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EX-4.1.1 - EX-4.1.1 - Federal Home Loan Bank of Pittsburghl40309exv4w1w1.htm
EX-31.2 - EX-31.2 - Federal Home Loan Bank of Pittsburghl40309exv31w2.htm
EX-32.2 - EX-32.2 - Federal Home Loan Bank of Pittsburghl40309exv32w2.htm
EX-32.1 - EX-32.1 - Federal Home Loan Bank of Pittsburghl40309exv32w1.htm
EX-31.1 - EX-31.1 - Federal Home Loan Bank of Pittsburghl40309exv31w1.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 June 30, 2010
   
     
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   25-6001324
(State or other jurisdiction of
incorporation or organization)
  (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.  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):
 
  o Large accelerated filer  o Accelerated filer  x Non-accelerated filer  oSmaller 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 40,399,353 shares of common stock with a par value of $100 per share outstanding at July 31, 2010.


 

 
FEDERAL HOME LOAN BANK OF PITTSBURGH
 
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PART I – FINANCIAL INFORMATION
 
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 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 liquidity so that funds are available to meet member 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 experienced volatility over 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. Despite 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 have wound down in the first half of 2010. There may be risks to the economy as these programs wind down and the government withdraws its support.
 
Housing starts and existing home sales continue to run at low levels. Delinquency and foreclosure rates continue to run at high levels. Foreclosures have increased 5 percent during second quarter 2010 compared to first quarter 2010 and 38 percent compared to second quarter 2009. While the agency mortgage-backed securities (MBS) market is active in funding new mortgage originations, the private label MBS market has not yet recovered. However, the commercial real estate market remains depressed but has stabilized somewhat in second quarter 2010.
 
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 half 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


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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, also known as advances, 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-guarantees 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. Since 2009, spreads have narrowed. This, along with the decline in U.S. Treasury yields, allowed the Bank to offer more attractive advance 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 316, 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


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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 updated CSP requested 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. This most recent updated CSP was accepted by the Finance Agency. The Bank has updated the CSP again and submitted it to the Finance Agency on July 30, 2010.
 
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 June 28, 2010, the Bank received final notification from the Finance Agency that it was considered adequately capitalized for the quarter ended March 31, 2010. In its determination, the Finance Agency expressed concerns regarding the Bank’s capital position and earnings prospects. The Finance Agency believes that the Bank’s retained earnings levels and poor quality of its private label MBS portfolio have created uncertainties about its ability to maintain sufficient capital. As provided for under the Finance Agency’s final rule on FHLBank capital classification and critical capital levels, the Director of the Finance Agency has discretion to reclassify the Bank’s capital classification even if the Bank meets or exceeds the regulatory requirements established. Details regarding factors that may be considered in making such discretionary determination are included in the Legislative and Regulatory Developments section of the Bank’s 2009 Annual Report filed on Form 10-K. As of the date of this filing, the Bank has not received final notice from the Finance Agency regarding its capital classification for the quarter ended June 30, 2010. The Bank exceeded its risk-based, total and leverage capital requirements at June 30, 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 variety of advance 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


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status based on the Bank’s determination of the member’s current financial condition and credit product usage, as well as other information that the Bank deems to be relevant. 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 the cost of taking title of the collateral and liquidation. 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. The Bank reviews the collateral weightings periodically and may adjust them for individual borrowers on a case-by-case basis. During the second quarter of 2010, the Bank implemented new adjusted collateral weightings for members in full collateral delivery for credit reasons. These weightings are computed on delivered loan collateral from these members and are based on a 1.10 times over-collateralization level, which is warranted to mitigate the higher risks inherent with these members and due to the market uncertainty in the event an advance would need to be liquidated, since advances are not readily marketable.
 
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.
 
At June 30, 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. In order to be eligible, the manufactured housing loans must be secured by real property. High-quality securities, including U.S. Treasuries, U.S. agency securities, GSE MBS, and select private label MBS, are also accepted as collateral. FHLBank deposits and multi-family residential mortgages, as well as other real estate related collateral (ORERC), comprise the remaining portion of qualifying collateral.
 
At June 30, 2010 and December 31, 2009, respectively, on a borrower-by-borrower basis, the Bank had a perfected security 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.
 
See the “Credit and Counterparty Risk – Total Credit Products and Collateral” 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 June 30, 2010.
 
Nationally, during the first six months of 2010, 86 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 and U.S. Treasury and agency securities that can be


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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 have nor does it 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.
 
As of June 30, 2010, 37 PFIs were eligible to participate in the MPF Xtra program. Of these, 11 have sold $35.7 million of mortgage loans through the MPF Xtra program during the current year through June 2010.
 
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. A minor number of loan modifications have occurred under this plan.
 
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 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


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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.  The Federal Reserve’s actions to phase out the lending programs established during the economic crisis have served as a sign of economic recovery and evidence of some credit market stabilization. The Term Asset-Backed Securities Loan Facility (TALF), which ended on June 30, 2010, was the last of the Federal Reserve’s special liquidity programs to be discontinued. In addition, information received since the last Federal Open Market Committee (FOMC) meeting suggests that the economic recovery is still uncertain and the labor market continues to show signs of weakness. Consumer income rose faster than spending in May, making it possible for consumers to increase savings and support economic recovery. However, consumer confidence has declined more recently due to high unemployment, lower housing wealth, and tight credit. Business spending on equipment and software has risen, although investment in commercial real estate continues to be weak and small businesses remain reluctant to add to payrolls due to concerns about the strength of the economic recovery. The financial markets have reflected this uncertainty, as both equity and fixed income markets have experienced volatility. The sovereign debt crisis in Europe sparked flight to quality during the second quarter, as investors questioned the stability of the European Union. In the midst of this uncertainty, the 10-year Treasury yield declined 100 basis points from its high in second quarter 2010 and 3-month LIBOR rates increased more than 25 basis points in April and May, and remained at this level in June. These events suggest a mixed message and, combined with the ongoing global economic concerns, the pace of economic recovery remains uncertain.
 
The labor market was hit particularly hard by the recession. It is likely that it will take a significant amount of time to restore the nearly 8.5 million jobs that were lost over 2008 and 2009 and unemployment is expected to remain high for the next few quarters.
 
In the housing market, sales and construction were temporarily boosted lately by the homebuyer tax credit. As these tax credits expired, and despite historically low mortgage rates, activity has decreased dramatically in recent months. These temporary programs served to support the housing market and stabilize prices in the first half of 2010, yet concern remains due to a large inventory of distressed or vacant existing houses and by the difficulties of many builders in obtaining credit. Housing starts and existing home sales have continued to decline. In addition, foreclosures have increased in second quarter 2010 compared to first quarter 2010. Commercial real estate activity has also been restrained by high vacancy rates, low property prices, and strained credit conditions.
 
Given the current economic environment and housing market conditions, the financial performance of the Bank has been significantly affected, primarily due to credit-related 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 two quarters of 2010 and could be expected throughout the remainder of the year. The specific amount of credit-related OTTI charges will depend on the actual performance of the underlying loan collateral as well as the Bank’s future modeling assumptions. Many factors could influence the future modeling assumptions including economic, financial market and housing conditions. If performance of the underlying loan collateral deteriorates and/or the Bank’s modeling assumptions become more


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pessimistic, the Bank could experience further losses on the portfolio. At the present time, the Bank cannot estimate the future amount of any additional OTTI charges.
 
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 experienced a slowing of GDP growth.
 
Second Quarter 2010.  During the second quarter of 2010, the FHLBanks continued to have sufficient access to debt funding. As the sovereign debt crisis unfolded in Europe, swap spreads widened and swapped funding costs improved significantly. The market seemed little affected by the conclusion of the Federal Reserve’s agency debt and agency MBS purchasing programs during the first quarter of 2010; instead, market participants focused on the sovereign debt crisis in Europe, high unemployment levels in the United States and pending financial regulatory reform. There was a flight to quality as investors turned to U.S. Treasury securities and agency securities as a safe haven.
 
Specific Program Activity
 
Federal Reserve Bank of New York (FRBNY).  The scheduled expiration of several of the FRBNY’s lending programs did not appear to have a major effect on the agency debt markets. In response to the re-emergence of strains in U.S. dollar short-term funding markets in Europe, the Bank of Canada, the Bank of England, the European Central Bank, the Federal Reserve, and the Swiss National Bank re-established temporary U.S. dollar liquidity swap facilities. These facilities are designed to help improve liquidity conditions in U.S. dollar funding markets and to prevent the spread of strains to other markets and financial centers.
 
Fannie Mae and Freddie Mac.  Loan modifications and refinancings by Fannie Mae and Freddie Mac increased significantly in the first half of 2010 as the volume of permanent modifications under the Administration’s Home Affordable Modification Program (HAMP) tripled, and refinancings steadily grew under the Home Affordable Refinance Program (HARP).
 
On June 16, 2010, the Finance Agency directed Fannie Mae and Freddie Mac, operating in conservatorship, to delist their common and preferred stock from the New York Stock Exchange and any other national securities exchange. The determination to direct delisting was related to stock exchange requirements for maintaining price levels and curing deficiencies.
 
Consolidated Obligations of the FHLBanks.  Over the course of the second quarter of 2010, the FHLBanks issued $138 billion of consolidated bonds, which was $16 billion less than during the first quarter of 2010. While weighted-average bond funding costs improved only slightly during the second quarter of 2010, the improvement was much more dramatic toward the end of the quarter as June’s weighted-average bond funding spreads were the most favorable since October 2009. This improvement in swapped funding levels was largely driven by a widening in swap spreads. During the second quarter of 2010, the FHLBanks relied heavily on negotiated bullet bonds and swapped callable bonds, including step-up callable bonds. Using the issuance calendar for FHLBank-mandated Global bullet bond issuance, the FHLBanks issued $3 billion of a new, three-year mandated Global bullet bond in April 2010, auctioned a $1 billion reopening of the most recent two-year mandated Global bullet bond in May 2010, and issued $3 billion of a new, two-year mandated Global bullet bond in June 2010.
 
FHLBank debt outstanding continued to contract during the second quarter of 2010. Although consolidated obligations outstanding remained relatively stable during April and May, they fell almost $26 billion during the month of June to close the second quarter at $847 billion. This drop was driven primarily by a decline of almost $18 billion in consolidated bonds; consolidated discount notes dropped approximately $7 billion during the second quarter. The decline in consolidated bonds outstanding may be attributed in part to significant consolidated bond redemptions during the second quarter of 2010; consolidated bond maturities were $75 billion and consolidated bond calls were $85 billion during the current quarter.


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Compared to the end of the first quarter of 2010, primary dealer inventories of agency discount notes and bonds ended second quarter 2010 mixed. During the second quarter of 2010, agency discount note inventories increased almost $21 billion, to $37 billion, and agency bond inventories decreased $5 billion, to $57 billion. Although dealer inventories did not close the second quarter at peak levels, dealer inventories did not experience a significant sell-off as the second quarter came to a close.
 
On a stand-alone basis, the Bank’s total consolidated obligations declined $4.9 billion, or 8.2%, since year-end 2009. Discount notes increased $1.9 billion, or 18.6%, from December 31, 2009 to June 30, 2010 and accounted for 22.2% and 17.2% of the Bank’s total consolidated obligations at June 30, 2010 and December 31, 2009, respectively. Total bonds decreased $6.8 billion, or 13.8%, from December 31, 2009 to June 30, 2010, and comprised a smaller percentage of the total debt portfolio, decreasing from 82.8% at December 31, 2009 to 77.7% at June 30, 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, began increasing steadily during the second quarter of 2010. Foreign investor holdings closed the second quarter approximately $46 billion higher, reaching a quarterly peak of $827 billion on June 23, 2010, the highest level since December 2008.
 
Taxable money market fund assets continued to decline during the second quarter of 2010, albeit at a slower pace than during the first quarter of 2010, declining $140 billion to $2.44 trillion. Likewise, the subset of taxable money market fund investments allocated to the U.S. Other Agency category also declined, dropping $11 billion during the second quarter of 2010. However, both asset categories saw an increase during June 2010, which may be attributed to investors’ concerns about the European sovereign debt crisis and possible effects on the U.S. economy. Furthermore, with the implementation of SEC money market fund reforms in May 2010, the weighted-average number of days to maturity of taxable money market funds contracted from 44 days to 36 days during the second quarter of 2010, the lowest level in more than 18 months.
 
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 FOMC will maintain the target range for the federal funds rate at 0.00% to 0.25% and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period.
 
The following table presents key market interest rates for the periods indicated (obtained from Bloomberg L.P.).
 
