Adjusted Earnings. As presented above, adjusted earnings for first quarter 2010 and 2009 exclude the impact of the LBSF contingency reserve, net OTTI losses and related assessments. For the first quarter of 2010, the Bank’s adjusted earnings totaled $30.1 million, a decrease of $0.9 million over the first quarter 2009 adjusted earnings. An increase in net interest income as well as a benefit for credit losses in the current year quarter were offset by losses on derivatives and hedging activities and higher other expense. The Bank’s adjusted return on average equity was 3.25% in first quarter 2010, compared to 3.02% in first quarter 2009. The decrease in average capital, due to higher noncredit OTTI losses in AOCI, more than offset the decrease in adjusted earnings in the quarter-over-quarter comparison, resulting in an increase in the overall return.

 

Dividend. On December 23, 2008, the Bank announced its voluntary decision to temporarily suspend payment of dividends until further notice. Therefore, there were no dividends declared or paid in the first quarters of 2010 and 2009. Retained earnings were $398.9 million as of March 31, 2010, compared to $389.0 million at December 31, 2009. See additional discussion regarding dividends and retained earnings levels in the Financial Condition section of this Item 2. Management’s Discussion and Analysis in the quarterly report filed on this Form 10-Q.

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 months ended March 31, 2010 and 2009.

 

Average Balances and Interest Yields/Rates Paid

 

Notes:

 

 

Net interest income increased $2.6 million, or 4.6%, to $59.0 million for first quarter 2010, compared with the same year-ago period. The improvement in net interest income was driven by favorable funding costs. Rates paid on interest-bearing liabilities fell 81 basis points while yields on interest-earning assets fell 67 basis points in the year-over-year comparison. Total average interest-earning assets for first quarter 2010 were $64.1 billion, a decrease of $23.1 billion, or 26.5%, from the same year-ago period. The majority of the decline in interest-earning assets was attributed to lower demand for advances, which declined $16.3 billion, or 28.9%, as members de-levered, increased deposits and utilized government programs aimed at improving liquidity. In addition, in response to the Bank’s temporary suspension of dividends and repurchase of excess capital stock, many of the Bank’s members may have reacted by limiting the use of the Bank’s advance products. The current economic conditions also decreased the Bank’s members’ need for funding from the Bank. For first quarter 2010, interest-bearing deposits decreased $9.1 billion from first quarter 2009, primarily due to a shift to investments in Federal funds sold. The first quarter 2009 interest bearing deposit balance was higher than normal because the Bank had shifted balances from Federal funds sold into higher-yielding interest-bearing Federal Reserve Bank (FRB) accounts. However, beginning in July 2009, the FRBs stopped paying interest on the excess balances it holds on the Bank’s behalf; consequently, the Bank shifted its investments back to Federal funds sold. During the second half of 2009 the Bank reduced its concentration in Federal funds sold due to the unattractive yields. This portfolio subsequently declined to $4.7 billion for the three months ended March 31, 2010. The Bank also experienced a reduction in its level of MBS and mortgage loans due primarily to paydowns. Additional details and analysis regarding the shift in the mix of these categories is included in the “Rate/Volume Analysis” discussion below.

 

The net interest margin improved 11 basis points to 37 basis points, compared to 26 basis points a year ago. Favorable funding costs, partially offset by lower yields on the investment of interest-free funds (capital), contributed to the improvement. The impact of favorable funding was evident within both the advance and investment securities portfolios, as the improvement in cost of funds, combined with the use of some short-term debt greatly improved spreads. Partially offsetting this improvement was a lower yield on interest-free funds (capital) typically invested in short-term assets.

 

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 first quarter 2010 and first quarter 2009.

 

 

Net interest income increased $2.6 million from first quarter 2009 to first quarter 2010. Total interest income decreased $231.8 million year-over-year. This decline included a decrease of $146.9 million due to rate and $84.9 million due to volume, driven primarily by the advances portfolio and, to a lesser extent, the investment securities portfolio, as discussed below. Total interest expense decreased $234.4 million in the same comparison,

including a rate impact of $147.8 million and a volume impact of $86.6 million, both due to the consolidated obligation bonds and discount notes portfolios, discussed in more detail below.

