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EX-99.2 - EXHIBIT 99.2 - Federal Home Loan Bank of Topekaex123117992.htm
EX-99.1 - EXHIBIT 99.1 - Federal Home Loan Bank of Topekaex123117991.htm
EX-32 - EXHIBIT 32 - Federal Home Loan Bank of Topekaex12311732.htm
EX-31.2 - EXHIBIT 31.2 - Federal Home Loan Bank of Topekaex123117312.htm
EX-31.1 - EXHIBIT 31.1 - Federal Home Loan Bank of Topekaex123117311.htm
EX-24.1 - EXHIBIT 24.1 - Federal Home Loan Bank of Topekaex123117241.htm
EX-14.1 - EXHIBIT 14.1 - Federal Home Loan Bank of Topekaex123117141.htm
EX-12.1 - EXHIBIT 12.1 - Federal Home Loan Bank of Topekaex123117121.htm
EX-10.25 - EXHIBIT 10.25 - Federal Home Loan Bank of Topekaex1231171025.htm
EX-10.24 - EXHIBIT 10.24 - Federal Home Loan Bank of Topekaex1231171024.htm
EX-10.23 - EXHIBIT 10.23 - Federal Home Loan Bank of Topekaex1231171023.htm
EX-10.2.4 - EXHIBIT 10.2.4 - Federal Home Loan Bank of Topekaex123117102_4.htm
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C.  20549
 
FORM 10-K
 
x      ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2017
 
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 000-52004
 
FEDERAL HOME LOAN BANK OF TOPEKA
(Exact name of registrant as specified in its charter)
 
Federally chartered corporation
 
48-0561319
(State or other jurisdiction of
incorporation or organization)
 
(I.R.S. Employer
Identification No.)
 
500 SW Wanamaker Road
Topeka, KS
 
 
66606
(Address of principal executive offices)
 
(Zip Code)
 
Registrant’s telephone number, including area code: 785.233.0507

Securities registered pursuant to Section 12(b) of the Act: None

Securities registered pursuant to Section 12(g) of the Act:
Class A Common Stock, $100 per share par value

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  ¨ Yes  x No

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  ¨ Yes  x No

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  x Yes  ¨ 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 (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  x  Yes  ¨  No
 
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  x

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and emerging growth company” in Rule 12b-2 of the Exchange Act.
¨ Large accelerated filer  ¨ Accelerated filer  x Non-accelerated filer  ¨ Smaller reporting company  ¨ Emerging growth company
 
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).  ¨ Yes  x No
 
Indicate the number of shares outstanding of each of the registrant’s classes of common stock, as of the latest practicable date.
 
 
Shares outstanding as of
March 13, 2018
Class A Stock, par value $100 per share
2,383,024
Class B Stock, par value $100 per share
14,952,521

Registrant’s common stock is not publicly traded and is only issued to members of the registrant. Such stock is issued, redeemed and repurchased at par value, $100 per share, with all issuances, redemptions and repurchases subject to the registrant’s capital plan as well as certain statutory and regulatory requirements. As of June 30, 2017, the aggregate par value of stock held by current and former members of the registrant was $1,439,805,500, and 14,398,055 total shares were outstanding as of that date.

Documents incorporated by reference:  None





.FEDERAL HOME LOAN BANK OF TOPEKA
TABLE OF CONTENTS
PART I 
 
Item 1.
Business
Item 1A.
Risk Factors
Item 1B.
Unresolved Staff Comments
Item 2.
Properties
Item 3.
Legal Proceedings
Item 4.
Mine Safety Disclosures
PART II
 
Item 5.
Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Item 6.
Selected Financial Data
Item 7.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 7A.
Quantitative and Qualitative Disclosures About Market Risk
Item 8.
Financial Statements and Supplementary Data
Item 9.
Changes in and Disagreements With Accountants on Accounting and Financial Disclosure
Item 9A.
Controls and Procedures
Item 9B.
Other Information
PART III
 
 
Item 10.
Directors, Executive Officers and Corporate Governance
Item 11.
Executive Compensation
Item 12.
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
Item 13.
Certain Relationships and Related Transactions, and Director Independence
Item 14.
Principal Accounting Fees and Services
PART IV
 
 
Item 15.
Exhibits, Financial Statement Schedules
Item 16.
Form 10-K Summary




Important Notice about Information in this Annual Report

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

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

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

Special Cautionary Notice Regarding Forward-looking Statements

The information in this Form 10-K contains forward-looking statements within the meaning of the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements include statements describing the objectives, projections, estimates or future predictions of the FHLBank’s operations. These statements may be identified by the use of forward-looking terminology such as “anticipates,” “believes,” “may,” “is likely,” “could,” “estimate,” “expect,” “will,” “intend,” “probable,” “project,” “should,” or their negatives or other variations of these terms. The FHLBank cautions that by their nature forward-looking statements involve risks or uncertainties and that actual results may differ materially from those expressed in any forward-looking statements as a result of such risks and uncertainties, including but not limited to:
Governmental actions, including legislative, regulatory, judicial or other developments that affect the FHLBank; its members, counterparties or investors; housing government-sponsored enterprises (GSE); or the FHLBank System in general;
Changes in the FHLBank’s capital structure;
Changes in economic and market conditions, including conditions in our district and the U.S. and global economy, as well as the mortgage, housing and capital markets;
Changes in demand for FHLBank products and services or consolidated obligations of the FHLBank System;
Effects of derivative accounting treatment and other accounting rule requirements, or changes in such requirements;
The effects of amortization/accretion;
Gains/losses on derivatives or on trading investments and the ability to enter into effective derivative instruments on acceptable terms;
Volatility of market prices, interest rates and indices and the timing and volume of market activity;
Membership changes, including changes resulting from member failures or mergers, changes due to member eligibility, or changes in the principal place of business of members;
Our ability to declare dividends or to pay dividends at rates consistent with past practices;
Soundness of other financial institutions, including FHLBank members, non-member borrowers, counterparties, and the other FHLBanks;
Changes in the value or liquidity of collateral underlying advances to FHLBank members or non-member borrowers or collateral pledged by reverse repurchase and derivative counterparties;
Competitive forces, including competition for loan demand, purchases of mortgage loans and access to funding;
The ability of the FHLBank to introduce new products and services to meet market demand and to manage successfully the risks associated with all products and services;
The ability of the FHLBank to keep pace with technological changes and the ability to develop and support technology and information systems, including the ability to securely access the internet and internet-based systems and services, sufficient to effectively manage the risks of the FHLBank’s business;
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 FHLBank has joint and several liability;
Changes in the U.S. government’s long-term debt rating and the long-term credit rating of the senior unsecured debt issues of the FHLBank System;
Changes in the fair value and economic value of, impairments of, and risks associated with, the FHLBank’s investments in mortgage loans and mortgage-backed securities (MBS) or other assets and related credit enhancement protections; and
The volume and quality of eligible mortgage loans originated and sold by participating members to the FHLBank through its various mortgage finance products (Mortgage Partnership Finance® (MPF®) Program). “Mortgage Partnership Finance,” “MPF,” and “MPF Xtra” are registered trademarks of the FHLBank of Chicago.

Readers of this report should not rely solely on the forward-looking statements and should consider all risks and uncertainties addressed throughout this report, as well as those discussed under Item 1A – “Risk Factors.”


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All forward-looking statements contained in this Form 10-K are expressly qualified in their entirety by reference to this cautionary notice. The reader should not place undue reliance on such forward-looking statements, since the statements speak only as of the date that they are made and the FHLBank has no obligation and does not undertake publicly to update, revise or correct any forward-looking statement for any reason to reflect events or circumstances after the date of this report.

PART I

Item 1: Business

General
One of 11 FHLBanks, FHLBank Topeka is a federally chartered corporation organized on October 13, 1932 under the authority of the Federal Home Loan Bank Act of 1932, as amended (Bank Act). Our primary business is making collateralized loans and providing other banking services to member institutions (members) and certain qualifying non-members (housing associates). We are a cooperative owned by our members and are generally limited to providing products and services only to those members. Each FHLBank operates as a separate corporate entity with its own management, employees, and board of directors. We are exempt from federal, state, and local taxation, except for real property taxes. We do not have any wholly- or partially-owned subsidiaries and do not have an equity position in any partnerships, corporations, or off-balance sheet special purpose entities.

We are supervised and regulated by the Federal Housing Finance Agency (FHFA), an independent agency in the executive branch of the U.S. government. The FHFA’s mission is to ensure that the housing GSEs operate in a safe and sound manner so that they serve as a reliable source of liquidity and funding for housing finance and community investment.

Any federally insured depository institution, insurance company, or community development financial institution (CDFI) certified by the CDFI fund, whose principal place of business is located in Colorado, Kansas, Nebraska, or Oklahoma is eligible to become one of our members. Except for community financial institutions (CFIs), applicants for membership must demonstrate they are engaged in residential housing finance or otherwise support our housing mission, and have a significant business presence in our district. CFIs are defined in the Housing and Economic Recovery Act of 2008 (Recovery Act) as those institutions that have, as of the date of the transaction at issue, less than a specified amount of average total assets over the three years preceding that date (subject to annual adjustment by the FHFA director based on the consumer price index). For 2017, this asset cap was $1.1 billion.

Our members are required to purchase and hold our capital stock as a condition of membership, and only members are permitted to purchase capital stock. All capital stock transactions are governed by our capital plan, which was developed under, is subject to, and operates within specific regulatory and statutory requirements.

Member institutions own nearly all of our outstanding capital stock and may receive dividends on that stock. Former members own capital stock as long as they have outstanding business transactions with us. A member must own an amount of capital stock in the FHLBank based on the member’s total assets, and each member may be required to purchase activity-based capital stock as it engages in certain business activities with the FHLBank, including advances and Acquired Member Assets (AMA). As a result of these stock purchase requirements, we conduct business with related parties in the normal course of business. For disclosure purposes, we include in our definition of a related party any member institution (or successor) that is known to be the beneficial owner of more than five percent of any class of our voting stock and any person who is, or at any time since the beginning of our last fiscal year (January 1) was, one of our directors or executive officers, among others. Information on business activities with related parties is provided in Tables 86 and 87 under Item 12 – “Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.”

Our business activities include providing collateralized loans, known as advances, to members and housing associates, and acquiring residential mortgage loans from members. By law, only certain general categories of collateral are eligible to secure FHLBank obligations. We also provide members and housing associates with letters of credit and certain correspondent services, such as safekeeping, wire transfers, and cash management.

FHFA regulations require that our strategic business plan describes how our business activities will achieve our mission, consistent with the FHFA’s core mission asset (CMA) guidance. Our strategic business plan includes a balance sheet management strategy consistent with this guidance, which includes emphasis on the issuance of advances and acquisition of member mortgage loans through the MPF Program. Our ratio of average advances and average mortgage loans to average consolidated obligations (CMA ratio) utilizing par balances as outlined in our strategic plan was 77 percent as of December 31, 2017. We generally intend to maintain the CMA ratio within the range of 70 to 80 percent, which exceeds the FHFA's recommended minimum ratio of 70 percent utilizing par balances. However, because this ratio is dependent on several variables, such as member demand for our advance and mortgage loan products, it is possible that we may be unable to maintain the ratio at this level indefinitely.


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Our primary funding source is consolidated obligations issued through the FHLBanks’ Office of Finance. The Office of Finance is a joint office of the FHLBanks that facilitates the issuance and servicing of the consolidated obligations. The FHFA and the U.S. Secretary of the Treasury oversee the issuance of all FHLBank debt. Consolidated obligations are debt instruments that constitute the joint and several obligations of all FHLBanks. Although consolidated obligations are not obligations of, nor guaranteed by, the U.S. government, the capital markets have traditionally viewed the FHLBanks’ consolidated obligations as “Federal agency” debt. As a result, the FHLBanks have historically had ready access to funding at relatively favorable spreads to U.S. Treasuries. Additional funds are provided by deposits (received from both member and non-member financial institutions), other borrowings and the issuance of capital stock.

Standard & Poor’s (S&P) and Moody’s Investor Service (Moody’s) base their ratings of the FHLBanks and the debt issues of the FHLBank System in part on the FHLBanks’ relationship with the U.S. government. S&P currently rates the long-term credit ratings on the senior unsecured debt issues of the FHLBank System and all FHLBanks (including FHLBank Topeka) at AA+. S&P rates all FHLBanks and the FHLBank System’s short-term debt issues at A-1+. S&P’s rating outlook for the FHLBank System’s senior unsecured debt and all FHLBanks is stable. Moody’s has affirmed the long-term Aaa rating on the senior unsecured debt issues of the FHLBank System and the FHLBanks and a short-term issuer rating of P-1, with a rating outlook of stable for senior unsecured debt.

Business Segments
We do not currently manage or segregate our operations by business or geographical segment.

Advances
We make advances to members and housing associates based on the value of the security of their residential mortgages and other eligible collateral. A brief description of our standard advance product offerings is as follows:
Line of credit advances are variable rate, non-amortizing, prepayable, revolving line products that provide an alternative to the purchase of Federal funds, brokered deposits or repurchase agreement borrowings;
Short-term fixed rate advances are non-amortizing, non-prepayable loans with terms to maturity from 3 to 93 days;
Regular fixed rate advances are non-amortizing loans, prepayable potentially with a fee, with terms to maturity from 94 days to 360 months;
Symmetrical fixed rate advances are non-amortizing loans with terms to maturity from 94 days to 360 months, prepayable with a fee, but the borrower also has the contractual ability to realize a gain from the market movement of interest rates upon prepayment;
Adjustable rate advances are non-amortizing loans with terms to maturity from 4 to 180 months, which are: (1) prepayable with a fee on interest rate reset dates, if the variable interest rate is tied to any one of a number of standard indices including the London Interbank Offered Rate (LIBOR), Treasury bills, Federal funds, or U.S. Prime; or (2) prepayable without a fee if the variable interest rate is tied to one of our short-term fixed rate advance products;
Callable advances can have a fixed or variable rate of interest for the term of the advance and contain an option(s) that allows for the prepayment of the advance without a fee on specified dates, with terms to maturity of 12 to 360 months for fixed rate loans or terms to maturity of 4 to 180 months for variable rate loans;
Amortizing advances are fixed rate loans with terms to maturity of 12 to 360 months, prepayable with a fee, that contain a set of predetermined principal payments to be made during the life of the advance;
Convertible advances are non-amortizing, fixed rate loans with terms to maturity of 12 to 180 months that contain an option(s) that allows us to convert the fixed rate advance to a prepayable, adjustable rate advance that re-prices monthly based upon our one-month short-term, fixed rate advance product. Once we exercise our option to convert the advance, it can be prepaid without a fee on the initial conversion date or on any interest rate reset date thereafter;
Forward settling advance commitments lock in the rate and term of future funding of regular and amortizing fixed rate advances up to 24 months in advance;
Member option advances are fixed rate advances with terms from 12 to 360 months that provide the member with an option to prepay without a fee at specific intervals throughout the life of the advance and are issued at a discount to reflect the cost of that option;
Structured advances are other advance types (e.g., regular fixed rate, callable, amortizing or adjustable rate) with terms from 12 to 180 months with an embedded interest rate cap, floor, or collar; and
Standby credit facilities are variable rate, non-amortizing, prepayable, revolving standby credit lines that provide the ability to draw advances after normal cutoff times.