                                                                                 
      2nd
    1st
    2nd
    Average
    Average
    2nd
    1st
    2nd
      Quarter
    Quarter
    Quarter
    Year-to-
    Year-to-
    Quarter
    Quarter
    Quarter
      2010
    2010
    2009
    Date
    Date
    2010
    2010
    2009
      Average     Average     Average     2010     2009     Ended     Ended     Ended
Target overnight Federal funds rate
      0.25 %       0.25 %       0.25 %       0.25 %       0.25 %       0.25 %       0.25 %       0.25 %
3-month LIBOR(1)
      0.44 %       0.26 %       0.84 %       0.35 %       1.04 %       0.53 %       0.29 %       0.60 %
2-yr U.S. Treasury
      0.86 %       0.91 %       1.00 %       0.88 %       0.95 %       0.61 %       1.02 %       1.12 %
5-yr. U.S. Treasury
      2.24 %       2.41 %       2.23 %       2.33 %       1.99 %       1.78 %       2.55 %       2.56 %
10-yr. U.S. Treasury
      3.47 %       3.70 %       3.30 %       3.59 %       3.00 %       2.93 %       3.83 %       3.54 %
15-yr. mortgage current coupon(2)
      3.40 %       3.54 %       3.84 %       3.47 %       3.79 %       3.00 %       3.62 %       4.01 %
30-yr. mortgage current coupon(2)
      4.23 %       4.40 %       4.31 %       4.32 %       4.22 %       3.76 %       4.52 %       4.63 %
 
Note:
 
(1)LIBOR – London Interbank Offered Rate
 
(2)Simple average of Fannie Mae and Freddie Mac MBS current coupon rates.


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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. Lehman was a guarantor under the Bank’s agreement with LBSF such that Lehman’s bankruptcy filing triggered an event of default. 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. The Bank sent a final settlement notice to LBSF and demanded return of the balance of posted Bank collateral of approximately $41.5 million.
 
The Bank has 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 June 30, 2010. As of June 30, 2010 the Bank maintained a $35.3 million reserve on the $41.5 million receivable noted above.
 
See Item 3. Legal Proceedings in the Bank’s 2009 Annual Report filed on Form 10-K for additional information concerning the proceedings discussed above and Item 1 of Part II of this quarterly report on Form 10-Q.
 
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. A majority of the Bank’s collateral securing advances was concentrated in 1-4 single family residential mortgage loans or multi-family residential mortgage loans. The remaining collateral was concentrated in other real estate-related collateral and high quality investment securities, including MBS. 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 QCR process, impacted the concentration of collateral types by category. Details regarding the breakdown of collateral concentration by type is included in the “Credit and Counterparty Risk – Total Credit Products and Collateral” 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.
 
As previously noted, the Bank also invests in MBS, including private label MBS, and has mortgage loans held for portfolio. Details regarding the Bank’s investment portfolio and the mortgage loans held for portfolio are included in the “Credit and Counterparty Risk – Investments” discussion in Risk Management and the Financial Condition section, both in this Item 2. Management’s Discussion and Analysis in the quarterly report filed on this Form 10-Q.
 
See the “Credit and Counterparty Risk – Derivatives” and “Qualitative and Quantitative Disclosures Regarding 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.


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Financial Highlights
 
The Statement of Operations data for the three and six months ended June 30, 2010 and the Condensed Statement of Condition data as of June 30, 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, as well as the Statement of Operations data for the six months ended June 30, 2009, is unaudited and was derived from the applicable quarterly reports filed on Form 10-Q.
 
Statement of Operations
 
                                                   
      For the Three Months Ended
      June 30,
    March 31,
    December 31,
    September 30,
    June 30,
(in millions, except per share data)     2010     2010     2009     2009     2009
Net interest income before provision (benefit) for credit losses
    $ 59.1       $ 59.0       $ 64.2       $ 67.5       $ 75.9  
Provision (benefit) for credit losses
      (1.3 )       (0.1 )       (5.5 )       1.4         1.1  
Other income (loss):
                                                 
Net OTTI losses(1)
      (110.7 )       (27.6 )       (65.4 )       (93.3 )       (39.3 )
Net gains (losses) on derivatives and hedging activities
      (8.0 )       (4.6 )       5.3         (4.5 )       12.4  
Net realized losses on available-for-sale securities
      (0.1 )       -         (2.2 )       -         -  
Net realized gains on held-to-maturity securities
      -         -         1.8         -         -  
All other income
      1.8         2.7         2.9         4.5         2.5  
                                                   
Total other loss
      (117.0 )       (29.5 )       (57.6 )       (93.3 )       (24.4 )
                                                   
Other expense
      15.1         16.2         17.6         16.2         15.3  
                                                   
Income (loss) before assessments
      (71.7 )       13.4         (5.5 )       (43.4 )       35.1  
Assessments
      (3.5 )       3.5         -         (3.0 )       3.0  
                                                   
Net income (loss)
    $ (68.2 )     $ 9.9       $ (5.5 )     $ (40.4 )     $ 32.1  
                                                   
                                                   
Earnings (loss) per share(2)
    $ (1.70 )     $ 0.25       $ (0.14 )     $ (1.01 )     $ 0.80  
                                                   
                                                   
                                                   
Dividends(3)
      -         -         -         -         -  
Return on average equity
      (7.01 )%       1.07 %       (0.61 )%       (4.39 )%       3.31 %
Return on average assets
      (0.45 )%       0.06 %       (0.03 )%       (0.23 )%       0.16 %
Net interest margin(4)
      0.39 %       0.37 %       0.38 %       0.38 %       0.38 %
Regulatory capital ratio(5)
      7.22 %       7.57 %       6.76 %       6.64 %       5.83 %
Total capital ratio (at period-end)(6)
      6.54 %       6.54 %       5.69 %       5.36 %       4.59 %
Total average equity to average assets
      6.38 %       5.88 %       5.45 %       5.17 %       4.88 %
                                                   
n/a – not applicable
Notes:
 
(1) Represents the credit-related portion of OTTI losses on private label MBS portfolio.
(2) Earnings (loss) per share calculated based on net income (loss).
(3) The Bank has temporarily suspended dividend payments, effective December 2008.
(4) Net interest margin is net interest income before provision (benefit) for credit losses as a percentage of average interest-  earning assets.
(5) Regulatory capital ratio is the total of period-end capital stock, mandatorily redeemable capital stock, retained earnings and  allowance for loan losses as a percentage of total assets at period-end.
(6) Total capital ratio is capital stock plus retained earnings and accumulated other comprehensive income (loss), in total at  period-end, as a percentage of total assets at period-end.
 


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      For the Six Months Ended
      June 30,
  June 30,
(in millions, except per share data)     2010   2009
Net interest income before provision (benefit) for credit losses
    $ 118.1     $ 132.3  
Provision (benefit) for credit losses
      (1.4 )     1.5  
Other income (loss):
                 
Net OTTI losses(1)
      (138.3 )     (69.8 )
Net gains (losses) on derivatives and hedging activities
      (12.6 )     11.2  
Net realized losses on available-for-sale securities
      (0.1 )     -  
Net realized gains on held-to-maturity securities
      -       -  
Contingency reserve
      -       (35.3 )
All other income
      4.5       5.1  
                   
Total other income (loss)
      (146.5 )     (88.8 )
                   
Other expense
      31.3       30.5  
                   
Income (loss) before assessments
      (58.3 )     11.5  
Assessments
      -       3.0  
                   
Net income (loss)
    $ (58.3 )   $ 8.5  
                   
                   
Earnings (loss) per share(2)
    $ (1.45 )   $ 0.21  
                   
                   
Dividends(3)
      -       -  
Return on average equity
      (3.07 )%     0.42 %
Return on average assets
      (0.19 )%     0.02 %
Net interest margin(4)
      0.38 %     0.32 %
Regulatory capital ratio(5)
      7.22 %     5.83 %
Total capital ratio (at period-end)(6)
      6.54 %     4.59 %
Total average equity to average assets
      6.13 %     4.81 %
                   
n/a – not applicable
 
Notes:
 
(1) Represents the credit-related portion of OTTI losses on private label MBS portfolio.
(2) Earnings (loss) per share calculated based on net income (loss).
(3) The Bank has temporarily suspended dividend payments, effective December 2008.
(4) Net interest margin is net interest income before provision (benefit) for credit losses as a percentage of average interest-  earning assets.
(5) Regulatory capital ratio is the total of period-end capital stock, mandatorily redeemable capital stock, retained earnings and  allowance for loan losses as a percentage of total assets at period-end.
(6) Total capital ratio is capital stock plus retained earnings and accumulated other comprehensive income (loss), in total at  period-end, as a percentage of total assets at period-end.

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Condensed Statement of Condition
 
                                                   
      June 30,
    March 31,
    December 31,
    September 30,
    June 30,
(in millions)     2010     2010     2009     2009     2009
Cash and due from banks
    $ 79.9       $ 251.6       $ 1,418.8       $ 373.3       $ 69.6  
Investments(1)
      19,246.0         16,241.0         17,173.5         19,039.9         24,444.3  
Advances
      36,058.4         36,823.8         41,177.3         41,363.4         45,799.6  
Mortgage loans held for portfolio, net(2)
      4,895.7         4,991.2         5,162.8         5,339.1         5,607.5  
Prepaid REFCORP assessment
      39.6         37.2         39.6         39.6         37.5  
Total assets
      60,629.7         58,656.0         65,290.9         66,510.5         76,401.6  
Consolidated obligations, net:
                                                 
Discount notes
      12,118.1         9,990.4         10,208.9         11,462.5         15,538.1  
Bonds
      42,325.8         42,477.1         49,103.9         49,022.3         54,090.5  
                                                   
Total consolidated obligations, net(3)
      54,443.9         52,467.5         59,312.8         60,484.8         69,628.6  
Deposits and other borrowings
      1,146.5         1,418.4         1,284.3         1,023.8         2,097.2  
Mandatorily redeemable capital stock
      36.3         8.3         8.3         8.2         8.2  
AHP payable
      17.2         22.1         24.5         28.0         32.7  
REFCORP payable
      -         -         -         -         -  
Capital stock – putable
      4,012.2         4,035.1         4,018.0         4,013.1         4,007.1  
Retained earnings
      330.7         398.9         389.0         394.5         434.9  
AOCI
      (375.0 )       (596.0 )       (693.9 )       (845.2 )       (938.1 )
Total capital
      3,967.9         3,838.0         3,713.1         3,562.4         3,503.9  
                                                   
Notes:
 
(1) Includes trading, available-for-sale and held-to-maturity investment securities, Federal funds sold, and interest-bearing  deposits. None of these securities were purchased under agreements to resell.
(2) Includes allowance for loan losses of $2.9 million, $2.9 million, $2.7 million, $7.5 million and $6.3 million at June 30, 2010,  March 31, 2010, December 31, 2009, September 30, 2009 and June 30, 2009, respectively.
(3) Aggregate FHLBank System-wide consolidated obligations (at par) were $846.5 billion, $870.9 billion, $930.6 billion,  $1.0 trillion and $1.1 trillion at June 30, 2010, March 31, 2010, December 31, 2009, September 30, 2009 and June 30,  2009, respectively.


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Because of the nature of (1) the OTTI charges and (2) the contingency reserve resulting from the Lehman-related transactions recorded during the three and six months ended June 30, 2010 and 2009, as applicable, 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
 
                             
      For the Three Months Ended June 30, 2010
      GAAP
    OTTI
  Adjusted
(in millions)     Earnings     Charges   Earnings
Net interest income before benefit for credit losses
    $ 59.1       $ -     $ 59.1  
Benefit for credit losses
      (1.3 )       -       (1.3 )
Other income (loss):
                           
Net OTTI losses
      (110.7 )       110.7       -  
Net losses on derivatives and hedging activities
      (8.0 )       -       (8.0 )
Net realized losses on available-for-sale securities
      (0.1 )       -       (0.1 )
All other income
      1.8         -       1.8  
                             
Total other income (loss)
      (117.0 )       110.7       (6.3 )
Other expense
      15.1         -       15.1  
                             
Income (loss) before assessments
      (71.7 )       110.7       39.0  
Assessments(1)
      (3.5 )       13.8       10.3  
                             
Net income (loss)
    $ (68.2 )       96.9     $ 28.7  
                             
                             
Earnings per share (loss)
    $ (1.70 )     $ 2.41     $ 0.71  
                             
                             
Return on average equity
      (7.01 )%       9.96 %     2.95 %
Return on average assets
      (0.45 )%       0.64 %     0.19 %
 
                           
      For the Three Months Ended June 30, 2009
      GAAP
  OTTI
  Adjusted
(in millions)     Earnings   Charges   Earnings
Net interest income before provision for credit losses
    $ 75.9     $ -     $ 75.9  
Provision for credit losses
      1.1       -       1.1  
Other income (loss):
                         
Net OTTI losses
      (39.3 )     39.3       -  
Net gains on derivatives and hedging activities
      12.4       -       12.4  
All other income
      2.5       -       2.5  
                           
Total other income (loss)
      (24.4 )     39.3       14.9  
Other expense
      15.3       -       15.3  
                           
Income before assessments
      35.1       39.3       74.4  
Assessments
      3.0       16.7       19.7  
                           
Net income
    $ 32.1     $ 22.6     $ 54.7  
                           
                           
Earnings per share
    $ 0.80     $ 0.57     $ 1.37  
                           
                           
Return on average equity
      3.31 %     2.34 %     5.65 %
Return on average assets
      0.16 %     0.12 %     0.28 %
 