 

For first quarter 2010, average Federal funds sold increased $4.7 billion from $13.9 million in first quarter 2009. In the first quarter 2009, the Bank utilized an interest-bearing deposit account with the FRBs due to favorable rates paid on these balances. These balances were reinvested in Federal funds sold once the FRBs stopped paying interest on these deposits. Related interest income increased $1.3 million, nearly entirely due to the higher balances. For first quarter 2010, average interest-bearing deposits decreased $9.1 billion, partially due to the shift to Federal funds sold noted above. Related interest income decreased $5.6 million due to the lower balances and the relatively low yields on short-term investments.

 

The decrease in yields on both Federal funds sold and interest-bearing deposits quarter-over-quarter 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 earlier in this Item 2. Management’s Discussion and Analysis.

 

The average investment securities portfolio balance for first quarter 2010 decreased $1.4 billion, or 9.2%, from first quarter 2009. Correspondingly, the interest income on this portfolio decreased $46.9 million, driven primarily by a 97 basis point decline in the yield, and secondarily by the volume decrease.

 

The investment securities portfolio includes trading, available-for-sale and held-to-maturity securities. The decrease in investments from first quarter 2009 to first quarter 2010 was due to declining certificates of deposit balances and run-off of the 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, and has not purchased any MBS in the first three months of 2010, and only purchased U.S. agency and GSE MBS in 2009.

 

The average advances portfolio decreased $16.3 billion, or 28.9%, from first quarter 2009 to first quarter 2010. This decline in volume, coupled with a 99 basis point decrease in the yield, resulted in a $167.4 million decline in interest income year-over-year. Advance demand began to decline in the fourth quarter of 2008 and continued through 2009 and into the first quarter of 2010, as members grew core deposits and gained access to additional liquidity from the Federal Reserve and other government programs that became available in the second half of 2008. The interest income on this portfolio was significantly impacted by the decline in short-term rates, as presented in the interest rate trend presentation in the “Current Financial and Mortgage Market Events and Trends” discussion earlier in this Item 2. Management’s Discussion and Analysis. Average 3-month LIBOR declined 98 basis points in the quarter-over-quarter comparison. Specific mix changes within the portfolio are discussed more fully below under “Average Advances Portfolio Detail.”

 

The mortgage loans held for portfolio balance declined $1.0 billion, or 16.7%, from first quarter 2009 to first quarter 2010. The related interest income on this portfolio declined $13.2 million in the same period. The quarter-over-quarter decrease was due to the continued runoff of the existing portfolio, which more than offset the new portfolio activity. The decrease in interest income was due primarily to lower average portfolio balances as the yields on the portfolio only declined 2 basis points.

 

Interest-bearing deposits decreased $381.5 million, or 21.9%, from first quarter 2009 to first quarter 2010. Interest expense on interest-bearing deposits decreased $0.2 million quarter-over-quarter, driven by a 4 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 $22.3 billion from first quarter 2009 to first quarter 2010. Discount notes accounted for $8.0 billion of the decline, while average bonds fell by $14.3 billion quarter over quarter. The decline in discount notes was consistent with the decline in short-term advance demand from members as noted above. Interest expense on discount notes decreased $22.2 million from the prior year quarter. The decrease was partially attributable to the volume decline and partially due to the 45 basis point declines in rates paid

quarter-over-quarter. The decline in rates paid was consistent with the general decline in short-term rates as previously mentioned. Interest expense on bonds decreased $212.0 million from first quarter 2009 to first quarter 2010. This was due in part to the 103 basis points decrease in rates paid on bonds, as well as the volume decline.

 

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 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 grew stronger during 2009 and the Bank continued to be able to issue discount notes and term bonds at attractive rates as needed into 2010. 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 the quarterly report filed on this Form 10-Q.

 

Average Advances Portfolio Detail

 

 

The par value of the Bank’s average advance portfolio decreased 28.7% from first quarter 2009 to first quarter 2010. The most significant percentage decrease in the comparison was in the Returnable product, which declined $3.5 billion, or 99.3%. The most significant dollar decrease was in the Repo product, which declined $9.4 billion, or 33.1% year-over-year.