Customized advances may be created on request, including advances with embedded interest rate floors and caps. All embedded derivatives in customized advances are evaluated to determine whether they are clearly and closely related to the advances. See Notes 1 and 8 in the Notes to Financial Statements under Item 8 for information on accounting for embedded derivatives. The types of derivatives used to hedge risks embedded in our advance products are indicated in Tables 61 and 62 under Item 7A – “Quantitative and Qualitative Disclosures About Market Risk – Interest Rate Risk Management.”


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We also offer a variety of specialized advance products to address housing and community development needs. The products include advances priced at our cost of funds plus reasonable administrative expenses. These advance products address needs for low-cost funding to create affordable rental and homeownership opportunities, and for commercial and economic development activities, including those that benefit low- and moderate-income neighborhoods. Refer to Item 1 – “Business – Other Mission-Related Activities” for more details.

In addition to members, we also make advances to housing associates. To qualify as a housing associate, the applicant must: (1) be approved under Title II of the National Housing Act of 1934; (2) be a chartered institution having succession; (3) be subject to the inspection and supervision of some governmental agency; (4) lend its own funds as its principal activity in the mortgage field; and (5) have a financial condition that demonstrates that advances may be safely made. Housing associates are not subject to certain provisions of the Bank Act that are applicable to members, such as the capital stock purchase requirements, but the same regulatory lending requirements generally apply to them as apply to members. Restrictive collateral provisions apply if the housing associate does not qualify as a state housing finance agency (HFA). We currently have three housing associates who are customers and all three are state HFAs.

At the time an advance is originated, we are required to obtain and then to maintain a security interest in sufficient collateral of the borrower, which is eligible in one or more of the following categories:
Fully disbursed, whole first mortgages on 1-4 family residential property or securities representing a whole interest in such mortgages;
Securities issued and guaranteed or insured by the U.S. government, U.S. government agencies and mortgage GSEs including, without limitation, MBS issued or guaranteed by Federal National Mortgage Association (Fannie Mae), Federal Home Loan Mortgage Corporation (Freddie Mac) or Government National Mortgage Association (Ginnie Mae);
Cash or deposits in an FHLBank;
Other acceptable real estate-related collateral, provided such collateral has a readily ascertainable market value and we can perfect a security interest in such property (e.g., privately issued collateralized mortgage obligations (CMOs), mortgages on multifamily residential real property, second mortgages on 1-4 family residential property, mortgages on commercial real estate); or
In the case of any CFI, secured loans to small business, small farm and small agri‑business or securities representing a whole interest in such secured loans.

As additional security for a member’s indebtedness, we have a statutory lien on that member’s FHLBank stock. Additional collateral may be required to secure a member’s or housing associate’s outstanding credit obligations at any time (whether or not such collateral would be eligible to originate an advance), at our discretion.

The Bank Act affords any security interest granted to us by any of our members, or any affiliate of any such member, priority over the claims and rights of any party, including any receiver, conservator, trustee, or similar party having rights of a lien creditor. The only exceptions are claims and rights held by actual bona fide purchasers for value or by parties that are secured by actual perfected security interests, and provided that such claims and rights would otherwise be entitled to priority under applicable law. In addition, our claims are given certain preferences pursuant to the receivership provisions in the Federal Deposit Insurance Act. Most members provide us a blanket lien covering substantially all of the member’s assets and consent for us to file a financing statement evidencing the blanket lien. Based on the blanket lien, the financing statement and the statutory preferences, we normally do not take control of collateral, other than securities collateral, pledged by blanket lien borrowers. We take control of all securities collateral through delivery of the securities to us or to an approved third-party custodian. With respect to non-blanket lien borrowers (typically insurance companies, CDFIs, and housing associates), we take control of all collateral. If the financial condition of a blanket lien member warrants such action because of the deterioration of the member’s financial condition, regulatory concerns about the member or other factors, we will take control of sufficient collateral intended to fully collateralize the member’s indebtedness to us.

Table 11 under Item 7 – "Management’s Discussion and Analysis of Financial Condition and Results of Operations – Results of Operations" presents the amount of total interest income contributed by our advance products. Tables 27 and 28 under Item 7 – “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Financial Condition” present information on our five largest borrowers as of December 31, 2017 and 2016 and the accrued interest income associated with the five borrowers providing the highest amount of interest income for the years ended December 31, 2017 and 2016.

Mortgage Loans
We purchase various residential mortgage loan products from participating financial institutions (PFIs) under the MPF Program, a secondary mortgage market structure created and maintained by FHLBank of Chicago. Under the MPF Program, we invest in qualifying 5- to 30-year conventional conforming and government-guaranteed or -insured (by the Federal Housing Administration (FHA), the Department of Veterans Affairs (VA), the Rural Housing Service of the Department of Agriculture (RHS) and the Department of Housing and Urban Development (HUD)) fixed rate mortgage loans on 1-4 family residential properties. These portfolio mortgage products, along with residential loans sold under the MPF Xtra and MPF Government MBS products, where the PFI sells a loan under the MPF Program structure to Fannie Mae or FHLBank of Chicago, respectively, for securitization, collectively provide our members an opportunity to further their cooperative partnership with us.


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The MPF Program helps fulfill our housing mission and provides an additional source of liquidity to FHLBank members that choose to sell mortgage loans into the secondary market rather than holding them in their own portfolios. MPF Program portfolio mortgage loans are considered AMAs, a core mission activity of the FHLBanks, as defined by FHFA regulations.

Allocation of Risk: The MPF Program is designed to allocate risks associated with residential mortgage loans between the PFIs and us. PFIs have direct knowledge of their mortgage markets and have developed expertise in underwriting and servicing residential mortgage loans. By allowing PFIs to originate residential mortgage loans, whether through retail or wholesale operations, and to retain or sell servicing rights of residential mortgage loans, the MPF Program gives control of those functions that mostly impact credit quality to PFIs. We are responsible for managing the interest rate, prepayment and liquidity risks associated with holding residential mortgage loans in portfolio.

Under the FHFA’s AMA regulation, the PFI must “bear the economic consequences” of certain losses with respect to a master commitment based upon the MPF product and other criteria. To comply with these regulations, MPF purchases and fundings are structured so the credit risk associated with MPF loans is shared with PFIs (excluding the MPF Xtra and government-guaranteed loan products). In order to share the credit risk with our PFIs, we use a model licensed from a Nationally Recognized Statistical Rating Organization (NRSRO) to determine the amount of credit enhancement obligation (CE obligation), needed to achieve a credit equivalent rating that is permissible under the AMA regulation and consistent with our risk appetite. The master commitment defines the pool of MPF loans for which the CE obligation is determined so the risk associated with investing in such a pool of MPF loans is equivalent to investing in a BBB-rated asset (effective December 2016). For master commitments with loans funded prior to December 2016, the CE obligation makes the risk equivalent to an AA-rated asset, unless the PFI has requested a realignment of the CE obligation.

The CE obligation methodology described above is applied to MPF portfolio products involving conventional mortgage loans. Subsequent to any private mortgage insurance (PMI), we share in the credit risk of the loans with the PFI. We assume the first layer of loss coverage as defined by the First Loss Account (FLA). If losses beyond the FLA layer are incurred for a pool, the PFI assumes the loan losses up to the amount of the CE obligation, or supplemental mortgage insurance (SMI) policy purchased to replace a CE obligation or to reduce the amount of the CE obligation to some degree, as specified in a master commitment agreement for each pool of conventional mortgage loans purchased from the PFI. The CE obligation provided by the PFI ensures they retain a credit stake in the loans they sell and PFIs are compensated for managing this credit risk, either as a credit enhancement fee (CE fee) paid monthly or a one-time upfront fee paid at purchase. In some instances, depending on the MPF product type (see Table 1), all or a portion of the CE fee may be performance-based. Any losses in excess of our responsibility under the FLA and the member’s CE obligation or SMI policy for a pool of MPF loans are our responsibility. All loss allocations among us and our PFIs are based upon formulas specific to pools of loans covered by a specific MPF product and master commitment (see Table 2). PFIs’ CE obligations must be fully collateralized with assets considered eligible under our collateral policy. See Item 1 – “Business – Advances” for a discussion of eligible collateral.

There are three MPF portfolio products from which PFIs currently may choose (see Table 1). MPF Original, MPF 125, and MPF Government are closed loan products in which we purchase loans acquired or closed by the PFI. Under these MPF portfolio products, the PFI performs all traditional retail loan origination functions. As mentioned above, MPF Xtra essentially represents a loan sale from the PFI to an end buyer that is not FHLBank Topeka. The end buyer of the mortgages under the MPF Xtra product is Fannie Mae. MPF Government MBS is essentially a loan sale of government loans from the PFI to FHLBank of Chicago for securitization into Ginnie Mae MBS. We receive a counterparty fee from our PFIs for facilitating their participation in the MPF Xtra and MPF Government MBS products.

The MPF portfolio products involving conventional mortgage loans are termed credit-enhanced products, because we share in the credit risk of the loans (as described above) with the PFIs. The MPF Government, MPF Government MBS, and MPF Xtra products do not have a first loss and/or credit enhancement structure.

Table 11 under Item 7 – "Management’s Discussion and Analysis of Financial Condition and Results of Operations – Results of Operations" presents the amount of total interest income contributed by our mortgage loan products. Table 29 under Item 7 – “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Financial Condition” presents the outstanding balances of mortgage loans sold to us, net of participations, from our top five PFIs and the percentage of those loans to total mortgage loans outstanding.

PFI Eligibility: Members and housing associates may apply to become PFIs. We review the general eligibility of the member, its servicing qualifications, and its ability to supply documents, data, and reports required to be delivered by PFIs under the MPF Program. A Participating Financial Institution Agreement provides the terms and conditions for the sale or funding of MPF loans by PFIs, including required CE obligations, and establishes the terms and conditions for servicing MPF loans. All of the PFI’s CE obligations under this agreement are secured in the same manner as the other obligations of the PFI under its regular advances agreement with us. We have the right under the advances agreement to request additional collateral to secure the PFI’s MPF CE obligations and cover repurchase risk.
 

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MPF Provider: FHLBank of Chicago serves as the MPF Provider for the MPF Program. It maintains the structure of MPF residential loan products and the eligibility rules for MPF loans, including MPF Xtra loans and MPF Government MBS loans, which primarily fall under the rules and guidelines provided by Fannie Mae and Ginnie Mae. In addition, the MPF Provider manages the pricing and delivery mechanism for MPF loans and the back‑office processing of MPF loans in its role as master servicer and program custodian. The MPF Provider has engaged Wells Fargo Bank N.A. as the vendor for master servicing and as the primary custodian for the MPF Program. We utilize the capability under the individual FHLBank pricing option to change the pricing offered to our PFIs for all MPF products, but any pricing changes made affect all delivery commitment terms and loan note rates in the same amount for all PFIs.
 
The MPF Provider publishes and maintains documentation (referred to as Guides) that details the requirements PFIs must follow in originating, underwriting or selling and servicing MPF loans. As indicated, under the MPF Xtra and MPF Government MBS products, we are a conduit that PFIs use to sell loans to FHLBank of Chicago, which simultaneously sells the loans to Fannie Mae or pools the loans into Ginnie Mae MBS, respectively. The MPF Provider maintains the infrastructure through which we can fund or purchase MPF loans through our PFIs. In exchange for providing these services, we pay the MPF Provider a transaction services fee, which is based upon the unpaid principal balances (UPB) before any charge-offs of MPF loans funded since January 1, 2004. Beginning in 2016, we also pay the MPF Provider a fixed service cost on a quarterly basis.

MPF Servicing: PFIs selling residential mortgage loans under the MPF Program may either retain the servicing function or transfer it and the servicing rights to an approved PFI servicer. If a PFI chooses to retain the servicing function, it receives a servicing fee. PFIs may utilize approved subservicers to perform the servicing duties. If the PFI chooses to transfer servicing rights to an approved third-party provider, the servicing is transferred concurrently with the sale of the residential mortgage loan with the PFI receiving a servicing-released premium. The servicing fee is paid to the third-party servicer. All servicing-retained and servicing-released PFIs are subject to the rules and requirements set forth in the MPF Servicing Guide. Throughout the servicing process, the master servicer monitors PFI compliance with MPF Program requirements and makes periodic reports to the MPF Provider.

Mortgage Standards: The MPF Program has adopted ability-to-repay and safe harbor qualified mortgage requirements for all mortgages with loan application dates on or after January 10, 2014. PFIs are required to deliver residential mortgage loans that meet the eligibility requirements in the MPF Guides. The eligibility guidelines in the MPF Guides applicable to the conventional mortgage loans in our portfolio are broadly summarized as follows:
Mortgage characteristics: MPF loans must be qualifying 5- to 30-year conforming conventional, fixed rate, fully amortizing mortgage loans, secured by first liens on owner-occupied 1- to 4-unit single-family residential properties and single-unit second homes.
Loan-to-value (LTV) ratio and PMI: The maximum LTV for conventional MPF loans is 95 percent, though Affordable Housing Program (AHP) MPF mortgage loans may have LTVs up to 100 percent. Conventional MPF mortgage loans with LTVs greater than 80 percent are insured by PMI from a mortgage guaranty insurance company that has successfully passed an internal credit review and is approved under the MPF Program.
Documentation and compliance: Mortgage documents and transactions are required to comply with all applicable laws. MPF mortgage loans are documented using standard Fannie Mae/Freddie Mac uniform instruments.
Government loans: Government mortgage loans sold under the MPF Program have substantially the same parameters as conventional MPF mortgage loans except that their LTVs may not exceed the LTV limits set by the applicable government agency and they must meet all requirements to be insured or guaranteed by the applicable government agency.
Ineligible mortgage loans: Loans not eligible for sale under the MPF Program include residential mortgage loans unable to be rated by S&P, loans not meeting eligibility requirements, loans classified as high cost, high rate, high risk, Home Ownership and Equity Protection Act loans or loans in similar categories defined under predatory or abusive lending laws, or subprime, non-traditional, or higher-priced mortgage loans.

Loss Calculations: Losses under the FLA for conventional mortgage loans are defined differently than losses for financial reporting purposes. The differences reside in the timing of the recognition of the loss and how the components of the loss are recognized. Under the FLA, a loss is the difference between the recorded loan value and the total proceeds received from the sale of a residential mortgage property after paying any associated expenses, not to exceed the amount of the FLA. The loss is recognized upon sale of the mortgaged property. For financial reporting purposes, when a mortgage loan is deemed a loss, the difference between the recorded loan value and the appraised value of the property securing the loan (fair market value) less the estimated costs to sell is recognized as a charge to the Allowance for Credit Losses on Mortgage Loans in the period the loss status is assigned to the loan. After foreclosure, any expenses associated with carrying the loan until sale are recognized as real estate owned (REO) expenses in the current period.

A majority of the states, and some municipalities, have enacted laws prohibiting mortgage loans considered predatory or abusive. Some of these laws impose liability for violations not only on the originator, but also upon purchasers and assignees of mortgage loans. We take measures that we consider reasonable and appropriate to reduce our exposure to potential liability under these laws and are not aware of any potential or pending claim, action, or proceeding asserting that we are liable under these laws. However, there can be no assurance that we will never have any liability under predatory or abusive lending laws.