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      For the Six Months Ended June 30, 2010
      GAAP
  OTTI
  Adjusted
(in millions)     Earnings   Charges   Earnings
Net interest income before benefit for credit losses
    $ 118.1     $ -     $ 118.1  
Benefit for credit losses
      (1.4 )     -       (1.4 )
Other income (loss):
                         
Net OTTI losses
      (138.3 )     138.3       -  
Net losses on derivatives and hedging activities
      (12.6 )     -       (12.6 )
Net realized losses on available-for-sale securities
      (0.1 )     -       (0.1 )
All other income
      4.5       -       4.5  
                           
Total other income (loss)
      (146.5 )     138.3       (8.2 )
Other expense
      31.3       -       31.3  
                           
Income (loss) before assessments
      (58.3 )     138.3       80.0  
Assessments(1)
      -       21.2       21.2  
                           
Net (loss) income
    $ (58.3 )   $ 117.1     $ 58.8  
                           
                           
Earnings (loss) per share
    $ (1.45 )   $ 2.91     $ 1.46  
                           
                           
Return on average equity
      (3.07 )%     6.16 %     3.09 %
Return on average assets
      (0.19 )%     0.38 %     0.19 %
 
                                     
      For the Six Months Ended June 30, 2009
      GAAP
    Lehman
  OTTI
  Adjusted
(in millions)     Earnings     Impact   Charges   Earnings
Net interest income before provision for credit losses
    $ 132.3       $ -     $ -     $ 132.3  
Provision for credit losses
      1.5         -       -       1.5  
Other income (loss):
                                   
Net OTTI losses
      (69.8 )       -       69.8       -  
Net gains on derivatives and hedging activities
      11.2         -       -       11.2  
Contingency reserve
      (35.3 )       35.3       -       -  
All other income
      5.1         -       -       5.1  
                                     
Total other income (loss)
      (88.8 )       35.3       69.8       16.3  
Other expense
      30.5         -       -       30.5  
                                     
Income before assessments
      11.5         35.3       69.8       116.6  
Assessments
      3.0         9.4       18.5       30.9  
                                     
Net income
    $ 8.5       $ 25.9     $ 51.3     $ 85.7  
                                     
                                     
Earnings (loss) per share
    $ 0.21       $ 0.65     $ 1.28     $ 2.14  
                                     
                                     
Return on average equity
      0.42 %       1.30 %     2.58 %     4.30 %
Return on average assets
      0.02 %       0.06 %     0.13 %     0.21 %
Note:
 
(1) Assessments on the Lehman impact and OTTI charges were prorated based on the required adjusted earnings assessment  expense to take into account the impact of the second quarter and six months ended 2010 GAAP net loss.
 
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.

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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 assumptions used in the quarterly OTTI process; 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 and six months ended June 30, 2010 compared to the three and six months ended June 30, 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 second quarter of 2010, the Bank recorded a net loss of $68.2 million, compared to net income of $32.1 million in second quarter 2009. This decline in results was driven by higher OTTI credit losses on the Bank’s private label MBS portfolio. OTTI credit losses were $110.7 million for second quarter 2010, compared to $39.3 million for second quarter 2009. For the six months ended June 30, 2010, the Bank recorded a net loss of $58.3 million, compared to net income of $8.5 million for the same prior year period primarily due to higher net OTTI credit losses year-over-year. Details of the Statement of Operations, including the impact of net interest income and derivatives and hedging activities on the results of operations, are presented more fully below.
 
Adjusted Earnings.  As presented above, adjusted earnings for second quarter and the six months ended June 30, 2010 and 2009 exclude the impact of the LBSF contingency reserve, net OTTI credit losses and related assessments, as applicable. For second quarter 2010, the Bank’s adjusted earnings totaled $28.7 million, a decrease of $26.0 million over second quarter 2009 adjusted earnings. This decline was driven by lower net interest income and losses on derivatives and hedging activities in the current quarter. The Bank’s adjusted return on average equity was 2.95% in second quarter 2010, compared to 5.65% in second quarter 2009.


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For the six months ended June 30, 2010, the Bank’s adjusted earnings totaled $58.8 million, a decrease of $26.9 million over the same prior year adjusted earnings. This decline was also driven primarily by lower net interest income and losses on derivatives and hedging activities. The Bank’s adjusted return on average equity was 3.09% for year-to-date June 2010, compared to 4.30% for year-to-date June 2009.
 
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 six months of 2010 and 2009. Retained earnings were $330.7 million as of June 30, 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 and six months ended June 30, 2010 and 2009.
 
Average Balances and Interest Yields/Rates Paid
 
                                                   
      Three Months Ended June 30,
      2010   2009
              Avg.
          Avg.
          Interest
  Yield/
      Interest
  Yield/
      Average
  Income/
  Rate
  Average
  Income/
  Rate
(dollars in millions)     Balance   Expense   (%)   Balance   Expense   (%)
Assets
                                                 
Federal funds sold(1)
    $ 4,824.0     $ 2.0       0.17     $ 114.3     $ 0.1       0.17  
Interest-bearing deposits(2)
      432.7       0.2       0.19       8,050.6       5.0       0.25  
Investment securities(3)
      13,734.2       101.0       2.95       16,216.0       143.3       3.55  
Advances(4)
      37,109.8       80.0       0.87       49,252.7       169.9       1.38  
Mortgage loans held for portfolio(5)
      4,945.5       62.3       5.05       5,790.2       70.3       4.87  
 
Total interest-earning assets
      61,046.2       245.5       1.61       79,423.8       388.6       1.96  
Allowance for credit losses
      (12.0 )                     (15.3 )                
Other assets(5)(6)
      93.9                       258.4                  
 
Total assets
    $ 61,128.1                     $ 79,666.9                  
                                                   
                                                   
Liabilities and capital
                                                 
Deposits(2)
    $ 1,223.6     $ 0.2       0.07     $ 1,832.8     $ 0.4       0.09  
Consolidated obligation discount notes
      11,588.7       5.1       0.17       15,859.7       8.8       0.22  
Consolidated obligation bonds(7)
      42,773.3       181.1       1.70       55,925.5       303.5       2.18  
Other borrowings
      44.3       -       0.23       8.5       -       0.79  
                                                   
Total interest-bearing liabilities
      55,629.9       186.4       1.34       73,626.5       312.7       1.70  
Other liabilities
      1,598.7                       2,156.1                  
Total capital
      3,899.5                       3,884.3                  
                                                   
Total liabilities and capital
    $ 61,128.1                     $ 79,666.9                  
                                                   
                                                   
Net interest spread
                      0.27                       0.26  
Impact of noninterest-bearing funds
                      0.12                       0.12  
                                                   
Net interest income/net interest margin
            $ 59.1       0.39             $ 75.9       0.38  
                                                   
Notes:
 
(1) The average balance of Federal funds sold, related interest income and average yield calculations may include loans to other FHLBanks.
(2) 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.
(3) Investment securities include trading, held-to-maturity and available-for-sale securities. The average balances of held-to-maturity 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 noninterest-earning hedge accounting adjustments of $1.3 billion and $2.0 billion in 2010 and 2009, respectively.
(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.
(7) Average balances reflect noninterest-bearing hedge accounting adjustments of $282.2 million and $460.3 million in 2010 and 2009, respectively.


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Net interest income was $59.1 million for second quarter 2010, a decline of $16.8 million, or 22.1%, from the second quarter 2009. The decline was driven primarily by a lower level of interest-earning assets. Total average interest-earning assets for second quarter 2010 were $61.0 billion, a decrease of $18.4 billion, or 23.1%, from second quarter 2009. The majority of the decline in interest-earning assets was attributed to lower demand for advances, which declined $12.1 billion, or 24.7%, 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 members’ need for funding. For second quarter 2010, interest-bearing deposits decreased $7.6 billion from second quarter 2009, primarily due to a shift into investments in Federal funds sold. The higher second quarter 2009 interest-bearing deposit balance was due to the Bank’s shift of 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 held 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. The overall average of this portfolio was $4.8 billion for second quarter 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 1 basis point to 39 basis points, compared to 38 basis points a year ago. The continuing low interest-rate environment resulted in a 36 basis point reduction of the rate paid on interest-bearing liabilities, which offset the 35 basis point reduction in the yield earned on interest-earning assets.
 


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      Six Months Ended June 30,
      2010     2009
                  Avg.
              Avg.
            Interest
    Yield/
          Interest
  Yield/
      Average
    Income/
    Rate
    Average
    Income/
  Rate
(dollars in millions)     Balance     Expense     (%)     Balance     Expense   (%)
Assets
                                                         
Federal funds sold(1)
    $ 4,773.3       $ 3.3         0.14       $ 64.4       $ 0.1       0.17  
Interest-bearing deposits(2)
      473.5         0.4         0.16         8,839.8         10.8       0.25  
Investment securities(3)
      13,698.2         207.5         3.05         15,636.3         296.7       3.83  
Advances(4)
      38,618.1         154.3         0.81         52,831.7         411.6       1.57  
Mortgage loans held for portfolio(5)
      5,007.6         126.0         5.07         5,936.7         147.2       5.00  
 
Total interest-earning assets
      62,570.7         491.5         1.59         83,308.9         866.4       2.10  
Allowance for credit losses
      (12.0 )                           (14.6 )                  
Other assets(5)(6)
      (18.1 )                           407.8                    
 
Total assets
    $ 62,540.6                           $ 83,702.1                    
 
 
Liabilities and capital
                                                         
Deposits(2)
    $ 1,293.2       $ 0.4         0.06       $ 1,789.2       $ 0.8       0.09  
Consolidated obligation discount notes
      10,759.7         7.7         0.14         16,858.0         33.6       0.40  
Consolidated obligation bonds(7)
      45,037.4         365.3         1.64         58,776.6         699.7       2.40  
Other borrowings
      27.7         -         0.29         7.3         -       0.94  
 
Total interest-bearing liabilities
      57,118.0         373.4         1.32         77,431.1         734.1       1.91  
Other liabilities
      1,591.1                             2,248.5                    
Total capital
      3,831.5                             4,022.5                    
 
Total liabilities and capital
    $ 62,540.6                           $ 83,702.1                    
 
 
Net interest spread
                          0.27                           0.19  
Impact of noninterest-bearing funds
                          0.11                           0.13  
 
Net interest income/net interest margin
              $ 118.1         0.38                 $ 132.3       0.32  
 
Notes:
 
(1) The average balance of Federal funds sold, related interest income and average yield calculations may include loans to other FHLBanks.
(2) 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.
(3) Investment securities include trading, held-to-maturity and available-for-sale securities. The average balances of held-to-maturity 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 noninterest-earning hedge accounting adjustments of $1.4 billion and $2.1 billion in 2010 and 2009, respectively.
(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.
(7) Average balances reflect noninterest-bearing hedge accounting adjustments of $296.1 million and $484.0 million in 2010 and 2009, respectively.
 
Net interest income was $118.1 million for the six months ended June 30, 2010, a decline of $14.2 million, or 10.7%, from the same year-ago period. The decline in interest-earning assets more than offset the benefit of favorable funding costs. Total average interest-earning assets for second quarter 2010 were $62.6 billion, a decrease of $20.7 billion, or 24.9%, from the same prior year period. The majority of the decline in interest-earning assets was attributed to lower demand for advances, which declined $14.2 billion, or 26.9%, as described previously. For the six months ended June 30, 2010, interest-bearing deposits decreased $8.4 billion from the same year-ago period, primarily due to a shift into investments in Federal funds sold. The higher interest-bearing deposit balance for the six months ended June 30, 2009 was due to the Bank’s shift in balances from Federal funds sold into higher-yielding interest-bearing FRB accounts, as noted above. The overall average balance in the Federal funds portfolio was

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$4.8 billion for the six months ended June 30, 2010. 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 6 basis points to 38 basis points, compared to 32 basis points a year ago. The continuing low interest-rate environment resulted in a 59 basis point reduction of the rate paid in interest-bearing liabilities, which was offset by the 51 basis point decline in the yield on interest-earning 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 2010 and 2009.
 