 

The decrease in average balances for the Repo product reflected the impact of members’ access to additional liquidity from government programs as well as members’ reactions to the Bank’s pricing of short-term advance products. Members have also taken other actions during the credit crisis, such as raising core deposits and reducing the size of their balance sheets. In addition, many of the Bank’s members may 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 advance products. The current economic recession has reduced the Bank’s members’ need for funding from the Bank as well. The majority of the decline was driven by decreases in average advances of the Bank’s larger borrowers, with five banks reducing their total average advances outstanding by $10.0 billion. The decline in Returnable product balances was due to one of the Bank’s largest borrowers exercising their option to return their advances. To a much lesser extent, the decrease in interest rates also contributed to the decline in the Returnable product balances.

 

As of March 31, 2010, 48.4% of the par value of loans in the portfolio had a remaining maturity of one year or less, compared to 47.7% at December 31, 2009. Details of the portfolio components are included in Note 7 to the unaudited financial statements in the quarterly report filed on this Form 10-Q.

 

The ability to grow the advance 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; (5) member reaction to the Bank’s voluntary decision to temporarily suspend dividend payments and

excess capital stock repurchases until further notice; (6) actions of the U.S. government; (7) housing market trends; and (8) the shape of the yield curve.

 

Beginning in 2008 and continuing through 2009, the Federal Reserve took a series of unprecedented actions that 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 2009 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 advance 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 March 31, 2010. For more information on collateral, see the “Loan Products” discussion in “Overview” and the Credit and Counterparty Risk discussion in “Risk Management” in this Item 2. Management’s Discussion and Analysis, both in the quarterly report filed on this Form 10-Q.

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 months ended March 31, 2010 and 2009. Derivative and hedging activities are discussed below in the “Other Income (Loss)” section.

 

 

Note:

 

 

The Bank uses derivatives to hedge the fair market value changes attributable to the change in the LIBOR benchmark interest rate. The Bank generally uses interest rate swaps to hedge a portion of advances and consolidated obligations which convert the interest rates on those instruments from a fixed rate 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 advances 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 first quarter 2010, the impact of derivatives decreased net interest income by $127.9 million and reduced the net interest spread 73 basis points. Average 3-month LIBOR for first quarter 2010 fell 98 basis points year-over-year and the impact of declining rates on existing derivative contracts continued to negatively impact net interest income. For first quarter 2009, the impact of derivatives decreased net interest income by $153.7 million and reduced net interest spread 68 basis points.

 

The mortgage loans held for portfolio derivative impact for the 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)

 

n/m = not meaningful

 

The Bank recorded total other losses of $29.5 million for first quarter 2010 compared to total other losses of $64.4 million for first quarter 2009. Losses on derivative and hedging activities were $4.6 million for first quarter 2010 compared to losses of $1.2 million for first quarter 2009. Net OTTI losses reflect the credit loss portion of OTTI charges taken on the private label MBS portfolio. The $35.3 million contingency reserve represents the establishment of a contingency reserve for the Bank’s LBSF receivable in first quarter 2009. There has been no change in the reserve in 2010.

 

See additional discussion on OTTI charges in the “Credit and Counterparty Risk – Investments” discussion in Risk Management, both in this Item 2. Management’s Discussion and Analysis in the quarterly report filed on this Form 10-Q. The activity related to net gains 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.

 

 

Fair Value Hedges.  The Bank uses fair value hedge accounting treatment for certain of its advances and consolidated obligation bonds using interest rate swaps. The interest rate swaps convert fixed-rate instruments to a variable-rate (i.e., LIBOR) or provide offset to options embedded within variable-rate instruments. For the first quarter of 2010, total ineffectiveness related to these fair value hedges resulted in a loss of $0.8 million compared to a loss of $1.8 million in the first quarter of 2009. During the same period, the overall notional amount decreased from $57.6 billion at March 31, 2009 to $42.8 billion at March 31, 2010. 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 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 $4.5 million in first quarter 2010 compared to a loss of $1.4 million in first quarter 2009. The majority of the first quarter 2010 loss was comprised of losses on the Bank’s interest rate caps. The overall notional amount of economic hedges increased from $0.8 billion at March 31, 2009 to $1.5 billion at March 31, 2010. The notional amount of the Bank’s interest rate caps was $1.4 billion at March 31, 2010. The Bank did not have any interest rate caps at March 31, 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 first quarter of 2010 were $0.4 million compared to total gains of $1.9 million for the first quarter of 2009. Total notional of the Bank’s mortgage delivery commitments decreased from $31.7 million at March 31, 2009 to $16.7 million at March 31, 2010.

Other Expense