8


Table 1 presents a comparison of the different characteristics for each of the MPF products either held on our balance sheet as of December 31, 2017 or currently offered as a loan sale from the PFI to FHLBank of Chicago:

Table 1
Product Name
Size of the FHLBank’s FLA
PFI CE Obligation Description
CE Fee
Paid to PFI
CE Fee Offset1
Servicing Fee
to PFI
MPF Original
4 basis points (bps) per year against unpaid balance, accrued monthly
Aggregate sum of the loan level credit enhancements (LLCEs)
10 bps per year, paid monthly based on remaining UPB; guaranteed2
No
25 bps per year, paid monthly
MPF 1003
100 bps fixed based on gross fundings at closing
Aggregate sum of the LLCEs less FLA

7 to 10 bps per year, paid monthly based on remaining UPB; performance-based after 3 years
Yes; after first 3 years, to the extent recoverable in future periods
25 bps per year, paid monthly
MPF 125
100 bps fixed based on gross fundings at closing
Aggregate sum of the LLCEs less FLA
7 to 10 bps per year, paid monthly based on remaining UPB; performance-based
Yes; to the extent recoverable in future periods
25 bps per year, paid monthly
MPF Plus4
Sized to equal expected losses
0 to 20 bps after FLA and SMI
7 bps per year plus 6 to 7 bps per year, performance-based (delayed for 1 year); all fees paid monthly based on remaining UPB
Yes; to the extent recoverable in future periods
25 bps per year, paid monthly
MPF Xtra
N/A
N/A
N/A
N/A
25 bps per year, paid monthly
MPF Government
N/A
N/A (unreimbursed servicing expenses only)
N/A5
N/A
44 bps per year, paid monthly
MPF Government MBS
N/A
N/A (unreimbursed servicing expenses only)
N/A
N/A
Based on note rate
                   
1 
Future payouts of performance-based CE fees are reduced when losses are allocated to the FLA. The annual offset is limited to fees payable in a given year but could be reduced in subsequent years if losses exceed the annual CE fee. The overall reduction is limited to the FLA amount for the life of the pool of loans covered by a master commitment agreement.
2 
The credit enhancement paid upfront when the mortgage loan is purchased is based upon the present value of the monthly CE fee payments, with consideration for expected prepayments.     
3 
The MPF 100 product is currently inactive due to regulatory requirements relating to loan originator compensation under the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act).
4 
Due to higher costs associated with the acquisition of supplemental insurance policies, the MPF Plus product is currently not active.
5 
Two government master commitments have been grandfathered and paid 2 bps per year. All other government master commitments are not paid a CE fee.


9


Table 2 presents an illustration of the FLA and CE obligation calculation for each conventional MPF product type listed as of December 31, 2017:

Table 2
Product Name
FLA
CE Obligation Calculation
MPF Original
4 bps x unpaid principal, annually1
(LLCE2 x PSF3) x Gross Fundings
MPF 100
100 bps x loan funded amount
((LLCE x PSF) - FLA) x Gross Fundings
MPF 125
100 bps x loan funded amount
((LLCE x PSF) - FLA) x Gross Fundings
MPF Plus
5 x variable CE Fee
(LLCE x PSF) - FLA - SMI4 = PCE5
                   
1 
Starts at zero and increases monthly over the life of the master commitment.
2 
LLCE represents the sum of the loan level credit enhancement amounts of the loans sold into the pool of loans covered by the master commitment agreement.
3 
The S&P Level’s Pool Size Factor (PSF) is applied at the MPF FHLBank level against the total of loans in portfolio.
4 
SMI represents the coverage obtained from the supplemental mortgage insurer. The initial premium for the insurance is determined based on a sample $100 million loan pool. The final premium determination is made during the 13th month of the master commitment agreement, at which time any premium adjustment is determined based on actual characteristics of loans submitted. The SMI generally covers a portion of the PFI’s CE obligation, which typically ranges from 200 to 250 bps of the dollar amount of loans delivered into a mortgage pool, but the PFI may purchase an additional level of coverage to completely cover the PFI’s CE obligation. The CE fees paid to PFIs for this program are capped at a maximum of 14 bps, which is broken into two components, fixed and variable. The fixed portion of the CE fee is paid to the SMI insurer for the coverage discussed above and is a negotiated rate depending on the level of SMI coverage, ranging from 6 to 8 bps. The variable portion is paid to the PFI, and ranges from 6 to 8 bps, with payments commencing the 13th month following initial loan purchase under the master commitment agreement.
5 
PCE represents the CE obligation that the PFI elects to retain rather than covering with SMI. Under this MPF product, the retained amount can range from 0 to 20 bps.

Investments
A portfolio of investments is maintained for liquidity and asset/liability management purposes. We maintain a portfolio of short-term investments in highly-rated institutions, including overnight Federal funds, term Federal funds, interest-bearing certificates of deposit and demand deposits, commercial paper, and securities purchased under agreements to resell (i.e., reverse repurchase agreements). A longer-term investment portfolio is also maintained, which includes securities issued or guaranteed by the U.S. government, U.S. government agencies and GSEs, as well as MBS that are issued by U.S. government agencies and housing GSEs (GSE securities are not explicitly guaranteed by the U.S. government) or privately issued MBS that carried the highest ratings from Moody’s, Fitch Ratings (Fitch) or S&P at the date of acquisition. We no longer purchase private-label MBS, although we continue to hold a small percentage of private-label MBS in our investment portfolio.

Under FHFA regulations, we are prohibited from investing in certain types of securities including:
Instruments, such as common stock, that represent an ownership in an entity, other than stock in small business investment companies or certain investments targeted to low-income persons or communities;
Instruments issued by non-U.S. entities other than those issued by U.S. branches and agency offices of foreign commercial banks;
Non-investment-grade debt instruments other than certain investments targeted to low-income persons or communities, and instruments that were downgraded after purchase;
Whole mortgages or other whole loans other than: (1) those acquired under our MPF Program; (2) certain investments targeted to low-income persons or communities; (3) certain marketable direct obligations of state, local, or tribal government units or agencies, having at least the second highest credit rating from an NRSRO; (4) MBS or asset-backed securities (ABS) backed by manufactured housing loans or home equity loans; and (5) certain foreign housing loans authorized under Section 12(b) of the Bank Act;
Non-U.S. dollar denominated securities;
Interest-only or principal-only stripped MBS, CMOs, real estate mortgage investment conduits (REMICs) and eligible ABS;
Residual-interest or interest-accrual classes of CMOs, REMICs and eligible ABS; and
Fixed rate MBS, CMOs, REMICs and eligible ABS, or floating rate MBS, CMOs, REMICs and eligible ABS that on the trade date are at rates equal to their contractual cap or that have average lives which vary by more than six years under an assumed instantaneous interest rate change of 300 bps.

In addition to the above limitations on allowable types of MBS investments, the FHFA limits our purchase of MBS by requiring that the aggregate value of MBS owned not exceed 300 percent of our month-end total regulatory capital, as most recently reported to the FHFA, on the day we purchase the securities. Aggregate value is calculated with the total amortized cost of available-for-sale and held-to-maturity MBS and the total fair value of trading MBS. Further, quarterly increases in holdings of MBS are restricted to no more than 50 percent of regulatory capital as of the beginning of such quarter. We generally utilize our MBS authority to maintain a portfolio of MBS investments approximating 300 percent of our total regulatory capital. As of December 31, 2017, the amortized cost of our MBS/CMO portfolio represented 288 percent of our regulatory capital.


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Debt Financing – Consolidated Obligations
Consolidated obligations, consisting of bonds and discount notes, are our primary liabilities and represent the principal source of funding for advances, traditional mortgage products, and investments. Consolidated obligations are the joint and several obligations of the FHLBanks, backed only by the financial resources of the FHLBanks. Consolidated obligations are not obligations of the U.S. government, and the U.S. government does not guarantee them; however, the capital markets have traditionally viewed the FHLBanks’ obligations as “Federal agency” debt. As such, the FHLBanks historically have had reasonably stable access to funding at relatively favorable spreads to U.S. Treasuries. Our ability to access the capital markets through the sale of consolidated obligations, across the maturity spectrum and through a variety of debt structures, assists us in managing our balance sheet effectively and efficiently. Moody’s currently rates the FHLBanks’ consolidated obligations Aaa/P-1, and S&P currently rates them AA+/A-1+. These ratings measure the likelihood of timely payment of principal and interest on consolidated obligations and also reflect the FHLBanks’ status as GSEs, which generally implies the expectation of a high degree of support by the U.S. government even though their obligations are not guaranteed by the U.S. government.

FHFA regulations govern the issuance of debt on behalf of the FHLBanks and related activities, and authorize the FHLBanks to issue consolidated obligations, through the Office of Finance as their agent, under the authority of Section 11(a) of the Bank Act. No FHLBank is permitted to issue individual debt under Section 11(a) without FHFA approval. We are primarily and directly liable for the portion of consolidated obligations issued on our behalf. In addition, we are jointly and severally liable with the other FHLBanks for the payment of principal and interest on the consolidated obligations of all FHLBanks under Section 11(a). The FHFA, at its discretion, may require any FHLBank to make principal or interest payments due on any consolidated obligations for which the FHLBank is not the primary obligor. Although it has never occurred, to the extent that an FHLBank would be required to make a payment on a consolidated obligation on behalf of another FHLBank, the paying FHLBank would be entitled to reimbursement from the non-complying FHLBank. However, if the FHFA determines that the non-complying FHLBank is unable to satisfy its obligations, then the FHFA may allocate the non-complying FHLBank’s outstanding consolidated obligation debt among the remaining FHLBanks on a pro rata basis in proportion to each FHLBank’s participation in all consolidated obligations outstanding, or on any other basis the FHFA may determine. If the principal or interest on any consolidated obligation issued on behalf of a specific FHLBank is not paid in full when due, that FHLBank may not pay dividends to, or redeem or repurchase shares of stock from, any member of that specific FHLBank.

Table 3 presents the par value of our consolidated obligations and the combined consolidated obligations of all the FHLBanks as of December 31, 2017 and 2016 (in millions):

Table 3
 
12/31/2017
12/31/2016
Par value of consolidated obligations of the FHLBank
$
44,953

$
42,481

 
 
 
Par value of consolidated obligations of all FHLBanks
$
1,034,260

$
989,311


FHFA regulations provide that we must maintain aggregate assets of the following types, free from any lien or pledge, in an amount at least equal to the amount of consolidated obligations outstanding:
Cash;
Obligations of, or fully guaranteed by, the U.S government;
Secured advances;
Mortgages that have any guaranty, insurance or commitment from the U.S. government or any agency of the U.S. government; and
Investments described in Section 16(a) of the Bank Act, which, among other items, includes securities that a fiduciary or trust fund may purchase under the laws of the state in which the FHLBank is located.

Table 4 illustrates our compliance with the FHFA’s regulations for maintaining aggregate assets at least equal to the amount of consolidated obligations outstanding as of December 31, 2017 and 2016 (dollar amounts in thousands):

Table 4
 
12/31/2017
12/31/2016
Total non-pledged assets
$
47,924,667

$
44,510,028

Total carrying value of consolidated obligations
$
44,935,119

$
42,497,676

Ratio of non-pledged assets to consolidated obligations
1.07

1.05



11


The Office of Finance has responsibility for facilitating and executing the issuance of the consolidated obligations on behalf of the FHLBanks. It also prepares the FHLBanks’ Combined Quarterly and Annual Financial Reports, services all outstanding debt, serves as a source of information for the FHLBanks on capital market developments and manages the FHLBanks’ relationship with the NRSROs with respect to ratings on consolidated obligations. In addition, the Office of Finance administers two tax-exempt government corporations, the Resolution Funding Corporation and the Financing Corporation, which were established as a result of the savings and loan crisis of the 1980s.

Consolidated Obligation Bonds: Consolidated obligation bonds are primarily used to satisfy our term funding needs. Typically, the maturities of these bonds range from less than one year to 30 years, but the maturities are not subject to any statutory or regulatory limit. Consolidated obligation bonds can be issued and distributed through negotiated or competitively bid transactions with approved underwriters or selling group members.

Consolidated obligation bonds generally are issued with either fixed or variable rate payment terms that use a variety of standardized indices for interest rate resets including, but not limited to, LIBOR, Constant Maturity Swap, U.S. Prime and Three-Month U.S. Treasury Bill Auction Yield. In addition, to meet the specific needs of certain investors in consolidated obligations, both fixed and variable rate bonds may also contain certain embedded features, which result in complex coupon payment terms and call features. Normally, when such a complex consolidated obligation bond is issued, we simultaneously enter into a derivative containing mirror or offsetting features to synthetically convert the terms of the complex bond to a simple variable rate callable bond tied to one of the standardized indices. We also simultaneously enter into derivatives containing offsetting features to synthetically convert the terms of some of our fixed rate callable and bullet bonds and floating rate bonds to a simple variable rate callable or bullet bond tied to one of the standardized indices.

Consolidated Obligation Discount Notes: The Office of Finance also sells consolidated obligation discount notes on behalf of the FHLBanks that generally are used to meet short-term funding needs. These securities have maturities up to one year and are offered daily through certain securities dealers in a discount note selling group. In addition to the daily offerings of discount notes, the FHLBanks auction discount notes with fixed maturity dates ranging from 4 to 26 weeks through competitive auctions held twice a week utilizing the discount note selling group. The amount of discount notes sold through the auctions varies based upon market conditions and/or on the funding needs of the FHLBanks. Discount notes are generally sold at a discount and mature at par.

Use of Derivatives
The FHLBank’s Risk Management Policy (RMP) establishes guidelines for our use of derivatives. Interest rate swaps, swaptions, interest rate cap and floor agreements, calls, puts, futures, forward contracts, and other derivatives can be used as part of our interest rate risk management and funding strategies. This policy, along with FHFA regulations, prohibits trading in, or the speculative use of, derivatives and limits credit risk to counterparties that arises from derivatives. In general, we have the ability to use derivatives to reduce funding costs for consolidated obligations and to manage other risk elements such as interest rate risk, mortgage prepayment risk, unsecured credit risk, and foreign currency risk.

Generally, we use derivatives by designating them as either a fair value or cash flow hedge of an underlying financial instrument, firm commitment, or forecasted transaction and in asset/liability management (i.e., economic hedge). Economic hedges are defined as derivatives hedging specific or non-specific underlying assets, liabilities, or firm commitments that do not qualify for hedge accounting, but are acceptable hedging strategies under our RMP. For example, we use derivatives in our overall interest rate risk management to adjust the interest rate sensitivity of consolidated obligations to approximate more closely the interest rate sensitivity of assets, including advances, investments and mortgage loans, and/or to adjust the interest rate sensitivity of advances, investments, and mortgage loans to approximate more closely the interest rate sensitivity of liabilities. We also use derivatives to manage embedded options in assets and liabilities, to hedge the market value of existing assets, liabilities, and anticipated transactions, to hedge the duration risk of prepayable instruments, to mitigate adverse impacts to earnings from the contraction or extension of certain assets (e.g., advances or mortgage assets) and liabilities, and to reduce funding costs as discussed below.