                                                             
      Increase (Decrease) in Interest Income/Expense Due to Changes
      in Rate/Volume
      Three Months Ended June 30     Six Months Ended June 30
(in millions)     Volume     Rate     Total     Volume     Rate     Total
Federal funds sold
    $ 1.9       $ -       $ 1.9       $ 3.2       $ -       $ 3.2  
Interest-bearing deposits
      (3.9 )       (0.9 )       (4.8 )       (7.6 )       (2.8 )       (10.4 )
Investment securities
      (20.1 )       (22.2 )       (42.3 )       (33.9 )       (55.3 )       (89.2 )
Advances
      (35.7 )       (54.2 )       (89.9 )       (91.6 )       (165.7 )       (257.3 )
Mortgage loans held for portfolio
      (10.5 )       2.5         (8.0 )       (23.4 )       2.2         (21.2 )
 
Total interest-earning assets
    $ (68.3 )     $ (74.8 )     $ (143.1 )     $ (153.3 )     $ (221.6 )     $ (374.9 )
 
Interest-bearing deposits
    $ (0.1 )     $ (0.1 )     $ (0.2 )     $ (0.2 )     $ (0.2 )     $ (0.4 )
Consolidated obligation discount notes
      (2.0 )       (1.7 )       (3.7 )       (9.3 )       (16.6 )       (25.9 )
Consolidated obligation bonds
      (63.3 )       (59.1 )       (122.4 )       (141.5 )       (192.9 )       (334.4 )
 
Total interest-bearing liabilities
    $ (65.4 )     $ (60.9 )     $ (126.3 )     $ (151.0 )     $ (209.7 )     $ (360.7 )
 
Total increase (decrease) in net interest income
    $ (2.9 )     $ (13.9 )     $ (16.8 )     $ (2.3 )     $ (11.9 )     $ (14.2 )
 
 
 
The average balance sheet has shrunk considerably in both the quarter-over-quarter and year-over-year comparisons. However, the decline in net interest income in both comparisons was primarily rate-driven. Quarter-over-quarter, interest income declined $143.1 million. This included a decrease of $74.8 million due to rate and $68.3 million due to volume, driven by the advances portfolio and, to a lesser extent, the investment securities portfolio. The mortgage loans held for portfolio experienced an increase in rate-related interest income, due to a slight uptick in yields, although overall still reported a decrease in interest income due to lower volume. Interest expense declined $126.3 million in the same comparison. This included a decrease of $65.4 million due to volume and $60.9 million due to rate, driven by the decline in volume and rates paid on consolidated obligation bonds.
 
In the year-over-year comparison, interest income declined $374.9 million. This included a decrease of $221.6 million due to rate and $153.3 million due to volume, driven by the advances portfolio and, to a lesser extent, the investment securities portfolio. Interest expense declined $360.7 million in the same comparison. This included a decrease of $151.0 million due to volume and $209.7 million due to rate, primarily driven by the decline in volume and rates paid on consolidated obligation bonds.
 
For second quarter 2010, average Federal funds sold increased $4.7 billion from $114.3 million in second quarter 2009. For the second 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 on Federal funds sold increased $1.9 million due to the higher balances. For second quarter 2010, average interest-bearing deposits decreased $7.6 billion, primarily due to the shift to Federal funds sold noted above. Related interest income on interest-bearing deposits decreased $4.8 million due to the lower balances and the relatively low yields on short-term investments.
 
For the six months ended June 30, 2010, average Federal funds sold increased $4.7 billion from $64.4 million for the same prior year period. Related interest income on Federal funds sold increased $3.2 million due to the higher balances. For year-to-date June 2010, average interest-bearing deposits decreased $8.4 billion, primarily due


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to the shift to Federal funds sold noted above. Related interest income on interest-bearing deposits decreased $10.4 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 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 earlier in this Item 2. Management’s Discussion and Analysis.
 
The average investment securities portfolio balance for second quarter 2010 decreased $2.5 billion, or 15.3%, from second quarter 2009. Correspondingly, the interest income on this portfolio decreased $42.3 million, due to a 60 basis point decline in the yield and by the volume decrease. For the six months ended June 30, 2010, the Bank’s average investment securities portfolio balance decreased $1.9 billion, or 12.4%, from the same prior year period. The related interest income decreased $89.2 million year-over-year, driven by a 78 basis point decline in the yield as well as the decrease in volume.
 
The investment securities portfolio includes trading, available-for-sale and held-to-maturity securities. The decrease in investments quarter-over-quarter and year-over-year 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. The Bank has not purchased any private label MBS since late 2007, purchasing only agency and GSE MBS since 2008, including $556 million in the first six months of 2010.
 
The average advances portfolio decreased $12.1 billion, or 24.7%, from second quarter 2009 to second quarter 2010. This decline in volume, coupled with a 51 basis point decrease in the yield, resulted in an $89.9 million decline in interest income quarter-over-quarter. For the six months ended June 30, 2010, the average advances portfolio decreased $14.2 billion, or 26.9%, from the same prior year period. This decline in volume, coupled with a 76 basis point decrease in the yield, resulted in a $257.3 million decline in interest income quarter-over-quarter.
 
Advance demand began to decline in the fourth quarter of 2008 and continued through 2009 and into the first half of 2010, as members grew core deposits and gained access to additional liquidity from the Federal Reserve and other government programs that initially became available in the second half of 2008. The interest income on this portfolio was significantly impacted by the decline in short-term rates. Specific mix changes within the portfolio are discussed more fully below under “Average Advances Portfolio Detail.” Average 3-month LIBOR declined 40 basis points and 69 basis points in the quarter-over-quarter and year-over-year comparisons, respectively.
 
The mortgage loans held for portfolio balance declined $844.7 million, or 14.6%, from second quarter 2009 to second quarter 2010. The related interest income on this portfolio declined $8.0 million in the quarter-over-quarter comparison; however the yield increased 18 basis points. For the six months ended June 30, 2010, the mortgage loans held for portfolio balance declined $929.1 million, or 15.7%, from the same prior year period. The related interest income on this portfolio declined $21.2 million year-over-year; however, the yield increased 7 basis points.
 
The decrease in the portfolio balance for both comparisons was due to the continued runoff of the existing portfolio, which more than offset new portfolio activity. The decrease in interest income was due to the lower average portfolio balances more than offsetting the yield increase. The yield increase in both comparisons was primarily due to lower amortization of basis adjustments in 2010 compared to 2009, as seen in the “Net Interest Income Derivative Effects” table below.
 
Mortgage loans contributed approximately 25.6% and 17.0% of total interest income for the first six months of 2010 and 2009, respectively. While interest income on mortgage loans dropped 14.4% in the year-over-year comparison, the Bank’s total interest income decreased 43.3%. Total interest income decreased more rapidly than interest income on mortgage loans held for portfolio as the Bank had significant funds invested in short-term assets, which experienced sharp rate declines in the year-over-year comparison.
 
Interest-bearing deposits decreased $609.2 million, or 33.2%, from second quarter 2009 to second quarter 2010. Interest expense on interest-bearing deposits decreased $0.2 million quarter-over-quarter, driven by the volume change and a 2 basis point decline in rates paid.


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For the six months ended June 30, 2010, interest-bearing deposits decreased $496.0 million, or 27.7%, from the same prior period. Interest expense on interest-bearing deposits decreased $0.4 million year-over-year, driven by the volume change and a 3 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 $17.4 billion from second quarter 2009 to second quarter 2010. Discount notes accounted for $4.3 billion of the decline, while average bonds fell by $13.1 billion quarter-over-quarter. The decline in discount notes was consistent with the decline in short-term advance demand from members as previously discussed. Interest expense on discount notes decreased $3.7 million from the prior year quarter. The decrease was partially attributable to the volume decline and partially due to the 5 basis point decline in rates paid quarter-over-quarter. The decline in rates paid was consistent with the general decline in short-term rates. Interest expense on bonds decreased $122.4 million from second quarter 2009 to second quarter 2010. This was due in part to the 48 basis point decrease in rates paid on bonds, as well as the volume decline.
 
For the six months ended June 30, 2010, the consolidated obligations portfolio balance decreased $19.8 billion from the same prior year period. Discount notes were down $6.1 billion, while average bonds fell by $13.7 billion year-over-year. The decline in discount notes was consistent with the decline in short-term advance demand from members as previously discussed. Interest expense on discount notes decreased $25.9 million from prior year-to-date June. The decrease was driven primarily by a 26 basis point declines in rates paid year-over-year and secondarily by the volume decline. The decline in rates paid was consistent with the general decline in short-term rates. Interest expense on bonds decreased $334.4 million year-over-year. This was due in part to the 76 basis point decrease in rates paid on bonds, as well as the volume decline.
 
A portion of the bond portfolio is currently swapped to 3-month LIBOR; therefore, as the LIBOR rate (decreases) increases, interest expense on swapped bonds, including the impact of swaps, (decreases) increases. See details regarding the impact of swaps on the quarterly rates paid in the “Net Interest Income Derivatives Effects” discussion below.
 
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. The Bank has been aided in obtaining favorable rates on debt issuance by the European debt crisis, which has led to more investor interest in GSE debt.
 
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
 
                                       
(in millions)     Three Months Ended June 30,     Six Months Ended June 30,
                    Product     2010     2009     2010   2009
Repo
    $ 16,367.8       $ 23,355.5       $ 17,732.4     $ 25,941.6  
Term Loans
      12,898.1         13,528.4         12,872.8       14,032.3  
Convertible Select
      6,336.1         7,314.8         6,465.5       7,350.1  
Hedge Select
      50.0         113.0         50.0       131.4  
Returnable
      28.8         2,924.6         27.3       3,236.4  
                                       
Total par value
    $ 35,680.8       $ 47,236.3       $ 37,148.0     $ 50,691.8  
                                       
                                       
 
The par value of the Bank’s average advance portfolio decreased 24.5% from second quarter 2009 to second quarter 2010 and 26.7% from the six months ended June 30, 2009 to the six months ended June 30, 2010. The most significant percentage decrease in both comparisons was in the Returnable product, which declined $2.9 billion, or 99.0%, quarter-over-quarter and $3.2 billion, or 99.2%, year-over-year. The most significant dollar decrease in both comparisons was in the Repo product, which declined $7.0 billion, or 29.9%, quarter-over quarter and $8.2 billion, or 31.6%, year-over-year.


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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 increased 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 $9.3 billion year-over-year. The decline in Returnable product balances was due to one of the Bank’s largest borrowers exercising their option to return their advances.
 
As of June 30, 2010, 47.3% 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) member reaction to the Bank’s voluntary decision to temporarily suspend dividend payments and excess capital stock repurchases until further notice; (4) the Bank’s liquidity position and how management chooses to fund the Bank; (5) current, as well as future, credit market conditions; (6) housing market trends; and (7) 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, which created increased competition for the Bank. See the Legislative and Regulatory Developments 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- and AA-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 June 30, 2010. For more information on collateral, see the “Credit and Counterparty Risk – Total Credit Products and Collateral” discussion in Risk Management in this Item 2. Management’s Discussion and Analysis in the quarterly report filed on this 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 six months ended June 30, 2010 and 2009. Derivative and hedging activities are discussed below in the “Other Income (Loss)” section.
 
                                                           
              Avg.
      Avg.
       
Three Months Ended
        Interest Inc./
  Yield/
  Interest Inc./
  Yield/
      Incr./
June 30, 2010
    Average
  Exp. with
  Rate
  Exp. without
  Rate
  Impact of
  (Decr.)
(dollars in millions)     Balance   Derivatives   (%)   Derivatives   (%)   Derivatives(1)   (%)
Assets:
                                                         
Advances
    $ 37,109.8     $ 80.0       0.87     $ 301.1       3.26     $ (221.1 )     (2.39 )
Mortgage loans held for portfolio
      4,945.5       62.3       5.05       63.0       5.11       (0.7 )     (0.06 )
All other interest-earning assets
      18,990.9       103.2       2.18       103.2       2.18       -       -  
                                                           
Total interest-earning assets
    $ 61,046.2     $ 245.5       1.61     $ 467.3       3.07     $ (221.8 )     (1.46 )
                                                           
                                                           
Liabilities and capital:
                                                         
Consolidated obligation bonds
    $ 42,773.3     $ 181.1       1.70     $ 292.1       2.74     $ (111.0 )     (1.04 )
All other interest-bearing liabilities
      12,856.6       5.3       0.16       5.3       0.16       -       -  
                                                           
Total interest-bearing liabilities
    $ 55,629.9     $ 186.4       1.34     $ 297.4       2.14     $ (111.0 )     (0.80 )
                                                           
Net interest income/net interest spread
            $ 59.1       0.27     $ 169.9       0.93     $ (110.8 )     (0.66 )
                                                           
                                                           
 
                                                           
              Avg.
      Avg.
       
Three Months Ended
        Interest Inc./
  Yield/
  Interest Inc./
  Yield/
      Incr./
June 30, 2009
    Average
  Exp. with
  Rate
  Exp. without
  Rate
  Impact of
  (Decr.)
(dollars in millions)     Balance   Derivatives   (%)   Derivatives   (%)   Derivatives(1)   (%)
Assets:
                                                         
Advances
    $ 49,252.7     $ 169.9       1.38     $ 456.5       3.72     $ (286.6 )     (2.34 )
Mortgage loans held for portfolio
      5,790.2       70.3       4.87       71.7       4.97       (1.4 )     (0.10 )
All other interest-earning assets
      24,380.9       148.4       2.44       148.4       2.44       -       -  
                                                           
Total interest-earning assets
    $ 79,423.8     $ 388.6       1.96     $ 676.6       3.42     $ (288.0 )     (1.46 )
                                                           
                                                           
Liabilities and capital:
                                                         
Consolidated obligation bonds
    $ 55,925.5     $ 303.5       2.18     $ 401.9       2.88     $ (98.4 )     (0.70 )
All other interest-bearing liabilities
      17,701.0       9.2       0.21       9.2       0.21       -       -  
                                                           
Total interest-bearing liabilities
    $ 73,626.5     $ 312.7       1.70     $ 411.1       2.24     $ (98.4 )     (0.54 )
                                                           
Net interest income/net interest spread
            $ 75.9       0.26     $ 265.5       1.18     $ (189.6 )     (0.92 )
                                                           
                                                           
Note:
 
(1)Impact of Derivatives includes net interest settlements and amortization of basis adjustments resulting from previously terminated hedging relationships.
 


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              Avg.
      Avg.
       
Six Months Ended
        Interest Inc./
  Yield/
  Interest Inc./
  Yield/
      Incr./
June 30, 2010
    Average
  Exp. with
  Rate
  Exp. without
  Rate
  Impact of
  (Decr.)
(dollars in millions)     Balance   Derivatives   (%)   Derivatives   (%)   Derivatives(1)   (%)
Assets:
                                                         
Advances
    $ 38,618.1     $ 154.3       0.81     $ 624.1       3.26     $ (469.8 )     (2.45 )
Mortgage loans held for portfolio
      5,007.6       126.0       5.07       127.4       5.13       (1.4 )     (0.06 )
All other interest-earning assets
      18,945.0       211.2       2.25       211.2       2.25       -       -  
                                                           
Total interest-earning assets
    $ 62,570.7     $ 491.5       1.59     $ 962.7       3.10     $ (471.2 )     (1.51 )
                                                           
                                                           
Liabilities and capital:
                                                         
Consolidated obligation bonds
    $ 45,037.4     $ 365.3       1.64     $ 597.8       2.68     $ (232.5 )     (1.04 )
All other interest-bearing liabilities
      12,080.6       8.1       0.13       8.1       0.13       -       -  
                                                           
Total interest-bearing liabilities
    $ 57,118.0     $ 373.4       1.32     $ 605.9       2.14     $ (232.5 )     (0.82 )
                                                           
Net interest income/net interest spread
            $ 118.1       0.27     $ 356.8       0.96     $ (238.7 )     (0.69 )
                                                           
                                                           
 
                                                           
              Avg.
      Avg.
       
Six Months Ended
        Interest Inc./
  Yield/
  Interest Inc./
  Yield/
      Incr./
June 30, 2009
    Average
  Exp. with
  Rate
  Exp. without
  Rate
  Impact of
  (Decr.)
(dollars in millions)     Balance   Derivatives   (%)   Derivatives   (%)   Derivatives(1)   (%)
Assets:
                                                         
Advances
    $ 52,831.7     $ 411.6       1.57     $ 955.6       3.65     $ (544.0 )     (2.08 )
Mortgage loans held for portfolio
      5,936.7       147.2       5.00       149.4       5.07       (2.2 )     (0.07 )
All other interest-earning assets
      24,540.5       307.6       2.53       307.6       2.53       -       -  
                                                           
Total interest-earning assets
    $ 83,308.9     $ 866.4       2.10     $ 1,412.6       3.42     $ (546.2 )     (1.32 )
                                                           
                                                           
Liabilities and capital:
                                                         
Consolidated obligation bonds
    $ 58,776.6     $ 699.7       2.40     $ 902.5       3.10     $ (202.8 )     (0.70 )
All other interest-bearing liabilities
      18,654.5       34.4       0.37       34.4       0.37       -       -  
                                                           
Total interest-bearing liabilities
    $ 77,431.1     $ 734.1       1.91     $ 936.9       2.44     $ (202.8 )     (0.53 )
                                                           
Net interest income/net interest spread
            $ 132.3       0.19     $ 475.7       0.98     $ (343.4 )     (0.79 )
                                                           
                                                           
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 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

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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 second quarter 2010, the impact of derivatives reduced net interest income by $110.8 million and the net interest spread by 66 basis points. Average 3-month LIBOR for second quarter 2010 fell 40 basis points quarter-over-quarter and the impact of declining rates on existing derivative contracts continued to negatively impact net interest income. For second quarter 2009, the impact of derivatives decreased net interest income by $189.6 million and reduced net interest income 92 basis points.
 
For the six months ended June 30, 2010, the impact of derivatives reduced net interest income by $238.7 million and net interest spread by 69 basis points. Average 3-month LIBOR for the six months ended June 30, 2010 fell 69 basis points from the prior year period and the impact of declining rates on existing derivative contracts continued to negatively impact net interest income. For the six months ended June 30, 2009, the impact of derivatives decreased net interest income by $343.4 million and reduced net interest income 79 basis points.
 
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.
 
Effective January 4, 2010, the Bank initiated a new funding and hedging strategy for bullet advances as part of the implementation of a Simplified Business Model. This funding and hedging strategy involves closely match-funding bullet advances with bullet debt and is designed in part to (1) avoid the use of derivatives where prudent, (2) restrain growth in the size of the Bank’s derivatives portfolio, and (3) reduce the Bank’s reliance on short-funding.
 
In addition, the Bank has initiated a program to lower derivative counterparty credit exposure by reducing the number of derivatives outstanding without materially impacting the Bank’s risk or earnings profiles. The initial phase of this program focused on bullet advances with balances between $5 and $10 million and involved the simultaneous termination of swaps hedging advances and swaps hedging comparable maturity bullet debt. Basis adjustments (BAs) that are created as a result of the discontinuation of fair value hedge accounting upon termination of the swaps are accreted or amortized over the remaining lives of the advances or debt. This strategy will result in additional accretion and amortization of BAs which will be reflected in the Statement of Operations within net interest income. If there are significant prepayments of debt that have associated BAs, there will be an acceleration of the amortization of the related BA, which may or may not be offset by prepayment fees. If a significant number of instruments prepay, this will result in volatility within the Statement of Operations.
 
Other Income (Loss)
 
                                                         
      Three Months Ended
          Six Months Ended
   
      June 30,           June 30,    
(In millions)     2010     2009     % Change     2010   2009   % Change
Services fees
    $ 0.7       $ 0.6         16.7       $ 1.3     $ 1.2       8.3  
Net losses on trading securities
      (0.4 )       (0.3 )       (33.3 )       (0.7 )     (0.3 )     (133.3 )
Net gains (losses) on derivatives and hedging activities
      (8.0 )       12.4         (164.5 )       (12.6 )     11.2       (212.5 )
Net gain (loss) on sale of AFS securities
      (0.1 )       -         n/m         (0.1 )     -       n/m  
Net OTTI credit losses
      (110.7 )       (39.3 )       (181.7 )       (138.3 )     (69.8 )     (98.1 )
Contingency reserve
      -         -         n/m         -       (35.3 )     (100.0 )
Other income, net
      1.5         2.2         (31.8 )       3.9       4.2       (7.1 )
                                                         
Total other loss
    $ (117.0 )     $ (24.4 )       (379.5 )     $ (146.5 )   $ (88.8 )     (65.0 )
                                                         
                                                         
n/m – not meaningful
 
Second quarter 2010 financial results included total other losses of $117.0 million, compared to total other losses of $24.4 million in second quarter 2009. The second quarter 2010 net losses on derivatives and hedging


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activities totaled $8.0 million compared to gains on derivatives and hedging activities of $12.4 million for second quarter 2009. Net OTTI credit losses for second quarter 2010 totaled $110.7 million, compared to $39.3 million of net credit losses in second quarter 2009. These losses reflect the credit loss portion of OTTI charges taken on the private label MBS portfolio. All other income, net decreased $0.7 million in the quarter-over-quarter comparison, primarily due to decreased standby letter of credit fees and changes in the market value of the split-dollar life insurance policy.
 
Year-to-date June 2010 financial results included total other losses of $146.5 million, compared to total other losses of $88.8 million for year-to-date June 2009. The year-to-date June 2010 net losses on derivatives and hedging activities totaled $12.6 million, compared to gains on derivatives and hedging activities of $11.2 million for the same prior year period. Net OTTI credit losses for the first six months of 2010 totaled $138.3 million, compared to $69.8 million for the same prior year period. The $35.3 million contingency reserve in the six months ended June 30, 2009 represents the establishment of a contingency reserve for the Bank’s LBSF receivable in first quarter 2009. There has been no change in this reserve in 2010. All other income, net decreased $0.3 million in the year-over-year comparison, primarily due to decreased standby letter of credit fees.
 
See additional discussion on OTTI charges in 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. 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.
 
                                   
      For the
  For the
      Three Months Ended   Six Months Ended
      June 30,
  June 30,
  June 30,
  June 30,
      2010
  2009
  2010
  2009
(in millions)     Gain (Loss)   Gain (Loss)   Gain (Loss)   Gain (Loss)
Derivatives and hedged items in hedge accounting relationships:
                                 
Advances
    $ (6.1 )   $ 10.0     $ (7.8 )   $ (9.2 )
Consolidated obligations
      (1.8 )     2.1       (0.9 )     19.5  
 
Total net gains (losses) related to fair value hedge ineffectiveness
      (7.9 )     12.1       (8.7 )     10.3  
 
Derivatives not designated as hedging instruments under hedge accounting:
                                 
Economic hedges
      (1.6 )     (1.1 )     (6.0 )     (2.5 )
Mortgage delivery commitments
      1.3       1.1       1.7       3.0  
Other
      0.2       0.3       0.4       0.4  
 
Total net gains (losses) related to derivatives not designated as hedging instruments under hedge accounting
      (0.1 )     0.3       (3.9 )     0.9  
 
Net gains (losses) on derivatives and hedging activities
    $ (8.0 )   $ 12.4     $ (12.6 )   $ 11.2  
 
 
 
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 second quarter of 2010, total ineffectiveness related to these fair value hedges resulted in a loss of $7.9 million compared to a gain of $12.1 million in the second quarter of 2009. For the six months ended June 30, 2010, total ineffectiveness resulted in a loss of $8.7 million compared to a gain of $10.3 million for the same prior year period. The overall notional amount decreased from $51.9 billion at June 30, 2009 to $37.8 billion at June 30, 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, which generally reverses over the life of hedge relationships, 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.


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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 $1.6 million in second quarter 2010 compared to a loss of $1.1 million in second quarter 2009. For the six months ended June 30, 2010, the Bank recorded net losses on economic hedges of $6.0 million, compared to losses of $2.5 million for the same prior year period. The majority of the losses in 2010 were comprised of losses on the Bank’s interest rate caps. The overall notional amount of economic hedges increased from $0.8 billion at June 30, 2009 to $1.5 billion at June 30, 2010. The notional amount of the Bank’s interest rate caps was $1.4 billion at June 30, 2010 compared to $84.3 million at June 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 second quarter 2010 were $1.3 million compared to total gains of $1.1 million for second quarter 2009. For the six months ended June 30, 2010, total gains on mortgage delivery commitments were $1.7 million compared to gains of $3.0 million for the same prior year period. Total notional of the Bank’s mortgage delivery commitments increased from $13.3 million at June 30, 2009 to $27.3 million at June 30, 2010.
 
Other Expense
 
                                                           
      For the
          For the
   
      Three Months Ended
          Six Months Ended
   
      June 30,           June 30,    
(in millions)     2010     2009     % Change     2010     2009   % Change
Operating – salaries and benefits
    $ 8.0       $ 8.0         -       $ 16.9       $ 16.2       4.3  
Operating – occupancy
      0.5         0.7         (28.6 )       1.2         1.3       (7.7 )
Operating – other
      5.1         5.2         (1.9 )       10.0         10.1       (1.0 )
Finance Agency
      0.9         0.7         28.6         1.9         1.5       26.7  
Office of Finance
      0.6         0.7         (14.3 )       1.3         1.4       (7.1 )
 
Total other expenses
    $ 15.1       $ 15.3         (1.3 )     $ 31.3       $ 30.5       2.6  
 
 
 
Other expense totaled $15.1 million for second quarter 2010 compared to $15.3 million for second quarter 2009, a decrease of $0.2 million, or 1.3%, driven by slight declines in occupancy and other operating expenses.
 
For the six months ended June 30, 2010, other expense totaled $31.3 million compared to $30.5 million for the same prior year period, an increase of $0.8 million, or 2.6%. This increase was primarily driven by an increase in salaries and benefits expense due to first quarter 2010 severance costs.
 
Collectively, the twelve FHLBanks are responsible for the operating expenses of the Finance Agency and the OF. These payments, allocated among the FHLBanks according to a cost-sharing formula, are reported as other expense on the Bank’s Statement of Operations. The combined operating expenses of the Finance Agency and the OF increased 7.1% and 10.3% quarter-over-quarter and year-over-year, respectively, driven by an increase in Finance Agency expenses. The Bank expects this trend to continue throughout 2010.
 
Affordable Housing Program (AHP) and Resolution Funding Corp. (REFCORP) Assessments
 
                                                           
      For the
          For the
   
      Three Months Ended
          Six Months Ended
   
      June 30,           June 30,    
(in millions)     2010     2009     % Change     2010     2009   % Change
Affordable Housing Program (AHP)
    $ (1.1 )     $ 0.9         (222.2 )     $ -       $ 0.9       (100.0 )
REFCORP
      (2.4 )       2.1         (214.3 )       -         2.1       (100.0 )
 
Total assessments
    $ (3.5 )     $ 3.0         (216.7 )     $ -       $ 3.0       (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


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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 second quarter of 2010 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. In addition, the FHLBanks must set aside for the AHP annually on a combined basis, the greater of an aggregate of $100 million or 10 percent of current year’s net earnings (income before interest expense related to mandatorily redeemable capital stock but after the assessment for REFCORP). The AHP, mandated by statute, is the largest and primary public policy program among the FHLBanks. The AHP funds, which are offered on a competitive basis, provide grants and below-market loans for both rental and owner-occupied housing for households at 80% or less of the area median income.
 