We often execute derivatives concurrently with the issuance of consolidated obligation bonds (collectively referred to as swapped consolidated obligation bond transactions) to reduce funding costs or to alter the characteristics of our liabilities to more closely match the characteristics of our assets. At times, we also execute derivatives concurrently with the issuance of consolidated obligation discount notes in order to create synthetic variable rate debt at a cost that is often lower than funding alternatives and comparable variable rate cash instruments issued directly by us. This strategy of issuing consolidated obligations while simultaneously entering into derivatives enables us to more effectively fund our variable rate and short-term fixed rate assets. It also allows us, in some instances, to offer a wider range of advances at more attractive prices than would otherwise be possible. Swapped consolidated obligation transactions depend on price relationships in both the FHLBank consolidated obligation market and the derivatives market, primarily the interest rate swap market. If conditions in these markets change, we may adjust the types or terms of the consolidated obligations issued and derivatives utilized to better match assets, meet customer needs, and/or improve our funding costs.


12


We frequently purchase interest rate caps with various terms and strike rates to manage embedded interest rate cap risk associated with our variable rate MBS and CMO portfolios. Although these derivatives are valid economic hedges against the prepayment and option risk of our portfolio of MBS and CMOs, they are not specifically linked to individual investment securities and therefore do not receive fair value or cash flow hedge accounting. The derivatives are marked to fair value through earnings. We may also use interest rate caps and floors, swaptions, and callable swaps to manage and hedge prepayment and option risk on MBS, CMOs and mortgage loans.

See Item 7A – “Quantitative and Qualitative Disclosures About Market Risk – Interest Rate Risk Management” for further information on derivatives.

Deposits
The Bank Act allows us to accept deposits from our members, housing associates, any institution for which we are providing correspondent services, other FHLBanks, and other government instrumentalities. We offer several types of deposit programs, including demand, overnight, and term deposits.

Liquidity Requirements: To support deposits, FHFA regulations require us to have at least an amount equal to current deposits received from our members invested in obligations of the U.S. government, deposits in eligible banks or trust companies, or advances with maturities not exceeding five years. In addition, we must meet the additional liquidity policies and guidelines outlined in our RMP. See Item 7 – “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Risk Management – Liquidity Risk Management” for further discussion of our liquidity requirements.

Capital, Capital Rules and Dividends
FHLBank Capital Adequacy and Form Rules: The Gramm-Leach-Bliley Act (GLB Act) allows us to have two classes of stock, and each class may have sub-classes. Class A Common Stock is conditionally redeemable on six months’ written notice from the member, and Class B Common Stock is conditionally redeemable on five years’ written notice from the member, subject in each case to certain conditions and limitations that may restrict our ability to effectuate such redemptions. Membership is voluntary. However, other than non-member housing associates (see Item 1 – “Business – Advances”), membership is required in order to utilize our credit and mortgage finance products. Members that withdraw may not reapply for membership for five years.

The GLB Act and the FHFA rules and regulations define total capital for regulatory capital adequacy purposes as the sum of an FHLBank’s permanent capital, plus the amounts paid in by its stockholders for Class A Common Stock; any general loss allowance, if consistent with U.S. generally accepted accounting principles (GAAP) and not established for specific assets; and other amounts from sources determined by the FHFA as available to absorb losses. The GLB Act and FHFA regulations define permanent capital for the FHLBanks as the amount paid in for Class B Common Stock plus the amount of an FHLBank’s retained earnings, as determined in accordance with GAAP.

Under the GLB Act and the FHFA rules and regulations, we are subject to risk-based capital rules. Only permanent capital can satisfy our risk-based capital requirement. In addition, the GLB Act specifies a five percent minimum leverage capital requirement based on total FHLBank capital, which includes a 1.5 weighting factor applicable to permanent capital, and a four percent minimum total capital requirement that does not include the 1.5 weighting factor applicable to permanent capital. We may not redeem or repurchase any of our capital stock without FHFA approval if the FHFA or our Board of Directors determines that we have incurred, or are likely to incur, losses that result in, or are likely to result in, charges against our capital, even if we are in compliance with our minimum regulatory capital requirements. Therefore, a member’s right to have its excess shares of capital stock redeemed is conditional on, among other factors, the FHLBank maintaining compliance with the three regulatory capital requirements: risk-based, leverage, and total capital.


13


Following are highlights from our capital plan:
Two classes of authorized stock - Class A Common Stock and Class B Common Stock;
Both classes have $100 par value per share and both are defined as common stock;
Class A Common Stock is required for membership. The membership or asset-based stock requirement for each member is currently 0.1 percent of that member's total assets at the end of the prior calendar year, with a minimum requirement of 10 shares ($1,000) and a cap of 5,000 shares ($500,000);
To the extent a member’s asset-based requirement in Class A Common Stock is insufficient to support its calculated activity-based requirement, Class B Common Stock must be purchased in order to support that member’s activities with us. The activity-based stock requirement is the sum of the stock requirements for each activity less the asset-based stock requirement in Class A Common Stock and is calculated whenever a member enters into a transaction, such as an advance (4.5 percent of outstanding advances (range = 4.0 to 6.0 percent));
Excess stock is calculated daily. We may exchange excess Class B Common Stock for Class A Common Stock, but only if we continue to meet our regulatory capital requirements after the exchange;
A member may hold excess Class A Common Stock or Class B Common Stock, subject to our right to repurchase excess stock or to exchange excess Class B Common Stock for Class A Common Stock, or may ask to redeem all or part of its excess Class A Common Stock or Class B Common Stock. A member may also ask to exchange all or part of its excess Class A Common Stock or Class B Common Stock for Class B Common Stock or Class A Common Stock, respectively, but all such exchanges are completed at our discretion;
As a member increases its activities with us above the amount of activity supported by its asset-based requirement, excess Class A Common Stock is first exchanged for Class B Common Stock to meet the activity requirement prior to the purchase of additional Class B Common Stock;
Under the plan, the Board of Directors establishes a dividend parity threshold that is a rate per annum expressed as a positive or negative spread relative to a published reference interest rate index (e.g., LIBOR, Federal funds, etc.) or an internally calculated reference interest rate based upon any of our assets or liabilities (e.g., average yield on advances, average cost of consolidated obligations, etc.);
Class A Common Stock and Class B Common Stock share in dividends equally up to the dividend parity threshold, then the dividend rate for Class B Common Stock can exceed the rate for Class A Common Stock, but the Class A Common Stock dividend rate can never exceed the Class B Common Stock dividend rate;
A member may submit a redemption request to us for any or all of its excess Class A Common Stock and/or Class B Common Stock;
Within five business days of receipt of a redemption request for excess Class A Common Stock, we must notify the member if we decline to repurchase the excess Class A Common Stock, at which time the six-month waiting period will apply. Otherwise, we will repurchase any excess Class A Common Stock within five business days, though it is usually repurchased on the same date as the member’s redemption request;
Within five business days of receipt of a redemption request for excess Class B Common Stock, we must notify the member if we decline to repurchase the excess Class B Common Stock, at which time the five-year waiting period will apply. Otherwise, we will repurchase any excess Class B Common Stock within five business days, though it is usually repurchased on the same date as the member’s redemption request;
A member may cancel or revoke its written redemption request prior to the end of the redemption period (six months for Class A Common Stock and five years for Class B Common Stock) or its written notice of withdrawal from membership prior to the end of a six-month period starting on the date we received the member’s written notice of withdrawal from membership. Our capital plan provides that we will charge the member a cancellation fee in accordance with a schedule where the amount of the fee increases with the passage of time. There is no grace period after the submission of a redemption request during which the member may cancel its redemption request without being charged a cancellation fee; and
Each required share of Class A Common Stock and Class B Common Stock is entitled to one vote subject to the statutorily imposed voting caps.

See Item 7 – “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Liquidity and Capital Resources - Capital” for additional information regarding capital.

Dividends: We may pay dividends from unrestricted retained earnings and current income. (For a discussion regarding restricted retained earnings, please see Joint Capital Enhancement Agreement under this Item 1.) Our Board of Directors may declare and pay dividends in either cash or capital stock. Under our capital plan, all dividends that are payable in capital stock must be paid in the form of Class B Common Stock, regardless of the class of stock upon which the dividend is being paid.


14


Consistent with FHFA guidance in Advisory Bulletin (AB) 2003-AB-08, Capital Management and Retained Earnings, we adopted guidelines to establish a minimum or threshold level for our retained earnings in light of alternative possible future financial and economic scenarios, which are currently included under our RMP. Our minimum (threshold) level of retained earnings is calculated quarterly and re-evaluated by the Board of Directors as part of each quarterly dividend declaration. The retained earnings threshold effective for the period presented ending March 31, 2017 and all subsequent periods includes detailed calculations of five components:
Market risk, which is calculated using a Monte Carlo simulation where the 99 percent confidence level result over a 90-day simulation horizon will represent the minimum market risk exposure level;
Credit risk, which requires that retained earnings be sufficient to credit-enhance all of our assets from their actual rating levels to the equivalent of triple-A ratings (where advances are considered to be triple-A rated);
Pre-settlement risk, which is based upon the pre-settlement risk exposure associated with recently issued and unsettled debt issuance and is based on the current daily potential maximum price risk exposure, based on the 99th percentile of daily price risk calculated on the most recent 10 years of daily activity. For periods presented prior to March 31, 2017, pre-settlement risk was not a component of the retained earnings threshold;
Operations risk, which is calculated using a combination of: (1) the Basel II standardized approach; and (2) our operational risk event loss history, taking into consideration operational loss events reported by the FHLBank System that could impact us in the future; and
Net income volatility, which is calculated using: (1) the largest net loss on derivative hedging activities under 100-basis-point interest rate shock scenarios (maximum derivative hedging loss under up or down shocks); and (2) dividend payment risk, computed as four times the dollar amount of dividends paid on all stock (including mandatorily redeemable capital stock) for the most recently paid quarterly dividend.

The retained earnings threshold was considered by the Board of Directors when dividends were declared during the last two years, but the retained earnings threshold calculated in accordance with the RMP did not significantly affect the amount of dividends declared and paid. Tables 5 and 6 reflect the quarterly retained earnings threshold calculations utilized during 2017 and 2016 (in thousands), respectively, compared to the actual amount of retained earnings at the end of each quarter:

Table 5
Retained Earnings Component (based upon prior quarter end)
12/31/2017
09/30/2017
06/30/2017
03/31/2017
Market Risk
$
79,542

$
82,124

$
62,341

$
67,921

Credit Risk
63,776

65,358

71,237

64,813

Pre-settlement Risk
30,000

30,000

30,000

30,000

Operations Risk
27,384

27,382

27,347

26,535

Net Income Volatility
119,162

121,098

118,954

109,766

Total Retained Earnings Threshold
319,864

325,962

309,879

299,035

Actual Retained Earnings as of End of Quarter
840,406

816,141

790,406

767,556

Overage
$
520,542

$
490,179

$
480,527

$
468,521


Table 6
 
 
 
 
 
Retained Earnings Component (based upon prior quarter end)
12/31/2016
09/30/2016
06/30/2016
03/31/2016
Market Risk
$
99,953

$
89,400

$
70,709

$
57,193

Credit Risk
45,031

49,862

49,825

49,421

Operations Risk
26,453

26,442

26,383

26,174

Net Income Volatility
95,366

85,903

92,173

85,950

Total Retained Earnings Threshold
266,803

251,607

239,090

218,738

Actual Retained Earnings as of End of Quarter
735,196

713,229

685,029

673,102

Overage
$
468,393

$
461,622

$
445,939

$
454,364


Under our retained earnings policy, any shortage of actual retained earnings with respect to the retained earnings threshold is to be met over a period generally not to exceed one year from the quarter-end calculation. The policy also provides that meeting the established retained earnings threshold has priority over the payment of dividends, but that the Board of Directors must balance dividends on capital stock against the period over which the retained earnings threshold is met. The retained earnings threshold level fluctuates from period to period because it is a function of the size and composition of our balance sheet and the risks contained therein at that point in time.


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Joint Capital Enhancement Agreement (JCE Agreement) – We, along with the other FHLBanks, entered into a JCE Agreement intended to enhance the capital position of each FHLBank. More specifically, the intent of the JCE Agreement is to allocate a portion of each FHLBank’s earnings to a Separate Restricted Retained Earnings Account (RRE Account) at that FHLBank. Thus, in accordance with the JCE Agreement, each FHLBank allocates 20 percent of its net income to an RRE Account and will do so until the balance of the account equals at least one percent of that FHLBank’s average balance of outstanding consolidated obligations for the previous quarter.

Key provisions under the JCE Agreement are as follows:
Under the JCE Agreement, each FHLBank will build its RRE Account to a minimum of one percent of its total outstanding consolidated obligations through the 20 percent allocation. For this purpose, total outstanding consolidated obligations is based on the most recent quarter's average carrying value of all consolidated obligations for which an FHLBank is the primary obligor, excluding hedging adjustments (Total Consolidated Obligations). Under the JCE Agreement, an FHLBank may make voluntary allocations above 20 percent of its net income and/or above the targeted balance of one percent of its Total Consolidated Obligations.
The JCE Agreement provides that any quarterly net losses of an FHLBank may be netted against its net income, if any, for other quarters during the same calendar year to determine the minimum required year-to-date or annual allocation to its RRE Account. Any year-to-date or annual losses must first be allocated to the unrestricted retained earnings of an FHLBank until such retained earnings are reduced to a zero balance. Thereafter, any remaining losses may be applied to reduce the balance of an FHLBank’s RRE Account, but not below a zero balance. In the event an FHLBank incurs a net loss for a cumulative year-to-date or annual period that results in a decrease to the balance of its RRE Account below the balance of the RRE Account as of the beginning of that calendar year, such FHLBank’s quarterly allocation requirement will thereafter increase to 50 percent of quarterly net income until the cumulative difference between the allocations made at the 50 percent rate and the allocations that would have been made at the regular 20 percent rate is equal to the amount of the decrease to the balance of its RRE Account at the beginning of that calendar year.
If the size of an FHLBank’s balance sheet would decrease and consequently, Total Consolidated Obligations would decline, the percent allocated could exceed the targeted one percent of Total Consolidated Obligations. The JCE Agreement provides that if an FHLBank's RRE Account exceeds 1.5 percent of its Total Consolidated Obligations, such FHLBank may transfer amounts from its RRE Account to the unrestricted retained earnings account, but only to the extent that the balance of its RRE Account remains at least equal to 1.5 percent of the FHLBank’s Total Consolidated Obligations immediately following such transfer. Finally, the JCE Agreement provides that during periods in which an FHLBank’s RRE Account is less than one percent of its Total Consolidated Obligations, such FHLBank may pay dividends only from unrestricted retained earnings or from the portion of quarterly net income not required to be allocated to its RRE Account.
The JCE Agreement can be voluntarily terminated by an affirmative vote of two-thirds of the boards of directors of the FHLBanks, or automatically after the occurrence of a certain event after following certain proscribed procedures (Automatic Termination Event). An Automatic Termination Event means: (1) a change in the FHLBank Act, or another applicable statute, that will have the effect of creating a new, or higher, assessment or taxation on net income or capital of the FHLBanks; or (2) a change in the FHLBank Act, or another applicable statute, or relevant regulations that will result in a higher mandatory allocation of an FHLBank’s quarterly net income to any retained earnings account other than the annual amount, or total amount, specified in an FHLBank’s capital plan. An FHLBank’s obligation to make allocations to the RRE Account terminates after it has been determined that an Automatic Termination Event has occurred and one year thereafter the restrictions on paying dividends out of the RRE Account, or otherwise reallocating funds from the RRE Account, are also terminated. Upon the voluntary termination of the JCE Agreement, an FHLBank’s obligation to make allocations to its RRE Account is terminated on the date written notice of termination is delivered to the FHFA, and restrictions on paying dividends out of the RRE Account, or otherwise reallocating funds from the RRE Account, terminate one year thereafter.

Tax Status
We are exempt from all federal, state and local taxation except for real property taxes.

Assessments
We are subject to a regulatory AHP assessment based on a percentage of our earnings. The FHLBanks are required to set aside annually the greater of an aggregate of $100 million or 10 percent of their current year’s income before charges for AHP. In accordance with FHFA guidance for the calculation of AHP expense, interest expense on mandatorily redeemable capital stock is added back to income before charges for AHP.

Other Mission-Related Activities
In addition to supporting residential mortgage lending, one of our core missions is to support related housing and community development. We administer and fund a number of targeted programs specifically designed to fulfill that mission. These programs provide housing opportunities for thousands of very low-, low- and moderate-income households and strengthen communities primarily in Colorado, Kansas, Nebraska, and Oklahoma.


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Affordable Housing Program: Amounts specified by the AHP requirements described in Item 1 – “Business – Assessments” are reserved for this program. AHP provides cash grants to members to finance the purchase, construction, or rehabilitation of very low-, low-, and moderate-income owner occupied or rental housing. In addition to the competitive AHP program funds, a customized homeownership set-aside program called the Homeownership Set-aside Program (HSP) is offered under the AHP. The HSP provides down payment, closing cost, and purchase-related repair assistance to first-time homebuyers in Colorado, Kansas, Nebraska, and Oklahoma.

Community Investment Cash Advance (CICA) Program. CICA loans to members specifically target underserved markets in both rural and urban areas. CICA loans represented 3.5 percent, 3.9 percent and 3.9 percent of total advances outstanding as of December 31, 2017, 2016, and 2015, respectively. Programs offered during 2017 under the CICA Program, which is not funded through the AHP, include:
Community Housing Program (CHP) – CHP makes loans available to members for financing the construction, acquisition, rehabilitation, and refinancing of owner-occupied housing for households whose incomes do not exceed 115 percent of the area’s median income and rental housing occupied by or affordable for households whose incomes do not exceed 115 percent of the area’s median income. For rental projects, at least 51 percent of the units must have tenants that meet the income guidelines, or at least 51 percent of the units must have rents affordable to tenants that meet the income guidelines. We provide advances for CHP-based loans to members at our estimated cost of funds for a comparable maturity plus a mark-up for administrative costs; and
Community Development Program (CDP) – CDP provides advances to members to finance CDP-qualified member financing including loans to small businesses, farms, agri-businesses, public or private utilities, schools, medical and health facilities, churches, day care centers, or for other community development purposes that meet one of the following criteria: (1) loans to firms that meet the Small Business Administration’s definition of a qualified small business concern; (2) financing for businesses or projects located in an urban neighborhood, census tract or other area with a median income at or below 100 percent of the area median; (3) financing for businesses, farms, ranches, agri-businesses, or projects located in a rural community, neighborhood, census tract, or unincorporated area with a median income at or below 115 percent of the area median; (4) firms or projects located in a Federal Empowerment Zone, Enterprise Community or Champion Community, Native American Area, Brownfield Area, Federally Declared Disaster Area, United States Department of Agriculture Drought Area, or Community Adjustment and Investment Program Area; (5) businesses in urban areas in which at least 51 percent of the employees of the business earn at or below 100 percent of the area median; or (6) businesses in rural areas in which at least 51 percent of the employees of the business earn at or below 115 percent of the area median. We provide advances for CDP-based loans to members at our estimated cost of funds for a comparable maturity plus a mark-up for administrative costs.

Other Housing and Community Development Programs. We have established a voluntary program intended to promote homebuyer education in our district. The Rural First-time Homebuyer Education Program provides up to $75,000 annually to support rural homeownership education and counseling while actively encouraging participating organizations to seek supplemental funding from other sources. The goal of the program is to support rural education and counseling in all four states in the district, especially in those areas with HSP-participating members. This program is not funded through AHP funds.

Competition
Advances: Demand for advances is affected by, among other things, the cost of alternative sources of liquidity available to our members, including deposits from members’ customers and other sources of liquidity that are available to members. Members mostly access alternative funding other than advances through the brokered deposit market and through repurchase agreements with commercial customers. Large members may have broader access to funding through repurchase agreements with investment banks and commercial banks as well as access to the national and global credit markets. While the availability of alternative funding sources to members can influence member demand for advances, the cost of the alternative funding relative to advances is the primary consideration when accessing alternative funding. Other considerations include product availability through the FHLBank, the member’s creditworthiness, ease of execution, level of diversification, and availability of member collateral for other types of borrowings.

Mortgage Loans: We are subject to competition in purchasing conventional, conforming fixed rate residential mortgage loans and government-guaranteed residential mortgage loans. We face competition in customer service, the prices paid for these assets, and in ancillary services such as automated underwriting. The most direct competition for purchasing residential mortgage loans comes from the other housing GSEs, which also purchase conventional, conforming fixed rate mortgage loans, specifically Fannie Mae and Freddie Mac. To a lesser extent, we also compete with regional and national financial institutions that buy and/or invest in mortgage loans. Depending on market conditions, these investors may seek to hold, securitize, or sell conventional, conforming fixed rate mortgage loans. We continuously reassess our potential for success in attracting and retaining members for our mortgage loan products and services, just as we do with our advance products. We compete for the purchase of mortgage loans primarily on the basis of price, products, and services offered.


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Debt Issuance: We compete with the U.S. government (including debt programs explicitly guaranteed by the U.S. government), U.S. government agencies, Fannie Mae, Freddie Mac, and other GSEs, as well as corporate, sovereign, and supranational entities for funds raised through the issuance of unsecured debt in the national and global capital markets. Collectively, Fannie Mae, Freddie Mac, and the FHLBanks are generally referred to as the housing GSEs, and the cost of the debt of each can be positively or negatively affected by political, financial, or other news that reflects upon any of the three housing GSEs. If the supply of competing debt products increases without a corresponding increase in demand, our debt costs may increase, or less debt may be issued. We compete for the issuance of debt primarily on the basis of rate, term, and structure of the debt, but also on the liquidity position and perceived risk of the issuer.

Derivatives: The sale of callable debt and the simultaneous execution of callable interest rate swaps with options that mirror the options in the debt have been an important source of competitive funding for us. As such, the depth of the markets for callable debt and mirror-image derivatives is an important determinant of our relative cost of funds. There is considerable competition among high-credit-quality issuers, especially among the three housing GSEs, for callable debt and for derivatives. There can be no assurance that the current breadth and depth of these markets will be sustained.

Regulatory Oversight, Audits and Examinations
General: We are supervised and regulated by the FHFA, which is an independent agency in the executive branch of the U.S. government. The FHFA is responsible for providing supervision, regulation and housing mission oversight of the FHLBanks to promote their safety and soundness so they serve as a reliable source of liquidity and funding for housing finance and community investment. The FHFA is headed by a Director appointed by the President of the United States for a five-year term, with the advice and consent of the Senate. The Federal Housing Finance Oversight Board advises the Director with respect to overall strategies and policies in carrying out the duties of the Director. The Federal Housing Finance Oversight Board is comprised of the Secretary of the Treasury, Secretary of HUD, Chair of the Securities and Exchange Commission (SEC), and the Director, who serves as the Chairperson of the Board. The FHFA is funded in part through assessments from the FHLBanks, with the remainder of its funding provided by Fannie Mae and Freddie Mac; no tax dollars or other appropriations support the operations of the FHFA or the FHLBanks. To assess our safety and soundness, the FHFA conducts annual, on-site examinations, as well as periodic on-site and off-site reviews. Additionally, we are required to submit monthly information on our financial condition and results of operations to the FHFA. This information is available to all FHLBanks.

Before a government corporation issues and offers obligations to the public, the Government Corporation Control Act provides that the Secretary of the Treasury shall prescribe the form, denomination, maturity, interest rate, and conditions of the obligations; the manner and time issued; and the selling price. The Bank Act also authorizes the Secretary of the Treasury, at his or her discretion, to purchase consolidated obligations up to an aggregate principal amount of $4 billion. No borrowings under this authority have been outstanding since 1977. The U.S. Treasury receives the FHFA’s annual report to Congress, monthly reports reflecting securities transactions of the FHLBanks, and other reports reflecting the operations of the FHLBanks.

Audits and Examinations: We have an internal audit department and our Board of Directors has an audit committee. The Chief Audit Executive reports directly to the audit committee. In addition, an independent registered public accounting firm audits our annual financial statements and effectiveness of internal controls over financial reporting. The independent registered public accounting firm conducts these audits following standards of the Public Company Accounting Oversight Board (United States) and Government Auditing Standards issued by the Comptroller General of the United States. The FHLBanks, the FHFA, and Congress all receive the audit reports. We must submit annual management reports to Congress, the President of the United States, the Office of Management and Budget, and the Comptroller General. These reports include a statement of financial condition, a statement of operations, a statement of cash flows, a statement of internal accounting and administrative control systems, and the report of the independent public accounting firm on the financial statements.

The Comptroller General has authority under the Bank Act to audit or examine the FHFA and the individual FHLBanks and to decide the extent to which they fairly and effectively fulfill the purposes of the Bank Act. Furthermore, the Government Corporation Control Act provides that the Comptroller General may review any audit of the financial statements conducted by an independent registered public accounting firm. If the Comptroller General conducts such a review, then he or she must report the results and provide his or her recommendations to Congress, the Office of Management and Budget, and the applicable FHLBank. The Comptroller General may also conduct his or her own audit of any financial statements of any individual FHLBank.

Personnel
As of February 28, 2018, we had 233 employees. Our employees are not represented by a collective bargaining unit, and we have a good relationship with our employees.


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Legislative and Regulatory Developments
FHFA Final Rule on Minority and Women Inclusion. On July 13, 2017, the FHFA issued a final rule, effective August 24, 2017, amending its Minority and Women Inclusion regulations to clarify the scope of the FHLBanks' obligation to promote diversity and ensure inclusion. The final rule updates the existing FHFA regulations aimed at promoting diversity and the inclusion and participation of minorities, women, and individuals with disabilities, and the businesses they own ("MWDOB") in all FHLBank business and activities, including management, employment, customer outreach and access, MWDOB participation in financial transactions with the FHLBanks, and contracting. The final rule encourages the FHLBanks to expand contracting opportunities for MWDOBs and minorities, women, and individuals with disabilities through subcontracting arrangements and to track the cumulative spend associated with such diverse subcontracting arrangements. In addition, the final rule requires each FHLBank to:
Develop stand-alone, board-approved diversity and inclusion strategic plans or incorporate diversity and inclusion principles into its existing strategic planning processes and adopt strategies for promoting diversity and ensuring inclusion;
Amend its policies on equal opportunity in employment by adding sexual orientation, gender identity, and status as a parent to the list of protected classifications;
Establish a process to grant or deny requests for accommodations to employees and job applicants based on their religious beliefs or practices;
Provide information in its annual reports to the FHFA about its efforts to advance diversity and inclusion through identifying and selecting MWDOB firms for participation in financial transactions with the FHLBank, identifying ways in which it may give consideration to MWDOB business with the FHLBank when reviewing and evaluating vendor contract proposals, and enhancing customer access by MWDOB businesses (including through the FHLBank's affordable housing and community investment programs;
Report data regarding the number of diverse individuals currently in supervisory or managerial positions and its strategies for promoting the diversity of supervisors and managers;
Classify and provide additional data in its annual reports about the number of, and amounts paid under, its MWDOB contracts, as well as demographic data regarding the categories of MWDOB entities to which it awards vendor contracts; and
Provide data to the FHFA regarding the type of contracts it considers exempt from these diversity and inclusion requirements, as well as the criteria and rationale for establishing such exemptions and an analysis of any potential negative or adverse impact such exemptions might have on contracting opportunities for MWDOB businesses or diverse individuals.

We do not expect this final rule to materially affect our financial condition or results of operations, but we anticipate that it may result in increased costs and substantially increase the amount of data tracking, monitoring, and reporting that will be required of us.

FHFA Proposed Rule on Capital Requirements. On July 3, 2017, the FHFA published a proposed rule to adopt, with amendments, the Federal Housing Finance Board regulations pertaining to the capital requirements for the FHLBanks. The proposed rule would carry over most of the existing regulations without material change, but would substantively revise the credit risk component of the risk-based capital requirement, as well as the limitations on extensions of unsecured credit and derivative exposure. The main revisions would remove requirements that the FHLBanks calculate credit risk capital charges and unsecured credit limits based on ratings issued by an NRSRO, and instead require that the FHLBanks establish and use their own internal rating methodology. With respect to derivatives, the proposed rule would impose a new capital charge for cleared derivatives, which under the existing rule do not carry a capital charge, and would change the way that the capital charge and risk limits are calculated for uncleared derivatives, in both cases to align with the Dodd-Frank Act’s clearing mandate and derivatives reforms. The proposed rule also would revise the percentages used in the regulation’s tables to calculate credit risk capital charges for advances and for non-mortgage assets. The FHFA proposes to retain for now the percentages used in the tables to calculate capital charges for mortgage-related assets, and to address at a later date the methodology for residential mortgage assets. While a March 2009 regulatory directive pertaining to certain liquidity matters would remain in place, the FHFA also proposes to rescind certain minimum regulatory liquidity requirements and address these liquidity requirements in a new regulatory directive.

We submitted a joint comment letter with the other FHLBanks on August 31, 2017. We continue to evaluate the proposed rule but do not expect this rule, if adopted as proposed, to materially affect our financial condition or results of operations.

Information Security Management Advisory Bulletin. On September 28, 2017, the FHFA issued Advisory Bulletin 2017-02, which supersedes previous guidance on an FHLBank’s information security program. The advisory bulletin describes three main components of an information security program and reflects the expectation that each FHLBank will use a risk-based approach to implement its information security program. The advisory bulletin contains expectations related to: (1) governance, including guidance related to roles and responsibilities, risk assessments, industry standards, and cyber-insurance; (2) engineering and architecture, including guidance on network security, software security, and security of endpoints; and (3) operations, including guidance on continuous monitoring, vulnerability management, baseline configuration, asset life cycle, awareness and training, incident response and recovery, user access management, data classification and protection, oversight of third parties, and threat intelligence sharing.

We do not expect this advisory bulletin to materially affect our financial condition or results of operations, but we anticipate that it may result in increased costs relating to enhancements to our information security program.


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Federal Reserve Board (FRB), Federal Deposit Insurance Corporation (FDIC) and Office of the Comptroller of the Currency (OCC) Final Rules on Mandatory Contractual Stay Requirements for Qualified Financial Contracts (QFCs). On September 12, 2017, the FRB published a final rule, effective November 13, 2017, requiring certain global systemically important banking institutions (GSIBs) regulated by the FRB to amend their covered QFCs to limit a counterparty’s immediate termination or exercise of default rights under the QFCs in the event of bankruptcy or receivership of the GSIB or an affiliate of the GSIB. Covered QFCs include derivatives, repurchase agreements and reverse repurchase agreements, and securities lending and borrowing agreements. On September 27, 2017, and on November 29, 2017, the FDIC and OCC respectively adopted final rules that are both substantively identical to the FRB rule, both effective January 1, 2018, with respect to QFCs entered into with certain FDIC- and OCC-supervised institutions.