Application of the REFCORP percentage rate as applied to the Bank’s second quarter 2010 loss resulted in reversal of assessment expense of $2.4 million. For the six months ended June 30, 2010, the Bank had no REFCORP assessment expense. Application of the REFCORP percentage rate as applied to earnings during three and six months ended June 30, 2009 resulted in expenses for the Bank of $2.1 million for both periods.
 
The Bank had a prepaid REFCORP assessment balance of $39.6 million as of June 30, 2010. This prepaid REFCORP assessment balance was recorded in fourth quarter 2008 as a result of the Bank overpaying its 2008 REFCORP assessment due to the loss recognized in fourth quarter 2008. The balance may fluctuate quarter-to-quarter based on the Bank’s earnings or losses. As instructed by the U.S. Treasury, the Bank is using its overpayment as a credit against future 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.
 
Application of the AHP percentage rate as applied to the Bank’s second quarter 2010 loss resulted in reversal of AHP assessment expense of $1.1 million. For the six months ended June 30, 2010, the Bank had no AHP assessment expense. Application of the AHP percentage rate as applied to earnings during three and six months ended June 30, 2009 resulted in expenses for the Bank of $0.9 million for both periods.
 
Financial Condition
 
The following is Management’s Discussion and Analysis of the Bank’s financial condition at June 30, 2010 compared to December 31, 2009. 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 2009 Annual Report filed on Form 10-K.
 
Assets
 
As a result of declining loan demand by members, the Bank’s total assets decreased $4.7 billion, or 7.2%, to $60.6 billion at June 30, 2010, down from $65.3 billion at December 31, 2009. Advances decreased $5.1 billion; this


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decrease was partially offset by a $1.9 billion increase in Federal funds sold and a $120.1 million increase in investment securities.
 
Total housing finance-related assets, which include MPF Program loans, advances, MBS and other mission-related investments, decreased $5.8 billion, or 10.4%, to $50.1 billion at June 30, 2010, down from $55.9 billion at December 31, 2009. Total housing finance-related assets accounted for 82.7% of assets as of June 30, 2010 and 85.7% of assets as of December 31, 2009.
 
Advances.  At June 30, 2010, total advances reflected balances of $36.1 billion to 219 borrowing members, compared to $41.2 billion at year-end 2009 to 222 borrowing members, representing a 12.4% decrease in the portfolio balance. A significant concentration of the advances continued to be generated from the Bank’s five largest borrowers, generally reflecting the asset concentration mix of the Bank’s membership base. Total advances outstanding to the Bank’s five largest members were $21.8 billion and $25.4 billion at June 30, 2010 and December 31, 2009, respectively. The decrease in advance balances reflected a stronger deposit market and limited growth in member lending. 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 following table provides a distribution of the number of members, categorized by individual member asset size, that had an outstanding average balance during the six months ended June 30, 2010 and the year ended December 31, 2009.
 
                   
Member Asset Size     2010   2009
Less than $100 million
      34       40  
Between $100 million and $500 million
      124       135  
Between $500 million and $1 billion
      41       39  
Between $1 billion and $5 billion
      29       30  
Greater than $5 billion
      15       16  
                   
Total borrowing members during the year
      243       260  
                   
                   
Total membership
      316       316  
Percent of members borrowing during the period
      76.9%       82.3%  
Total borrowing members with outstanding loan balances at period-end
      219       222  
Percent of members borrowing at period-end
      69.3%       70.3%  
                   
 
As of June 30, 2010, the par value of the RepoPlus products decreased $4.4 billion, or 21.9%, to $15.7 billion, compared to $20.1 billion at December 31, 2009. These products represented 45.4% and 50.6% of the par value of the Bank’s total advances portfolio at June 30, 2010 and December 31, 2009, respectively. The Bank’s shorter-term advances decreased as a result of members having less need for liquidity from the Bank as they have taken other actions during the credit crisis, such as raising core deposits, reducing their balance sheets, and identifying alternative sources of funds. The short-term portion of the advances 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 2009 Annual Report filed on Form 10-K for details regarding the Bank’s various loan products.
 
The Bank’s longer-term advances, referred to as Term Advances, decreased $291.2 million, or 2.3%, to $12.5 billion at June 30, 2010 compared to $12.8 billion at December 31, 2009. These balances represented 36.3% and 32.2% of the Bank’s advance portfolio at June 30, 2010 and December 31, 2009, respectively. A number of the Bank’s members have a high percentage of long-term mortgage assets on their balance sheets and these members generally fund these assets through these longer-term borrowings with the Bank to mitigate interest rate risk. Certain members also prefer Term Advances given the current interest rate environment. Meeting the needs of such members has been, and will continue to be, an important part of the Bank’s advances business.


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As of June 30, 2010, the Bank’s longer-term option embedded advances decreased $530.4 million to $6.3 billion, down from $6.8 billion as of December 31, 2009. These products represented 18.3% and 17.2% of the Bank’s advances portfolio on June 30, 2010 and December 31, 2009, respectively. The decrease in balances was due to regularly scheduled maturing advances. New member interest in option-embedded advances was limited as the current cost/benefit of many of these advances is not economical compared to non-option-embedded advance products.
 
Mortgage Loans Held for Portfolio.  The Bank held approximately $4.9 billion and $5.2 billion in net mortgage loans held for portfolio under the MPF Program at June 30, 2010 and December 31, 2009, respectively, representing 8.1% and 7.8% of total assets. This reflected a decrease of $267.1 million, or 5.2%, from year-end, driven primarily by the continued runoff of the existing portfolio, which more than offset new portfolio purchase activity.
 
As previously discussed, the Bank currently has a loan modification plan in place for participating PFIs. As of June 30, 2010, there had been minimal requests for loan modifications under this loan modification plan. There was one loan in the 90-day trial period as of June 30, 2010. In addition, there was one loan which had been modified and completed the 90-day trial period with an unpaid principal balance of $117 thousand as of June 30, 2010.
 
Loan Portfolio Analysis.  The Bank’s outstanding advances, net mortgage loans, nonaccrual mortgage loans, mortgage loans 90 days or more past due and accruing interest, troubled debt restructuring and Banking on Business (BOB) loans are presented in the following table.
 
                   
      June 30,
  December 31,
(in millions)     2010   2009
Advances(1)
    $ 36,058.4     $ 41,177.3  
Mortgage loans held for portfolio, net(2)
      4,895.7       5,162.8  
Nonaccrual mortgage loans, net(3)
      77.2       71.2  
Mortgage loans past due 90 days or more and still accruing interest(4)
      13.1       16.5  
Troubled debt restructurings – mortgage loans(5)
      0.1       -  
BOB loans, net(6)
      13.4       11.8  
                   
Notes:
 
(1) There are no advances 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) Only government-insured or -guaranteed loans (e.g., FHA, VA, HUD or RHS) continue to accrue interest after becoming 90 days or more delinquent.
(5) Troubled debt restructurings includes mortgage loan balances related to loan modifications under the Bank’s current program. The balance at June 30, 2010 was $117 thousand, representing one loan. There were no balances at December 31, 2009.
(6) Due to the nature of the program, all BOB loans are considered nonaccrual loans. Balances are reflected net of allowance for credit losses.
 
The amount of foregone interest income on the Bank’s nonaccrual mortgage loans and troubled debt restructurings was $85 thousand and $53 thousand for the three months ended June 30, 2010 and 2009, respectively. For the six months ended June 30, 2010 and 2009, respectively, the amounts were $188 thousand and $89 thousand These amounts include activity related to loan modifications under the Bank’s current program for 2010.
 
The Bank has experienced an increase in its nonaccrual mortgage loans held for portfolio. Nonaccrual mortgage loans increased approximately $6.0 million, or 8.4%, from December 31, 2009 to June 30, 2010. This increase was driven by the general economic conditions. The Bank permits PFI’s to repurchase loans that meet certain pre-established criteria (i.e., government-guaranteed loans) at the time of the sale of the loans to the Bank.


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The decrease in mortgage loans past due 90 days or more and still accruing from December 31, 2009 to June 30, 2010 reflects these repurchases, totaling $1.3 million, as well as net activity related to loans moving into more current past due categories.
 
The Bank increased its allowance for loan losses on mortgage loans held for portfolio, from $2.7 million at December 31, 2009 to $2.9 million at June 30, 2010, an increase of 7.4%. This slight increase was due to deterioration in the portfolio related to higher delinquencies. The Bank experienced minimal net charge-offs during the six months ended June 30, 2010 and 2009.
 
Delinquencies in the Bank’s portfolio remain markedly below national delinquency rates for prime mortgage loans. Details of delinquencies within the Bank’s conventional mortgage loan portfolio are presented in the table below.
 
                     
    June 30,
   
(dollars in millions)   2010   December 31, 2009
30-59 days delinquent and not in foreclosure
  $ 72 .3     $ 69 .7  
60-89 days delinquent and not in foreclosure
    17 .3       21 .5  
90+ days delinquent and not in foreclosure
    27 .3       31 .5  
In process of foreclosure(1)
    44 .4       34 .2  
Real estate owned (REO) inventory
    12 .3       11 .1  
                     
Serious delinquency rate(2)
    1 .6%       1 .4%  
Notes:
 
(1) Includes loans where the decision of foreclosure or similar alternative such as pursuit of deed-in-lieu has been reported.
(2) 90+ days delinquent and not in foreclosure plus In process of foreclosure as a percent of total conventional loan principal  balance.
 
Interest-Bearing Deposits and Federal Funds Sold.  At June 30, 2010, these short-term investments totaled $5.0 billion, a net increase of $2.0 billion, or 64.9%, from December 31, 2009. These combined balances have continued to grow over the last two years, reflecting the Bank’s strategy to maintain its short-term liquidity position in part to be able to meet members’ loan demand and regulatory liquidity requirements.
 
Investment Securities.  The $120.1 million, or 0.8%, increase in investment securities from December 31, 2009 to June 30, 2010 was due to an increase in certificates of deposit in the held-to-maturity portfolio and purchases of agency and GSE MBS. This activity was offset by MBS paydowns during the first half of 2010. The Bank has not invested in any private label MBS since late 2007. Available-for-sale MBS paydowns were offset by an increase in the fair value of certain investments as well as the transfers of seven OTTI held-to-maturity securities to available-for-sale during the first six months of 2010.


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The following tables summarize key investment securities portfolio statistics.
 
                 
    June 30,
  December 31,
(in millions)   2010   2009
Trading securities:
               
Mutual funds offsetting deferred compensation
  $ 6.2     $ 6.7  
U.S. Treasury bills
    1,029.8       1,029.5  
TLGP investments
    250.4       250.0  
                 
Total trading securities
  $ 1,286.4     $ 1,286.2  
                 
                 
Available-for-sale securities:
               
Mutual funds partially securing supplemental retirement plan
  $ 2.0     $ 2.0  
MBS
    2,646.3       2,395.3  
                 
Total available-for-sale securities
  $ 2,648.3     $ 2,397.3  
                 
                 
Held-to-maturity securities:
               
Certificates of deposit
  $ 3,750.0     $ 3,100.0  
State or local agency obligations
    532.3       608.4  
U.S. government-sponsored enterprises
    67.1       176.7  
MBS
    6,001.9       6,597.3  
                 
Total held-to-maturity securities
    10,351.3       10,482.4  
                 
Total investment securities
  $ 14,286.0     $ 14,165.9  
                 
                 
 
The following table presents the maturity and yield characteristics for the investment securities portfolio as of June 30, 2010.
 
                 
(dollars in millions)   Book Value   Yield (%)
Trading securities:
               
Mutual funds offsetting deferred compensation
  $ 6.2       n/a  
U.S. Treasury bills
    1,029.8       0.29  
TLGP investments
    250.4       0.51  
                 
Total trading securities
  $ 1,286.4       0.33  
                 
                 
Available-for-sale securities:
               
Mutual funds partially securing supplemental retirement plan
  $ 2.0       n/a  
MBS
    2,646.3       5.39  
                 
Total available-for-sale securities
  $ 2,648.3       5.39  
                 
                 
Held-to-maturity securities:
               
Certificates of deposit
  $ 3,750.0       0.37  
State or local agency obligations:
               
Within one year
    71.6       5.89  
After one but within five years
    5.7       4.21  
After five years but within ten years
    10.1       0.50  
After ten years
    444.9       2.87  
                 
Total state or local agency obligations
  $ 532.3       3.25  
                 
                 
U.S. government-sponsored enterprises:
               
After five years but within ten years
    67.1       4.05  
                 
Total U.S. government-sponsored enterprises
    67.1       4.05  
                 
MBS
    6,001.9       2.92  
                 
Total held-to-maturity securities
  $ 10,351.3       2.02  
                 
                 
n/a – not applicable


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As of June 30, 2010, the Bank held securities from the following issuers with a book value greater than 10 percent of Bank total capital.
 