Although we are not a covered entity under these rules, as a counterparty to covered entities under QFCs, we may be required to amend QFCs entered into with FRB-regulated GSIBs or applicable FDIC- and OCC-supervised institutions. These rules may impact our ability to terminate business relationships with covered entities and could adversely impact the amount we recover in the event of the bankruptcy or receivership of a covered entity. However, we do not expect these final rules, or the proposed amendments to the Swap Margin Rules, to materially affect our financial condition or results of operations. We do not expect this final rule to materially affect our financial condition or results of operations.

OCC, FRB, FDIC, Farm Credit Administration, and FHFA Proposed Rule on Margin and Capital Requirements for Covered Swap Entities. On February 21, 2018, OCC, FRB, FDIC, Farm Credit Administration, and FHFA published a joint proposed amendment to each agency’s final rule on Margin and Capital Requirements for Covered Swap Entities (“Swap Margin Rules”) to conform the definition of “eligible master netting agreement” in such rules to the FRB’s, OCC’s, and FDIC’s final QFC rules, and to clarify that a legacy swap will not be deemed to be a covered swap under the Swap Margin Rules if it is amended to conform to the QFC Rules.

Comments on the proposed rule are due by April 23, 2018. We continue to evaluate the proposed rule, but we do not expect this rule, if adopted substantially as proposed, to materially affect our financial condition or results of operations.

Where to Find Additional Information
We file our annual, quarterly, and current reports and related information with the SEC. You may read and copy such material at the public reference facilities maintained by the SEC at 100 F Street, NE, Washington, DC 20549. Please call the SEC at 1-800-732-0330 for more information on the public reference room. You can also find our SEC filings at the SEC’s website at www.sec.gov. Additionally, on our website at www.fhlbtopeka.com, you can find a link to the SEC’s website which can be used to access our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 (Exchange Act), as soon as reasonably practicable after we electronically file such material with, or furnish it to, the SEC. Except for the documents specifically incorporated by reference into this Annual Report on Form 10-K, information contained on our website or that can be accessed through our website is not incorporated by reference into this Annual Report on Form 10-K. Reference to our website is made as an inactive textual reference.

Item 1A: Risk Factors
 
Our business has been, and may continue to be, adversely impacted by legislation and other ongoing actions by the U. S. government in response to periodic disruptions in the financial markets. To the extent that any actions by the U.S. government in response to an economic downturn, recession, inflation or other macro-level events or conditions cause a significant decrease in the aggregate amount of advances or increase our operating costs, our financial condition and results of operations may be adversely affected. Our primary regulator, the FHFA, also continues to issue proposed and final regulatory and other requirements as a result of the Recovery Act, the Dodd-Frank Act and other mandates. We cannot predict the effect of any new regulations or other regulatory guidance on our operations. Changes in regulatory requirements could result in, among other things, an increase in our cost of funding or overall cost of doing business, or a decrease in the size, scope or nature of our membership base, or our lending, investment, or mortgage loan activity, which could negatively affect our financial condition and results of operations. See Item 1 – “Business – Legislative and Regulatory Developments” for more information on potential future legislation and other regulatory activity affecting us.

We are subject to a complex body of laws and regulatory and other requirements that could change in a manner detrimental to our operations. The FHLBanks are GSEs organized under the authority of the Bank Act, and, as such, are governed by federal laws, regulations and other guidance adopted and applied by the FHFA. In addition, Congress may amend the Bank Act or pass other legislation that significantly affects the rights, obligations, and permissible activities of the FHLBanks and the manner in which the FHLBanks carry out their housing-finance and liquidity missions and business operations. The U.S. Congress is considering broad legislation for reform of GSEs as a result of the disruptions in the financial and housing markets and the conservatorships of Fannie Mae and Freddie Mac. We do not know how, when, or to what extent GSE reform legislation will be adopted, and if adopted, how it would impact the business or operations of the FHLBank or the FHLBank System. We are, or may also become, subject to further regulations promulgated by the SEC, Commodity Futures Trading Commission (CFTC), Federal Reserve Board, Financial Crimes Enforcement Network, or other regulatory agencies.

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We cannot predict whether new regulatory or other requirements will be promulgated by the FHFA or other regulatory agencies, or whether Congress will enact new legislation, and we cannot predict the effect of any new regulatory requirements or legislation on our operations. Changes in regulatory, statutory or other requirements could result in, among other things, an increase in our cost of funding and the cost of operating our business, a change in our permissible business activities, or a decrease in the size, scope or nature of our membership or our lending, investment or mortgage loan activities, which could negatively affect our financial condition and results of operations.

We share a regulator with Fannie Mae and Freddie Mac. The FHFA currently serves as the federal regulator of the FHLBanks and the Office of Finance, Fannie Mae, and Freddie Mac. Because the business models of Fannie Mae and Freddie Mac are significantly different from that of the FHLBanks, there is a risk that actions by the FHFA toward Fannie Mae and Freddie Mac may have an unfavorable impact on the FHLBanks’ operations and/or financial condition. In addition, there is a risk that our funding costs and access to funds could be adversely affected by changes in investors’ perception of the systemic risks associated with Fannie Mae and Freddie Mac.
 
Changes to our balance sheet management strategies could adversely impact our results of operations. In 2015, the FHFA issued an advisory bulletin establishing a CMA ratio by which the FHFA will assess each FHLBank’s core mission achievement. Core mission achievement is determined using a ratio of primary mission assets, which includes the average par balances of advances and mortgage loans acquired from members, to the average par balance of consolidated obligations. Any adjustments to our balance sheet to meet and/or maintain CMA ratios may result in lower net income and, therefore, adversely impact our financial condition and results of operations as we continue to implement and maintain a core mission asset balance sheet.

An increase in required AHP contributions could adversely affect our results of operations, our ability to pay dividends, or our ability to redeem or repurchase capital stock. The FHLBank Act requires each FHLBank to contribute to its AHP the greater of: (1) 10 percent of the FHLBank’s net earnings for the previous year; or (2) that FHLBank’s pro rata share of an aggregate of $100 million, the proration of which is based on the net earnings of the FHLBanks for the previous year. A failure of the FHLBanks to make the minimum $100 million annual AHP contribution in a given year could result in an increase in our required AHP contribution, which could adversely affect our results of operations, our ability to pay dividends, or our ability to redeem or repurchase capital stock. 

We may not be able to pay dividends at rates consistent with past practices. Our Board of Directors may only declare dividends on our capital stock, payable to members, from our unrestricted retained earnings and current net income. Our ability to pay dividends also is subject to statutory and regulatory requirements, including meeting all regulatory capital requirements. The potential promulgation of regulations or other requirements by the FHFA that would require higher levels of required or restricted retained earnings could lead to higher levels of retained earnings, and thus, lower amounts of unrestricted retained earnings available to be paid out to our members as dividends. Failure to meet any of our regulatory capital requirements would prevent us from paying any dividend.

Events such as changes in our market risk profile, credit quality of assets held, and increased volatility of net income caused by the application of certain GAAP accounting guidance may affect the adequacy of our retained earnings and may require us to increase our threshold level of retained earnings and correspondingly reduce our dividends from historical payout ratios to achieve and maintain the threshold amounts of retained earnings under our RMP. Additionally, FHFA regulations on capital classifications could restrict our ability to pay dividends. Further, our ability to pay dividends at historical rates is impacted directly by our net income, so a decline in net income could result in a decline in dividend rates.

Changes in our credit ratings may adversely affect our business operations. As of March 13, 2018, we are rated Aaa with a stable outlook by Moody’s and AA+ with a stable outlook by S&P. Adverse revisions to or the withdrawal of our credit ratings could adversely affect us in a number of ways. It might influence counterparties to limit the types of transactions they would be willing to enter into with us or cause counterparties to cease doing business with us. We have issued letters of credit to support deposits of public unit funds with our members. In some circumstances, loss of or reduction in any of our current ratings could result in our letters of credit no longer being acceptable to collateralize public unit deposits or other transactions. We have also executed various standby bond purchase agreements (SBPA) in which we provide a liquidity facility for bonds issued by the HFAs by agreeing to purchase the bonds in the event they are tendered and cannot be remarketed in accordance with specified terms and conditions. If our current short-term ratings are reduced, suspended, or withdrawn, the issuers will have the right to terminate these SBPAs, resulting in the loss of future fees that would be payable to us under these agreements.
 
Changes in the credit standing of the U.S. Government or other FHLBanks, including the credit ratings assigned to the U.S. Government or those FHLBanks, could adversely affect us. Pursuant to criteria used by S&P and Moody’s, the FHLBank System’s debt is linked closely to the U.S. sovereign rating because of the FHLBanks’ status as GSEs and the public perception that the FHLBank System would be likely to receive U.S. government support in the event of a crisis. The U.S. government’s fiscal challenges could impact the credit standing or credit rating of the U.S. government, which could in turn result in a revision of the rating assigned to us or the consolidated obligations of the FHLBank System.

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The FHLBanks issue consolidated obligations that are the joint and several liability of all FHLBanks. Significant developments affecting the credit standing of one or more of the other FHLBanks, including revisions in the credit ratings of one or more of the other FHLBanks, could adversely affect the cost of consolidated obligations. An increase in the cost of consolidated obligations would adversely affect our cost of funds and negatively affect our financial condition. As of March 13, 2018, the consolidated obligations of the FHLBanks are rated Aaa/P-1 by Moody’s and AA+/A-1+ by S&P. All of the FHLBanks are rated Aaa with a stable outlook by Moody’s and AA+ with a stable outlook by S&P. Changes in the credit standing or credit ratings of one or more of the other FHLBanks could result in a revision or withdrawal of the ratings of the consolidated obligations by the rating agencies at any time, which may negatively affect our cost of funds and our ability to issue consolidated obligations for our benefit.

We may become liable for all or a portion of the consolidated obligations of one or more of the other FHLBanks. We are jointly and severally liable with the other FHLBanks for all consolidated obligations issued on behalf of all FHLBanks through the Office of Finance. We cannot pay any dividends to members or redeem or repurchase any shares of our capital stock unless the principal and interest due on all our consolidated obligations have been paid in full. If another FHLBank were to default on its obligation to pay principal or interest on any consolidated obligation, the FHFA may allocate the outstanding liability among one or more of the remaining FHLBanks on a pro rata basis or on any other basis the FHFA may determine. As a result, our ability to pay dividends to our members or to redeem or repurchase shares of our capital stock could be affected not only by our own financial condition, but also by the financial condition of one or more of the other FHLBanks.

The yield on, or value of, our MBS investments may be adversely affected by increased delinquency rates and credit losses related to mortgage loans that back our MBS investments. Trends in unemployment, home price growth, and foreclosure inventory have generally been moving in a positive direction for the past several years, which has supported the underlying health of our MBS investments. However, if one or more of these macroeconomic variables deteriorates noticeably, delinquency and/or default rates on the underlying collateral supporting these investments will likely increase, and we could experience reduced yields or losses on our MBS investments. Any increase in delinquency rates and credit losses related to mortgage loans pooled into MBS/CMO and HFA securities, which are insured by one of the monoline mortgage insurance companies, could adversely affect the yield on or value of our MBS/CMO and HFA investments. The magnitude of potential losses in the home mortgage loan market could potentially overwhelm one or more of the monoline mortgage insurance companies resulting in such company’s failure to perform. If collateral losses exceed the coverage ability of the insurance company, the MBS/CMO or HFA bondholders could experience losses of principal. Furthermore, market illiquidity has, from time to time, increased the amount of management judgment required to value private-label MBS and certain other securities. Subsequent valuations may result in significant changes in the value of private-label MBS and other investment securities. If we decide to sell securities due to credit deterioration, the price we may ultimately realize will depend on the demand and liquidity in the market at that time and may be materially lower than the fair value reflected in our financial statements.
 
Loan modification and liquidation programs could have an adverse impact on the value of our MBS investments. Efforts of mortgage servicers to modify delinquent loans in order to mitigate losses may include reductions in interest rates and/or principal on these loans. Losses from such loan modifications may be allocated to investors in MBS backed by these loans in the form of lower interest payments and/or reductions in future principal amounts received. In addition, efforts by the U.S. government to address delinquent mortgage loans could result in reductions in interest rates and/or principal and may also result in additional foreclosures that could result in an adverse impact on the value of our MBS investments.
 
Many servicers are contractually required to advance principal and interest payments on delinquent loans backing MBS investments, regardless of whether the servicer has received payment from the borrower, provided that the servicer believes it will be able to recoup the advanced funds from the underlying property securing the mortgage loan. Once the related property is liquidated, the servicer is entitled to reimbursement for these advances and other expenses incurred while the loan was delinquent. Such reimbursements may result in higher losses than we may have expected or experienced to date being allocated to our MBS investments backed by such loans, which may have an adverse impact on our results of operations and financial condition.
  
Defaults by one or more of our institutional counterparties on its obligations to us could adversely affect our results of operations or financial condition. We have a high concentration of credit risk exposure to financial institutions as counterparties, the majority of which are located within the United States, Canada, Australia, and Europe. Our primary exposures to institutional counterparty risk are with: (1) obligations of mortgage servicers that service the loans we have as collateral on our credit obligations; (2) third-party providers of credit enhancements on the MBS that we hold in our investment portfolio, including mortgage insurers, bond insurers, and financial guarantors; (3) third-party providers of PMI and SMI for mortgage loans purchased under the MPF Program; (4) uncleared derivative counterparties; (5) third-party custodians and futures commission merchants associated with cleared derivatives; and (6) unsecured money market and Federal funds investment transactions. A default by a counterparty with significant obligations to us could adversely affect our ability to conduct operations efficiently and at cost-effective rates, which in turn could adversely affect our results of operations and financial condition.


22


A default by a derivatives clearinghouse on its obligations could adversely affect our results of operations or financial condition. The Dodd-Frank Act and implementing CFTC regulations require all clearable derivatives transactions to be cleared through a derivatives clearinghouse. As a result of such statutes and regulations, we are required to centralize our risk with the derivatives clearinghouses as opposed to the pre-Dodd-Frank Act methods of entering into derivatives transactions that allowed us to distribute our risk among various counterparties. A default by a derivatives clearinghouse: (1) could adversely affect our financial condition in the event the derivatives clearinghouse is unable to make payments owed to us or return our posted initial margin; (2) jeopardize the effectiveness of derivatives hedging transactions; and (3) adversely affect our operations as we may be unable to enter into certain derivatives transactions or do so at cost-effective rates.

Securities or loans pledged as collateral by our members or collateral securing mortgage loans or MBS investments could be adversely affected by the devaluation of, or inability to liquidate, the collateral in the event of a default. Although we seek to obtain sufficient collateral on our credit obligations to protect ourselves from credit losses, changes in market conditions, uninsured or underinsured natural disasters, or other factors may cause the collateral to deteriorate in value, which could lead to a credit loss in the event of a default by a member or a borrower and adversely affect our financial condition and results of operations. A reduction in liquidity in the financial markets or otherwise could have the same effect.
 
Our funding depends on our ability to access the capital markets. Our primary source of funds is the sale of consolidated obligations in the capital markets, including the short-term discount note market. Our ability to obtain funds through the sale of consolidated obligations depends in part on prevailing conditions in the capital markets (including investor demand) at the time. Our counterparties in the capital markets are also subject to additional regulation following the financial crisis that ended in 2010. These regulations could alter the balance sheet composition, market activities, and behavior of our counterparties in a way that could be detrimental to our access to the capital markets and overall financial market liquidity, which could have a negative impact on our funding costs and results of operations. Further, we rely on the Office of Finance for the issuance of consolidated obligations, and a failure or interruption of services provided by the Office of Finance could hinder our ability to access the capital markets. Accordingly, we cannot make any assurance that we will be able to obtain funding on terms acceptable to us in the future, if we are able to obtain funding at all in the case of another severe financial, economic, or other disruption. If we cannot access funding when needed, our ability to support and continue our operations would be adversely affected, negatively affecting our financial condition and results of operations.
 
Changes in interest rates could significantly affect our earnings. Changes in interest rates that are detrimental to our investment and debt positions could negatively affect our financial condition and results of operations. Like many financial institutions, we realize income primarily from earnings on our invested capital as well as the spread between interest earned on our outstanding advances, mortgage loans, and investments and interest paid on our borrowings and other liabilities. Although we use various methods and procedures to monitor and manage our exposures to risk due to changes in interest rates, we may experience instances when our interest-bearing liabilities will be more sensitive to changes in interest rates than our interest-earning assets, or vice versa. These impacts could be exacerbated by prepayment and extension risk, which is the risk that mortgage-related assets will be refinanced in low interest-rate environments or will remain outstanding at below-market yields when interest rates increase.

Changes to and replacement of the LIBOR benchmark interest rate could adversely affect our business, results of operations, and financial condition. In July 2017, the United Kingdom's Financial Conduct Authority announced that it plans to phase out the regulatory oversight of LIBOR interest rate indices by 2021. Other financial services regulators and industry groups are evaluating alternative interest rate indices or reference rates, but there is no definitive information regarding the future utilization of LIBOR or of any particular replacement rate. Many of our assets and liabilities are indexed to LIBOR, so the impact of such a transition could adversely affect our business, results of operations, and financial condition.


23


We rely on derivatives to lower our cost of funds and reduce our interest rate, option and prepayment risk, and we may not be able to enter into effective derivative instruments on acceptable terms; thus, these derivatives may adversely affect our results of operations. We use derivatives to: (1) obtain funding at more favorable rates; and (2) reduce our interest rate risk, option risk and mortgage prepayment risk. Management determines the nature and quantity of hedging transactions using derivatives based on various factors, including market conditions and the expected volume and terms of advances or other transactions. As a result, our effective use of derivatives depends on management’s ability to determine the appropriate hedging positions considering: (1) our assets and liabilities; and (2) prevailing and anticipated market conditions. In addition, the effectiveness of our hedging strategies depends on our ability to enter into derivatives with acceptable counterparties or through derivative clearinghouses, on terms desirable to us and in the quantities necessary to hedge our corresponding obligations, interest rate risk or other risks. The cost of entering into derivative instruments has increased as a result of: (1) consolidations, mergers and bankruptcy or insolvency of financial institutions, which have led to fewer counterparties, resulting in less liquidity in the derivatives market; and (2) increased uncertainty related to the potential changes in legislation and regulations regarding over-the-counter derivatives including increased margin and capital requirements, and increased regulatory costs and transaction fees associated with clearing and custodial arrangements. If we are unable to manage our hedging positions properly, or are unable to enter into derivative hedging instruments on desirable terms or at all, we may incur higher funding costs, be required to limit certain advance product offerings, and be unable to effectively manage our interest rate risk and other risks, which could negatively affect our financial condition and results of operations.

The use of derivatives also subjects us to earnings volatility caused primarily by the changes in the fair values of derivatives that do not qualify for hedge accounting and, to a lesser extent, by hedge ineffectiveness, which is the difference in the amounts recognized in our earnings for the changes in fair value of a derivative and the related hedged item. If we are unable to apply hedge accounting due to changes in standards or other changes in circumstances that impact our ability to utilize hedge accounting, the result could be an increase in the volatility of our earnings from period to period. Such increases in earnings volatility could affect our ability to pay dividends, our ability to meet our retained earnings threshold, and our members’ willingness to hold the capital stock necessary for membership and/or lending activities with us.

Lack of a public market and restrictions on transferring our stock could result in an illiquid investment for the holder. Under the GLB Act, FHFA regulations and our capital plan, our Class A Common Stock may be redeemed upon the expiration of a six-month redemption period and our Class B Common Stock after a five-year redemption period following our receipt of a redemption request. Only capital stock in excess of a member’s minimum investment requirement, capital stock held by a member that has submitted a notice to withdraw from membership, or capital stock held by a member whose membership has been terminated may be redeemed at the end of the redemption period. Further, we may elect to repurchase excess capital stock of a member at any time at our sole discretion.
 
We cannot guarantee, however, that we will be able to redeem capital stock even at the end of the redemption periods. The redemption or repurchase of our capital stock is prohibited by FHFA regulations and our capital plan if the redemption or repurchase of the capital stock would cause us to fail to meet our minimum regulatory capital requirements. Likewise, under such regulations and the terms of our capital plan, we could not honor a member’s capital stock redemption request if the redemption would cause the member to fail to maintain its minimum capital stock investment requirement. Moreover, since our capital stock may only be owned by our members (or, under certain circumstances, former members and certain successor institutions), and our capital plan requires our approval before a member may transfer any of its capital stock to another member, we can provide no assurance that a member would be allowed to sell or transfer any excess capital stock to another member at any point in time.
 
We may also suspend the redemption of capital stock if we reasonably believe that the redemption would prevent us from maintaining adequate capital against a potential risk, or would otherwise prevent us from operating in a safe and sound manner. In addition, approval from the FHFA for redemptions or repurchases is required if the FHFA or our Board of Directors were to determine that we have incurred, or are likely to incur, losses that result in, or are likely to result in, charges against our capital. Under such circumstances, we cannot guarantee that the FHFA would grant such approval or, if it did, upon what terms it might do so. We may also be prohibited from repurchasing or redeeming our capital stock if the principal and interest due on any consolidated obligations that we issued through the Office of Finance has not been paid in full or if we become unable to comply with regulatory liquidity requirements to satisfy our current obligations.
 
Accordingly, there are a variety of circumstances that would preclude us from redeeming or repurchasing our capital stock that is held by a member. Since there is no public market for our capital stock and transfers require our approval, we cannot guarantee that a member’s purchase of our capital stock would not effectively become an illiquid investment.


24


We may not be able to meet our obligations as they come due or meet the credit and liquidity needs of our members in a timely and cost-effective manner. We seek to be in a position to meet our members’ credit and liquidity needs and to pay our obligations without maintaining excessive holdings of low-yielding liquid investments or being forced to incur unnecessarily high borrowing costs. In addition, in accordance with the FHFA’s requirement to maintain five calendar days of contingent liquidity, we maintain a contingency liquidity plan designed to protect against temporary disruptions in access to the FHLBank debt markets in response to a rise in capital market volatility. Our efforts to manage our liquidity position, including carrying out our contingency liquidity plan, may not enable us to meet our obligations and the credit and liquidity needs of our members, which could have an adverse effect on our net interest income, and thereby, our financial condition and results of operations.
 
We rely on financial models to manage our market and credit risk, to make business decisions, and for financial accounting and reporting purposes. The impact of financial models and the underlying assumptions used to value financial instruments may have an adverse impact on our financial condition and results of operations. We make significant use of financial models for managing risk. For example, we use models to measure and monitor exposures to interest rate and other market risks, including prepayment risk, as well as credit risk. We also use models in determining the fair value of financial instruments for which independent price quotations are not available or reliable. The degree of management judgment in determining the fair value of a financial instrument is dependent on the availability of quoted market prices or observable market parameters. For financial instruments that are actively traded and have quoted market prices or parameters readily available, there is little to no subjectivity in determining fair value. If market quotes are not available, fair values are based on discounted cash flows using market estimates of interest rates and volatility or on dealer prices or prices of similar instruments. Pricing models and their underlying assumptions are based on management's best estimates for discount rates, prepayments, market volatility, and other factors. These assumptions may have a significant effect on the reported fair values of assets and liabilities, including derivatives, the related income and expense, and the expected future behavior of assets and liabilities. While the models we use to value instruments and measure risk exposures are subject to regular validation by independent parties, rapid changes in market conditions could impact the value of our instruments. The use of different models and assumptions, as well as changes in market conditions, could impact our financial condition and results of operations.
 
The information provided by these models is also used in making business decisions relating to strategies, initiatives, transactions, and products, and in financial statement reporting. We have adopted policies, procedures, and controls to monitor and manage assumptions used in these models. However, models are inherently imperfect predictors of actual results because they are based on assumptions about future performance. Changes in any models or in any of the assumptions, judgments, or estimates used in the models may cause the results generated by the model to be materially different. If the results are not reliable due to inaccurate assumptions, judgments, or estimates, we could make poor business decisions, including asset and liability management, or other decisions, which could result in an adverse financial impact. Furthermore, any strategies that we employ to attempt to manage the risks associated with the use of models may not be effective.
 
We rely heavily on information systems and other technology. We rely heavily on information systems and other technology to conduct and manage our business. If key technology platforms become obsolete, or if we experience disruptions, including difficulties in our ability to process transactions, our revenue and results of operations could be materially adversely affected. To the extent that we experience a failure or interruption in any of these systems or other technology, we may be unable to conduct and manage our business effectively, including, without limitation, our funding, hedging, and advance activities. Additionally, a failure in or breach of our operational or security systems or infrastructure, or those of third parties with which we do business, including as a result of cyber attacks, could disrupt our systems or data necessary for the operation of our business and/or result in the disclosure or misuse of confidential or proprietary information, or the unavailability of systems or data that are necessary for the operation of our business. While we have implemented disaster recovery, business continuity, and legacy software reduction plans, we can make no assurance that these plans will be able to prevent, timely and adequately address, or mitigate the negative effects of any such failure or interruption. A failure to maintain current technology, systems, and facilities or an operational failure or interruption could significantly harm our customer relations, risk management, and profitability, which could negatively affect our financial condition and results of operations.

Our controls and procedures may fail or be circumvented, and risk management policies and procedures may be inadequate. We may fail to identify and manage risks related to a variety of aspects of our business, including without limitation, operational risk, legal and compliance risk, human capital risk, liquidity risk, market risk, and credit risk. We have adopted controls, procedures, policies, and systems to monitor and manage these risks. Our management cannot provide complete assurance that such controls, procedures, policies, and systems are adequate to identify and manage the risks inherent in our business and because our business continues to evolve, we may fail to fully understand the implications of changes in our business, and therefore, we may fail to enhance our risk governance framework to timely or adequately address those changes. Failed or inadequate controls and risk management practices could have an adverse effect on our financial condition, results of operations or reputation.


25


We may be unable to attract and retain a highly qualified and diverse workforce, including key management. Our success depends on the talents and efforts of our employees, and particularly our management. We may be unable to retain key management or to attract other highly qualified employees, particularly if we do not offer employment terms that are competitive with the rest of the market. Failure to attract and retain highly qualified and diverse employees, or failure to develop and implement an adequate succession plan for key members of management, could adversely affect our financial condition and results of operations.

Reliance on FHLBank of Chicago as MPF Provider could have a negative impact on our business if FHLBank of Chicago were to default on its contractual obligations owed to us. As part of our business, we participate in the MPF Program with FHLBank of Chicago. In its role as MPF Provider, FHLBank of Chicago provides the infrastructure, operational support, and maintenance of investor relations for the MPF Program and is also responsible for publishing and maintaining the MPF Guides, which include the requirements PFIs must follow in originating or selling and servicing MPF mortgage loans. If FHLBank of Chicago changes its MPF Provider role, ceases to operate the MPF Program, or experiences a failure or interruption in its information systems and other technology, our mortgage loan assets could be adversely affected, and we could experience a related decrease in our net interest margin and profitability. In the same way, we could be adversely affected if any of FHLBank of Chicago's third-party vendors engaged in the operation of the MPF Program, or investors that purchase mortgages under the MPF Program, were to experience operational or other difficulties that prevent the fulfillment of their contractual obligations.

We face competition for loan demand, purchases of mortgage loans and access to funding, which could adversely affect our earnings. Our primary business is making advances to our members. We compete with other suppliers of wholesale funding, both secured and unsecured, including investment banks, commercial banks, and, in certain circumstances, other FHLBanks. Our members have access to alternative funding sources that may offer more favorable terms than we offer on our advances, including more flexible credit or collateral standards. In addition, many of our competitors are not subject to the same regulations that are applicable to us. This enables those competitors to offer products and terms that we are not able to offer.
 
The availability of alternative funding sources to our members may significantly decrease the demand for our advances. Any change we might make in pricing our advances, in order to compete more effectively with competitive funding sources, may decrease our profitability on advances. A decrease in the demand for our advances or a decrease in our profitability on advances, would negatively affect our financial condition and results of operations.
 
Likewise, our acquisition of mortgage loans is subject to competition. The most direct competition for purchases of mortgage loans comes from other buyers of conventional, conforming, fixed rate mortgage loans, such as Fannie Mae and Freddie Mac. Increased competition can result in the acquisition of a smaller market share of the mortgage loans available for purchase and, therefore, lower income from this business activity.
 
We also compete in the capital markets with Fannie Mae, Freddie Mac, and other GSEs, as well as corporate, sovereign, and supranational entities for funds raised through the issuance of consolidated obligations and other debt instruments. Our ability to obtain funds through the issuance of debt depends in part on prevailing market conditions in the capital markets (including investor demand), such as effects on the reduction in liquidity in financial markets, which are beyond our control. Accordingly, we may not be able to obtain funding on terms that are acceptable to us. Increases in the supply of competing debt products in the capital markets may, in the absence of increases in demand, result in higher debt costs to us or lesser amounts of debt issued at the same cost than otherwise would be the case. Although our supply of funds through issuance of consolidated obligations has always kept pace with our funding needs, we cannot guarantee that this will continue in the future, especially in the case of financial market disruptions when the demand for advances by our members typically increases.
 
Member mergers or consolidations, failures, or other changes in member business with us may adversely affect our financial condition and results of operations. The financial services industry periodically experiences consolidation, which may occur as a result of various factors including adjustments in business strategies and increasing expense and compliance burdens. If future consolidation occurs within our district, it may reduce the number of current and potential members in our district, resulting in a loss of business to us and a potential reduction in our profitability. Member failures and out-of-district consolidations also can reduce the number of current and potential members in our district. The resulting loss of business could negatively impact our financial condition and the results of operations, as well as our operations generally. If our advances are concentrated in a smaller number of members, our risk of loss resulting from a single event (such as the loss of a member’s business due to the member’s acquisition by a non-member) would become proportionately greater.


26


Further, while member failures may cause us to liquidate pledged collateral if the outstanding advances are not repaid, historically, failures have been resolved either through repayment directly from the FDIC or through the purchase and assumption of the advances by another surviving financial institution. Liquidation of pledged collateral by us may cause financial statement losses. Additionally, if members become financially distressed, we may, at the request of their regulators, decrease lending limits or, in certain circumstances, cease lending activities to certain members if they do not have adequate eligible collateral to support additional borrowings. If members are unable to obtain sufficient liquidity from us, that member's financial position may continue to deteriorate. This may negatively impact our reputation and, therefore, negatively impact our financial condition and results of operations.