                 
    Total
  Total
(in millions)   Book Value   Fair Value
Government National Mortgage Association
  $ 1,795.2     $ 1,805.0  
J.P. Morgan Mortgage Trust
    1,223.1       1,205.6  
U.S. Treasury
    1,029.8       1,029.8  
Federal Home Loan Mortgage Corp. 
    898.1       940.5  
Wells Fargo Mortgage Backed Securities Trust
    697.1       671.0  
Federal National Mortgage Association
    635.9       647.9  
Structured Adjustable Rate Mortgage Loan Trust
    447.2       434.3  
                 
Total
  $ 6,726.4     $ 6,734.1  
                 
                 
 
During the third quarter of 2009, Taylor, Bean & Whitaker (TBW), a servicer on one of the Bank’s private label MBS filed for bankruptcy. There is now a replacement servicer on this security. The replacement servicer has provided monthly remittances related to 2010 activity. However, final remittances related to certain months in 2009, which had various reconciliation items because of issues with the original servicer, have not yet been determined by the replacement servicer.
 
For additional information on the credit risk of the investment portfolio, see “Credit and Counterparty Risk-Investments” 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.
 
Liabilities and Capital
 
Deposits.  At June 30, 2010, time deposits in denominations of $100 thousand or more totaled $500 thousand, all of which had a maturity of six to twelve months.
 
Commitment and Off-Balance Sheet Items.  At June 30, 2010, the Bank was obligated to fund approximately $417.3 million in additional advances, $27.3 million of mortgage loans and $7.0 billion in outstanding standby letters of credit, and to issue $169.0 million in consolidated obligations. The Bank does not consolidate any off-balance sheet special purpose entities or other 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. In accordance with the Finance Agency’s RBC regulations, when the Bank’s market value of equity to book value of equity falls below 85%, the Bank is required to provide for additional market RBC. In response to recent regulatory guidance, management has revised its Asset Classification Policy. This change may result in certain MBS being assigned a higher level of credit risk for reasons beyond a credit rating below investment grade. Management’s assessment as of June 30, 2010 indicated that this new guidance did not have a material impact with respect to required retained earnings levels. This assessment will be performed on an ongoing basis, so the impact on future periods could prove to be material.
 


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    Six Months Ended June 30,
(in millions)   2010   2009
Balance, beginning of the period
  $ 389.0     $ 170.5  
Cumulative effect of adoption of the amended OTTI guidance
    -       255.9  
Net income (loss)
    (58.3 )     8.5  
                 
Balance, end of the period
  $ 330.7     $ 434.9  
                 
                 
 
At June 30, 2010, retained earnings were $330.7 million, a decrease of $58.3 million from December 31, 2009. This decrease reflects the Bank’s net loss for the first six months of 2010. At June 30, 2009, retained earnings were $434.9 million, representing an increase of $264.4 million 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. Excluding the cumulative effect adjustment, retained earnings increased $8.5 million from prior year-end due to the Bank’s net income for the first six months of 2009.
 
Additional information regarding the amended OTTI guidance is available in the Critical Accounting Policies and Note 3 to the audited financial statements, both in the Bank’s 2009 Annual Report filed on Form 10-K. Further details of the components of required RBC are presented in the Capital Resources discussion in Management’s Discussion and Analysis in the quarterly report filed on this Form 10-Q. See Note 19 to the audited financial statements in the Bank’s 2009 Annual Report filed on Form 10-K for further discussion of 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 June 30, 2010, which should be read in conjunction with the unaudited interim financial conditions and notes included in the quarterly report filed on this Form 10-Q and the audited financial statements in the Bank’s 2009 Annual Report filed on Form 10-K.
 
Risk-Based Capital (RBC)
 
The Finance Agency’s RBC regulations require 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.
 
                         
    June 30,
  March 31,
  December 31,
(in millions)   2010   2010   2009
Permanent capital:
                       
Capital stock(1)
  $ 4,048.5     $ 4,043.4     $ 4,026.3  
Retained earnings
    330.7       398.9       389.0  
                         
Total permanent capital
  $ 4,379.2     $ 4,442.3     $ 4,415.3  
                         
                         
                         
RBC requirement:
                       
Credit risk capital
  $ 932.5     $ 909.2     $ 943.7  
Market risk capital
    649.3       1,042.7       1,230.8  
Operations risk capital
    474.6       585.5       652.4  
                         
Total RBC requirement
  $ 2,056.4     $ 2,537.4     $ 2,826.9  
                         
                         
Note:
 
(1) Capital stock includes mandatorily redeemable capital stock

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The Bank held excess permanent capital over RBC requirements of $2.3 billion, $1.9 billion and $1.6 billion at June 30, 2010, March 31, 2010 and December 31, 2009, respectively. The decline in the RBC requirement from December 31, 2009 was driven by lower market risk capital requirements due to narrowing mortgage credit spreads, resulting in an increase in fair values of the Bank’s private label MBS portfolio.
 
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. The Bank exceeded all regulatory capital requirements at June 30, 2010.
 
                         
    June 30,
  March 31,
  December 31,
(dollars in millions)   2010   2010   2009
Capital Ratio
                       
Minimum capital (4.0% of total assets)
  $ 2,425.2     $ 2,346.2     $ 2,611.6  
Regulatory capital (permanent capital plus loan loss reserves)
    4,379.3       4,442.3       4,415.4  
Total assets
    60,629.7       58,656.0       65,290.9  
Capital ratio (regulatory capital as a percent of total assets)
    7.2%       7.6%       6.8%  
                         
Leverage Ratio
                       
Minimum leverage capital (5.0% of total assets)
  $ 3,031.5     $ 2,932.8     $ 3,264.5  
Leverage capital (permanent capital multiplied by a 1.5 weighting factor plus loan loss reserves)
    6,568.9       6,663.4       6,623.1  
Leverage ratio (leverage capital as a percent of total assets)
    10.8%       11.4%       10.1%  
 
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. The percentages in effect at June 30, 2010 were 4.75%, 0.75% and 4.0% of member loans outstanding, unused borrowing capacity and Acquired Member Assets (AMA) activity, respectively.
 
Through a notice dated May 21, 2010, the Bank informed its members that modifications to the Bank’s Capital Plan had been approved and described the general effects of the modifications. The amended Capital Plan replaces the unused borrowing capacity membership stock purchase requirement, which was calculated quarterly and when a member borrowed from the Bank, with an annual Membership Asset Value stock purchase requirement based on the member’s prior December 31 call report data. This calculation is not affected by the amount the member borrows from the Bank. Membership assets include, but are not limited to, the following: U.S. Treasury securities; U.S. agency securities; U.S. agency MBS; nonagency MBS; 1-4 family residential first mortgage loans; multi-family mortgage loans; 1-4 family residential second mortgage loans; home equity lines of credit; and commercial real estate loans. A factor is applied to each membership asset category and the resulting Membership Asset Value is determined by summing the products of the membership asset categories and the respective factor. The Membership Asset Value capital stock requirement range is from 0.05% – 1.00%. All members will be required to fully transition to the amended Capital Plan by the first Membership Asset Value re-calculation date of April 10, 2011. The range of the capital stock requirement on advances has been expanded from 4.50% – 6.00% to 3.00% – 6.00%. The initial capital stock requirement under the amended Capital Plan for advances has been lowered from 4.75% to 4.60%. The range of the capital stock requirement on MPF loans sold to the Bank and put on its balance sheet has been expanded


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from 0.00% – 4.00% to 0.00% – 6.00%. The amended Capital Plan also introduces a new requirement on letters of credit. See the amended Capital Plan filed as Exhibit 4.1.1 to the quarterly report on this Form 10-Q.
 
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 temporarily suspended excess capital stock repurchases on a voluntary basis until further notice. At June 30, 2010 and December 31, 2009, excess capital stock held by the Bank’s stockholders totaled $1.4 billion and $1.2 billion, respectively. Under the updated Capital Plan, certain members did not have adequate capital stock. As noted above, these members will have until April 2011 to fully transition to the new requirements.
 
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 be outside of normal operating ranges as evidenced by their levels through June 30, 2010.
 
As previously mentioned, the Bank’s capital stock is owned by its members. The concentration of the Bank’s capital stock and the composition of the Bank’s membership by institution type are presented in the tables below.
 
                 
    June 30,
  December 31,
(dollars in millions)   2010   2009
Commercial banks
  $ 2,136.0     $ 2,151.7  
Thrifts
    1,798.8       1,797.6  
Credit unions
    57.6       57.0  
Insurance companies
    19.8       11.7  
                 
Total GAAP capital stock
    4,012.2       4,018.0  
Mandatorily redeemable capital stock
    36.3       8.3  
                 
Total capital stock
  $ 4,048.5     $ 4,026.3  
                 
 
                 
    June 30,
  December 31,
    2010   2009
Commercial banks
    197       197  
Thrifts
    92       92  
Credit unions
    24       24  
Insurance companies
    3       3  
                 
Total
    316       316  
                 
 
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 2009 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 Form 10-Q, provide information on how


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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 2009 Annual Report filed on Form 10-K:
•  Other-Than-Temporary Impairment Assessments for Investment Securities*
•  Fair Value Calculations and Methodologies
•  Accounting for Derivatives
•  Advances and Related Allowance for Credit Losses
•  Guarantees and Consolidated Obligations
•  Accounting for Premiums and Discounts on Mortgage Loans and MBS
•  Allowance for Credit Losses on Banking on Business Loans
•  Allowance for Credit Losses on Mortgage Loans Held for Portfolio
•  Future REFCORP Payments
 
*The critical accounting policies in the Bank’s 2009 Annual Report filed on Form 10-K includes discussion regarding the impact of the amended OTTI guidance issued by the FASB during April 2009 and adopted by the Bank effective January 1, 2009. The Bank’s 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 in AOCI.
 
The Bank did not implement any material changes to its accounting policies or estimates, nor did the Bank implement any new accounting policies that had a material impact on the Bank’s Statement of Operations and Statement of Condition for the six months ended June 30, 2010.
 
Recently Issued Accounting Standards and Interpretations.  See Note 2 to the unaudited financial statements in Item 1. Financial Statements and Supplementary Financial Data in the quarterly report filed on this Form 10-Q for a discussion of recent accounting pronouncements that are relevant to the Bank’s businesses.
 
The FASB has proposed Accounting for Financial Instruments and Revisions to the Accounting for Derivative Instruments and Hedging Activities Exposure Draft (FI ED). Although only proposed at this time and not expected to be finalized until the first half of 2011, the FI ED is expected to have a material impact on the Bank’s Statements of Operations, Condition, and Changes in Capital. In addition, the FI ED, as proposed, is expected to significantly change all of the Bank’s Critical Accounting Policies except for Guarantees and Consolidated Obligations and Future REFCORP Payments. At this time, the Bank is continuing to evaluate the FI ED and monitor its status.
 
Legislative and Regulatory Developments
 
Legislation
 
Financial Regulatory Reform – The Dodd-Frank Act.  On July 21, 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) was enacted. The Dodd-Frank Act, among other things: (1) creates an inter-agency oversight council that will identify and regulate systemically important financial institutions; (2) regulates the over-the-counter derivatives market; (3) imposes new executive compensation proxy and disclosure requirements; (4) establishes new requirements, including a risk-retention requirement, for MBS; (5) reforms the credit rating agencies; (6) makes a number of changes to the federal deposit insurance system; and (7) creates a consumer financial protection agency. The FHLBanks’ business operations, funding costs, rights, obligations, and/or the environment in which FHLBanks carry out their housing-finance mission may be affected by the Dodd-Frank Act.
 
The change in the federal deposit insurance assessment methodology may result in reductions in advance demand. Regulations on the over-the-counter derivatives market that may be issued under the Dodd-Frank Act


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could materially affect an FHLBank’s ability to hedge its interest rate risk exposure from advances, achieve the FHLBank’s risk management objectives, act as an intermediary between its members and counterparties and may increase Bank funding costs and the costs of advances. For example, under the derivatives regulation portion of the Dodd-Frank, if an FHLBank is considered to be a “major swap participant,” it will be required to trade certain of its standardized derivatives transactions through an exchange and clear those transactions through a centralized clearing house, and it will be subject to additional swap-based capital and margin requirements. In addition, all derivatives transactions not subject to exchange trading or centralized clearing will also be subject to additional margin requirements, and all derivatives transactions will be subject to new reporting requirements. Furthermore, if the FHLBanks are identified as being systemically important financial institutions under the Dodd-Frank Act, they would be subject to heightened prudential standards established by the Federal Reserve Board. These standards include, at minimum, risk-based capital requirements, liquidity requirements and risk management. Other standards could encompass such matters as a requirement to issue contingent capital instruments, additional public disclosures, and limits on short-term debt. The Dodd-Frank Act also requires systemically important financial institutions to report to the Federal Reserve on the nature and extent of their credit exposures to other significant companies and undergo semi-annual stress tests. Under the Volcker Rule provision in the Dodd-Frank Act, such institutions are subject to higher capital requirements and quantitative limits with regard to their proprietary trading. The Dodd-Frank Act also makes a number of changes to the federal deposit insurance program. It: (1) requires the FDIC to base future assessments for deposit insurance on the amount of assets held by an institution, instead of on the amount of deposits that institution holds; (2) permanently increases deposit insurance coverage to $250,000; (3) increases the reserve ratio for the FDIC insurance fund, which will cause an increase in the assessments imposed on federally-insured institutions; and (4) requires insured depository institutions with assets of $10 billion or more to pay an additional deposit insurance assessment. The Dodd-Frank Act may provide an incentive for some members of the FHLBanks to hold more deposits than they would if non-deposit liabilities were not a factor in determining an institution’s deposit insurance assessments.
 
In addition, the U.S. Treasury and the Department of Housing and Urban Development are developing recommendations regarding the future of the housing GSEs, including the FHLBanks. The Administration is expected to unveil its plan for GSE reform that will likely impact the FHLBanks at the end of 2010.
 
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 June 30, 2010, the Bank had 69 private label MBS with a par value of $3.4 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.


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Regulations
 
Final Regulation Regarding Restructuring the Office of Finance.  On May 3, 2010, the Finance Agency issued a final regulation restructuring the Office of Finance’s board of directors, which became effective on June 2, 2010. Among other things, the regulation: (1) increases the size of the board such that it will be comprised of the twelve FHLBank presidents and five independent directors; (2) creates an audit committee; (3) provides for the creation of other committees; (4) sets a method for electing independent directors along with setting qualifications for these directors; and (5) provides that the method of funding the Office of Finance and allocating its expenses among the FHLBanks shall be as determined by policies adopted by the board of directors. The newly-created audit committee will be comprised solely of the five independent directors and will be charged with oversight of greater consistency in accounting policies and procedures among the FHLBanks. On July 9, 2010 the Finance Agency issued an order appointing the initial five independent directors of the reconstituted Office of Finance board of directors. The newly-created audit committee will be comprised solely of the five independent directors and will be charged with oversight of greater consistency in accounting policies and procedures among the FHLBanks related to the combined financial reports published by the OF.
 
Proposed Finance Agency Regulation on Conservatorship and Receivership.  On July 9, 2010, the Finance Agency issued a proposed regulation on the conservatorship and receivership of Fannie Mae, Freddie Mac and the FHLBanks that would set forth the basic authorities of the Finance Agency as conservator or receiver, including the enforcement and repudiation of contracts; establish procedures for conservators and receivers and priorities of claims for contract parties and other claimants; and address whether and to what extent claims by current and former holders of equity interests in the regulated entities will be paid. The Bank cannot predict when a final regulation will be issued.
 
Proposed Finance Agency Regulation on FHLBank Housing Goals.  On May 28, 2010, the Finance Agency issued a proposed regulation with a comment deadline of July 12, 2010 that would establish certain housing acquisition goals and related counting and reporting rules for FHLBanks that purchase in excess of $2.5 billion in unpaid principal balance of AMA program (such as MPF) eligible mortgage loans per year. FHLBanks that exceed the $2.5 billion threshold would be assigned market-based, low-income families, low-income housing, very low income families, and refinancing mortgage purchase goals. Participations in mortgage loans do not count toward satisfaction of mortgage purchase goals; the actual acquiring FHLBank receives the credit. FHLBanks that do not satisfy their housing goals are subject to Finance Agency enforcement. The Bank cannot predict when a final regulation will be issued but does not currently purchase AMA eligible mortgage loans in an amount that would be sufficient to subject the Bank to the proposed regulation’s threshold of applicability.
 
Proposed Finance Agency Regulation on FHLBank Investments.  On May 4, 2010, the Finance Agency issued a proposed regulation with a comment deadline of July 6, 2010 that, among other things, requests comment on whether additional limitations on an FHLBank’s MBS investments, including its private label MBS investments, should be adopted as part of a final regulation and whether, for private label MBS investments, such limitations should be based on an FHLBank’s level of retained earnings.
 
Proposed Finance Agency Regulation on Enforcement Proceedings.  On August 4, 2010 the Finance Agency announced that it is issuing a Notice of Proposed Rulemaking to the Federal Register on Rules of Practice and Procedure to address procedural and related rules for enforcement proceedings. The proposed rule implements the stronger cease and desist and civil money penalty provisions of the Housing Act. Comments on the proposal are due 60 days after publication in the Federal Register.
 
Final Rule–Extension of FDIC Transaction Account Guarantee (TAG) Program.  On June 28, 2010, the FDIC published in the Federal Register a final rule extending the TAG program to December 31, 2010 for banks currently participating in the program. The TAG program provides FDIC insurance for all funds held at participating banks in qualifying noninterest-bearing transaction accounts. The final rule also allows the FDIC to further extend the TAG program without further rulemaking, for a period of time not to exceed December 31, 2011, upon a determination by the FDIC that continuing economic difficulties warrant the extension.


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Proposed Regulation on FDIC Assessments.  On May 3, 2010, the FDIC issued a proposed regulation with a comment deadline of July 2, 2010 to revise the assessment system applicable to financial institutions that would, among other things, revise the initial base assessment rates for all insured depository institutions. The FDIC’s proposed regulation would not change the assessment rates for FHLBank advances unless an institution’s secured liabilities exceed 25 percent of its domestic deposits. Accordingly, increases in the assessment rates for impacted members may have a negative impact on their demand for the FHLBanks’ advances to their members.
 
Money Market Fund Reform.  On March 4, 2010, the SEC published a final rule, amending the rules governing money market funds under the Investment Company Act. These amendments resulted in tightened liquidity requirements, such as: maintaining certain financial instruments for short-term liquidity; reducing the maximum weighted-average maturity of portfolio holdings and improving the quality of portfolio holdings. The final rule includes overnight FHLBank consolidated discount notes in the definition of “daily liquid assets” and “weekly liquid assets” and will encompass FHLBank consolidated discount notes with remaining maturities of up to 60 days in the definition of “weekly liquid assets.” These provisions reflect changes to the SEC’s proposed rule that would have excluded certain FHLBank consolidated discount notes, other than overnight FHLBank consolidated discount notes, from the definition of both “daily liquid assets” and “weekly liquid assets.” The final rule’s requirements became effective on May 5, 2010 unless another compliance date is specified for a requirement (e.g., daily and weekly liquidity requirements became effective on May 28, 2010).
 
U.S. Treasury Department’s Financial Stability Plan.  On March 23, 2009, in accordance with the U.S. Treasury’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 U.S. Treasury announced the initial closings of two Public Private Investment Funds established under PPIP to purchase legacy securities. Through June 30, 2010 the market value of the PPIP residential MBS transactions executed was $13.5 billion. The PPIP’s activities in purchasing such residential MBS could affect the values of residential MBS.
 
Risk Management
 
Financial and housing markets have experienced volatility over 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. Despite 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. High unemployment, modest income growth, lower housing wealth, and tight credit have restricted household spending. Financial conditions have become less supportive of economic growth on balance, largely reflecting developments abroad. Given the uncertainty in the mortgage markets, MBS continue to be subject to various rating agency downgrades. However, liquidity and credit spreads have begun to recover, as evidenced in improvement in the Bank’s Market Value of Equity to Par Value of Capital Stock ratio, described in detail below. Central banks, including the Federal Reserve and the European Central Bank, have sought to prevent a serious and extended economic downturn resulting from these and other market difficulties by making significant interest rate reductions and taking other actions to free up credit.
 
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 2009 Annual Report filed on Form 10-K. Additionally, the Bank has outstanding credit exposures related to the MPF Program and investments in


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private label MBS, which are affected by the mortgage market deterioration. All of these risk exposures are continually monitored and are discussed in more detail in the following sections.
 
For further information regarding the financial and residential markets in the first six months of 2010, see the “Current Financial and Mortgage Markets and Trends” discussion in the Overview section of this Item 2. Management’s Discussion and Analysis in the quarterly report filed on this 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 2009 Annual Report filed on Form 10-K.
 
During first quarter 2010, the Board, with the support of management, conducted an evaluation of the Bank’s risk appetite. This included updates/changes to the Board level risk metrics being used to monitor the Bank’s risk position. Information regarding the new and/or revised metrics is included in each relevant discussion in more detail below.
 
Capital Adequacy Measures.  During 2008 and 2009, the Bank’s overarching capital adequacy metric was the Projected Capital Stock Price (PCSP). The PCSP was calculated using risk components for interest rates, spread, credit, operating and accounting risk. The sum of these components represented an estimate of projected capital stock price variability and was used in evaluating the adequacy of retained earnings and developing dividend payout recommendations to the Board. The Board had established a PCSP floor of 85% and a target of 95%. The difference between the actual PCSP and the floor or target, if any, represented 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.
 
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. In response to these unprecedented market developments, 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.
 
The following table presents the Bank’s PCSP calculation under the provisions of the Risk Governance Policy through December 31, 2009. 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    
December 31, 2009
      34.1%         68.4%         85%         95%      
                                             
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%      
                                             
 
As a part of the risk appetite evaluation previously mentioned, the Board and management reviewed the PCSP calculation. Given the uncertainty in the credit markets, reflected in current market values, the PCSP calculation became less meaningful in terms of assessing Bank risk. As a result, the Bank transitioned from using the PCSP metric and replaced it with a new key risk indicator – Market Value of Equity to Par Value of Capital Stock (MV/CS) – beginning in first quarter 2010. The risk metric is used to evaluate the adequacy of retained earnings and


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develop dividend payment recommendations. The metric also provides a current assessment of fair value of the balance sheet on a liquidation basis.
 
An initial floor of 85% was established for MV/CS. The floor represents the estimated level from which the MV/CS would recover to par, through the retention of retained earnings, over the five-year par put redemption period of the Bank’s capital stock. MV/CS will be measured against the floor monthly. When MV/CS is below the established floor, excess capital stock repurchases and dividend payouts will be restricted. When MV/CS is above the established floor, additional analysis of the adequacy of retained earnings will be performed, taking into consideration the impact of excess capital stock repurchases and/or dividend payouts.
 
The following table presents the MV/CS calculations for June 30, 2010, as well as the previous four quarters.
 
           
      MV/CS
June 30, 2010
      87.1 %
           
March 31, 2010
      80.7 %
           
December 31, 2009
      74.4 %
           
September 30, 2009
      66.6 %
           
June 30, 2009
      48.5 %
           
 
During first quarter 2010, the change in the MV/CS was primarily due to narrower mortgage spreads, which drove fair values higher, principal paydowns on private label MBS and lower longer term interest rates and volatility. There was marked improvement in the MV/CS calculation in the second quarter of 2010. This improvement was driven by the overall increase in the prices on the private label MBS portfolio, as well as principal paydowns on the portfolio and additional declines in longer term interest rates.
 
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. The unprecedented private label mortgage credit spreads have significantly reduced the Bank’s net market value.
 
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 June 30, 2010, mortgage assets totaled 22.3% 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 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.  The Bank employs an Earnings-at-Risk framework for certain mark-to-market positions, including economic hedges. This framework establishes 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. Beginning in the fourth


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quarter of 2009, the rate shocks used to measure the Earnings-at-Risk Board-level metric were expanded to include flattening and steepening scenarios.
 
In February 2010, the Board updated the daily exposure limit to $2.4 million, compared to the previous limit of $2.5 million. The Bank’s Asset and Liability Committee (ALCO) has a more restrictive daily exposure operating guideline of $2.0 million. Throughout the second quarter of 2010, the daily forward-looking exposure was below the operating guidelines of $2.0 million and at June 30, 2010 measured $350 thousand. The Bank’s Capital Markets and Corporate Risk Management departments 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. One of the most critical market-based model assumptions relates to the prepayment of principal on mortgage-related instruments, which was upgraded in 2009 and the first and second quarters of 2010 to more accurately reflect expected prepayment behavior.
 
In recognition of the importance of the accuracy and reliability of the valuation of financial instruments, management engages in an ongoing internal review of model valuations for various instruments. These valuations are evaluated on a quarterly basis to confirm the reasonableness of the valuations. The Bank regularly validates the models used to generate fair values. The verification and validation procedures depend on the nature of the instrument and valuation methodology being reviewed and may include comparisons with observed trades or other sources and independent verification of key model inputs. Results of the quarterly verification process, as well as any changes in valuation methodologies, are reported to ALCO, which is responsible for reviewing and approving the approaches used in the valuation to ensure that they are well controlled and effective, and result in reasonable fair values.
 
The duration of equity, return volatility and market value of equity volatility metrics were historically the direct primary metrics used by the Bank to manage its interest rate risk exposure. As discussed above, in first quarter 2010 the Bank re-evaluated its risk appetite, which included review and, when necessary, revisions and/or replacements of the primary market risk metrics. As a result, the return volatility metric was renamed as the Earned Dividend Spread (EDS) Floor and a new key risk indicator, EDS Volatility, was established. The Bank’s asset/liability management policies specify acceptable ranges for duration of equity, EDS Floor and EDS Volatility, and the Bank’s exposures are measured and managed against these limits. These metrics are described in more detail below.
 
During the first quarter of 2010, the Bank established measures of refunding and reset risk which measures the income exposure associated with an increase in funding spreads and differences in the timing of floating rate asset and liability rate resets. In the second quarter of 2010, ALCO established operating guidelines for both measures that will be monitored on a monthly basis.
 
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 designe