A high proportion of advances and capital is concentrated with a few members, and a loss of, or change in business activities with, such institutions could adversely affect us. We have a high concentration of advances (see Table 27) and capital with a few institutions. A reduction in advances by such institutions, or the loss of membership by such institutions, whether through merger, consolidation, withdrawal, or other action, may result in a reduction in our total assets and a possible reduction of capital as a result of the repurchase or redemption of capital stock. The reduction in assets and capital may also reduce our net income.

Item 1B: Unresolved Staff Comments
 
Not applicable.
 
Item 2: Properties
 
Construction of our new 95,000 square foot facility was completed during January 2018. We own this property and have relocated our operations to this facility located at 500 SW Wanamaker Road, Topeka, Kansas. We also maintain in Topeka a leased off-site back-up facility with approximately 3,000 square feet.
 
Item 3: Legal Proceedings
 
We are subject to various pending legal proceedings arising in the normal course of business. After consultation with legal counsel, management does not anticipate that the ultimate liability, if any, arising out of these matters will have a material adverse effect on our financial condition or results of operations. Additionally, management does not believe that we are subject to any material pending legal proceedings outside of ordinary litigation incidental to our business.
 
Item 4: Mine Safety Disclosures

Not applicable.

PART II
 
Item 5: Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
 
As a cooperative, members own almost all of our Class A Common Stock and Class B Common Stock with the remainder of the capital stock held by former members that are required to retain capital stock ownership to support outstanding advance and mortgage loan activity the former members executed while they were members. Note, however, that the portion of our capital stock subject to mandatory redemption is treated as a liability and not as capital, including the capital stock of former members. There is no public trading market for our capital stock.
 
All of our member directors are elected by and from the membership, and we conduct our business in advances and mortgage loan acquisitions almost exclusively with our members. Depending on the class of capital stock, it may be redeemed at par value either six months (Class A Common Stock) or five years (Class B Common Stock) after we receive a written request by a member, subject to regulatory limits and to the satisfaction of any ongoing stock investment requirements applying to the member under our capital plan. We may repurchase shares held by members in excess of the members’ required stock holdings at our discretion at any time at par value. Par value of all common stock is $100 per share. As of March 13, 2018, we had 740 stockholders of record and 2,383,024 shares of Class A Common Stock and 14,952,521 shares of Class B Common Stock outstanding, including 19,748 shares of Class A Common Stock and 32,280 shares of Class B Common Stock subject to mandatory redemption by members or former members. "Classes" of stock are not registered under the Securities Act of 1933 (as amended). The Recovery Act amended the Exchange Act to require the registration of a class of common stock of each FHLBank under Section 12(g) and for each FHLBank to maintain such registration and to be treated as an “issuer” under the Exchange Act, regardless of the number of members holding such a class of stock at any given time. Pursuant to an FHFA regulation, we voluntarily registered one of our classes of stock pursuant to Section 12(g)(1) of the Exchange Act.
 

27


We paid quarterly stock dividends during the years ended December 31, 2017 and 2016, which excludes dividends treated as interest expense for mandatorily redeemable shares. Dividends paid on capital stock are outlined in Table 7 (dollar amounts in thousands):
 
Table 7
 
Class A Common Stock
Class B Common Stock
 
Percent
Dividends Paid in Cash1
Dividends Paid in Class B Common Stock
Total Dividends Paid2
Percent
Dividends Paid in Cash1
Dividends Paid in Class B Common Stock
Total Dividends Paid2
12/31/2017
1.25
%
$
38

$
669

$
707

6.50
%
$
30

$
23,361

$
23,391

09/30/2017
1.25

36

636

672

6.50

30

23,077

23,107

06/30/2017
1.00

38

507

545

6.50

31

22,192

22,223

03/31/2017
1.00

36

479

515

6.50

28

20,813

20,841

12/31/2016
1.00

38

496

534

6.00

35

18,838

18,873

09/30/2016
1.00

39

506

545

6.00

34

19,444

19,478

06/30/2016
1.00

39

486

525

6.00

33

19,217

19,250

03/31/2016
1.00

39

443

482

6.00

34

18,638

18,672

                   
1 
The cash dividends listed are cash dividends paid for partial shares and dividends paid to former members. Stock dividends are paid in whole shares.
2 
Excludes dividends paid on mandatorily redeemable capital stock classified as interest expense.

Dividends may be paid in cash or shares of Class B Common Stock as authorized under our capital plan and approved by our Board of Directors. FHFA regulation prohibits any FHLBank from paying a stock dividend if excess stock outstanding will exceed one percent of its total assets after payment of the stock dividend. We were able to manage our excess capital stock position in the past two years in order to pay stock dividends.

We anticipate paying a 1.25 percent dividend on Class A Common Stock and a 6.50 percent dividend on Class B Common Stock for the first quarter of 2018. Historically, dividend levels have been influenced by several factors, including: (1) an objective of moving dividend rates gradually over time; (2) an objective of having dividends reflective of the level of current short‑term interest rates; and (3) an objective of managing the balance of retained earnings to appropriate levels as set forth in the retained earnings policy. See Item 1 – “Business – Capital, Capital Rules and Dividends” for more information regarding our retained earnings policy, and also see Item 7 – “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Liquidity and Capital Resources - Capital” for a discussion of restrictions on dividend payments in the form of capital stock.

Our retained earnings balances have been significantly above the threshold set forth in the retained earnings policy and were not a factor in determining dividend declarations in 2017 and 2016. There is a possibility that the retained earnings threshold level could change and be a greater consideration for dividend levels in the future because the threshold is a function of the size and composition of our balance sheet.

Item 6: Selected Financial Data

Table 8 presents Selected Financial Data for the periods indicated (dollar amounts in thousands):


28


Table 8
 
12/31/2017
12/31/2016
12/31/2015
12/31/2014
12/31/2013
Statement of Condition (as of period end):
 
 
 
 
 
Total assets
$
48,076,605

$
45,216,749

$
44,426,133

$
36,853,977

$
33,950,304

Investments1
13,998,599

13,609,653

13,606,080

9,620,399

8,704,552

Advances
26,295,849

23,985,835

23,580,371

18,302,950

17,425,487

Mortgage loans, net2
7,286,397

6,640,725

6,390,708

6,230,172

5,949,480

Total liabilities
45,570,502

43,254,301

42,584,381

35,268,710

32,149,084

Deposits
461,769

598,931

759,366

595,775

961,888

Consolidated obligation discount notes, net3
20,420,651

21,775,341

21,813,446

14,219,612

10,889,565

Consolidated obligation bonds, net3
24,514,468

20,722,335

19,866,034

20,221,002

20,056,964

Total consolidated obligations, net3
44,935,119

42,497,676

41,679,480

34,440,614

30,946,529

Mandatorily redeemable capital stock
5,312

2,670

2,739

4,187

4,764

Total capital
2,506,103

1,962,448

1,841,752

1,585,267

1,801,220

Capital stock
1,640,039

1,226,675

1,208,947

974,041

1,252,249

Total retained earnings
840,406

735,196

651,782

627,133

567,332

Accumulated other comprehensive income (loss) (AOCI)
25,658

577

(18,977
)
(15,907
)
(18,361
)
Statement of Income (for the year ended):
 
 
 
 
 
Net interest income
270,008

257,184

239,680

225,165

217,773

(Reversal) provision for credit losses on mortgage loans
(186
)
(109
)
(1,909
)
(1,615
)
1,926

Other income (loss)
15,987

(13,830
)
(80,089
)
(55,850
)
(30,818
)
Other expenses
67,036

63,706

57,762

53,143

52,762

Income before assessments
219,145

179,757

103,738

117,787

132,267

AHP
21,934

17,984

10,378

11,783

13,229

Net income
197,211

161,773

93,360

106,004

119,038

Selected Financial Ratios and Other Financial Data (for the year ended):
 
 
 
 
 
Dividends paid in cash4
267

291

296

299

291

Dividends paid in stock4
91,734

78,068

68,415

45,904

32,697

Weighted average dividend rate5
5.77
%
5.29
%
5.26
%
4.22
%
2.42
%
Dividend payout ratio6
46.65
%
48.44
%
73.60
%
43.59
%
27.71
%
Return on average equity
8.18
%
7.45
%
4.78
%
6.29
%
6.37
%
Return on average assets
0.37
%
0.33
%
0.21
%
0.30
%
0.33
%
Average equity to average assets
4.55
%
4.47
%
4.45
%
4.82
%
5.24
%
Net interest margin7
0.51
%
0.53
%
0.55
%
0.64
%
0.61
%
Total capital ratio8
5.21
%
4.34
%
4.14
%
4.30
%
5.31
%
Regulatory capital ratio9
5.17
%
4.34
%
4.19
%
4.36
%
5.37
%
Ratio of earnings to fixed charges10
1.39

1.56

1.46

1.58

1.59

                   
1 
Includes trading securities, available-for-sale securities, held-to-maturity securities, interest-bearing deposits, securities purchased under agreements to resell, and Federal funds sold.
2 
The allowance for credit losses on mortgage loans was $1,208,000, $1,674,000, $1,972,000, $4,550,000, and $6,748,000 as of December 31, 2017, 2016, 2015, 2014, and 2013, respectively.
3 
Consolidated obligations are bonds and discount notes that we are primarily liable to repay. See Note 17 to the financial statements for a description of the total consolidated obligations of all FHLBanks for which we are jointly and severally liable.
4 
Dividends reclassified as interest expense on mandatorily redeemable capital stock and not included as dividends recorded in accordance with GAAP were $195,000, $79,000, $39,000, $40,000, and $25,000 for the years ended December 31, 2017, 2016, 2015, 2014, and 2013, respectively.
5 
Dividends paid in cash and stock on both classes of stock as a percentage of average capital stock eligible for dividends.
6 
Ratio disclosed represents dividends declared and paid during the year as a percentage of net income for the period presented, although the FHFA regulation requires dividends be paid out of known income prior to declaration date.
7 
Net interest income as a percentage of average earning assets.
8 
GAAP capital stock, which excludes mandatorily redeemable capital stock, plus retained earnings and AOCI as a percentage of total assets.
9 
Regulatory capital (i.e., permanent capital and Class A Common Stock) as a percentage of total assets.
10 
Total earnings divided by fixed charges (interest expense including amortization/accretion of premiums, discounts and capitalized expenses related to indebtedness).


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Item 7: Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
The following Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) is intended to assist the reader in understanding our business and assessing our operations both historically and prospectively. This discussion should be read in conjunction with our audited financial statements and related notes presented under Item 8 of this annual report on Form 10-K. Our MD&A includes the following sections:
Executive Level Overview - a general description of our business and financial highlights;
Financial Market Trends - a discussion of current trends in the financial markets and overall economic environment, including the related impact on our operations;
Critical Accounting Policies and Estimates - a discussion of accounting policies that require critical estimates and assumptions;
Results of Operations - an analysis of our operating results, including disclosures about the sustainability of our earnings;
Financial Condition - an analysis of our financial position;
Liquidity and Capital Resources - an analysis of our cash flows and capital position;
Risk Management - a discussion of our risk management strategies; and
Recently Issued Accounting Standards.

Executive Level Overview
We are a regional wholesale bank that makes advances (loans) to, purchases mortgage loans from, and provides limited other financial services primarily to our members. The FHLBanks, together with the Office of Finance, a joint office of the FHLBanks, make up the FHLBank System, which consists of 11 district FHLBanks. As independent, member-owned cooperatives, the FHLBanks seek to maintain a balance between their public purpose and their ability to provide adequate returns on the capital supplied by their members. The FHLBanks are supervised and regulated by the FHFA, an independent agency in the executive branch of the U.S. government. The FHFA’s mission is to ensure that the housing GSEs operate in a safe and sound manner so that they serve as a reliable source of liquidity and funding for housing finance and community investment.

Our primary funding source is consolidated obligations issued through the FHLBanks’ Office of Finance that facilitates the issuance and servicing of the consolidated obligations. The FHFA and the U.S. Secretary of the Treasury oversee the issuance of FHLBank debt. Consolidated obligations are debt instruments that constitute the joint and several obligations of all FHLBanks. Although consolidated obligations are not obligations of, nor guaranteed by, the U.S. government, the capital markets have traditionally viewed the FHLBanks’ consolidated obligations as “Federal agency” debt. As a result, the FHLBanks have historically had ready access to funding at relatively favorable spreads to U.S. Treasuries. Additional funds are provided by deposits (received from both member and non-member financial institutions), other borrowings, and the issuance of capital stock.

We serve eligible financial institutions in Colorado, Kansas, Nebraska, and Oklahoma (collectively, the Tenth District of the FHLBank System), who are also the member-owners of the FHLBank. Initially, a member is required to purchase shares of Class A Common Stock based on the member’s total assets subject to a per member cap of $500 thousand. Each member may be required to purchase activity-based capital stock (Class B Common Stock) as it engages in certain business activities with the FHLBank, including advances, standby letters of credit, and AMA, at levels determined by management with the Board of Director’s approval and within the ranges stipulated in the Capital Stock Plan. Currently, our capital increases when members are required to purchase additional capital stock in the form of Class B Common Stock to support an increase in their advance borrowings. In the past, capital stock also increased when members sold additional mortgage loans to us; however, members are no longer required to purchase capital stock for AMA activity, as the mortgage loans are supported by the retained earnings of the FHLBank (former members previously required to purchase AMA activity-based stock are subject to the prior requirement as long as there are UPBs outstanding). At our discretion, we may repurchase excess stock if there is a decline in a member’s advances. We believe it is important to manage our business and the associated risks so that we strive to provide franchise value by maintaining a core mission asset focus and meeting the following objectives: (1) achieve our liquidity, housing finance and community development missions by meeting member credit needs by offering advances, supporting residential mortgage lending through the MPF Program and through other products; (2) periodically repurchase excess capital stock in order to appropriately manage the size of our balance sheet; and (3) pay acceptable dividends.


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Net income for the year ended December 31, 2017 was $197.2 million compared to $161.8 million for the year ended December 31, 2016. The $35.4 million increase in net income was driven primarily by fair value fluctuations on derivatives and hedging activities and trading securities, which resulted in a net increase of $31.0 million compared to the prior year period. The increase in the LIBOR swap curve between periods had a positive impact on the net interest settlements on interest rate swaps, which accounted for a large part of the net increase in unrealized gains on derivatives and hedging activities for year ended December 31, 2017 when compared to the prior year. The positive fair value fluctuations on trading securities were generally due to changes in the relative level of interest rates. Net interest income increased $12.8 million for the year ended December 31, 2017 as a result of continued growth in advances and mortgage loans, along with the corresponding increase in investments. Further, the replacement of matured and called consolidated obligations at a lower cost during the last half of 2016 partially offset the increase in the cost of debt resulting from the increase in market interest rates in 2017. Despite the increase in net interest income, net interest margin decreased slightly for the year ended December 31, 2017 due to increases in the average rate on borrowings between periods, which was largely offset by increases in the average yield on interest-earning assets between periods. Increases to net income were partially offset by increases in compensation and benefits, software expenses, and AHP funds available to members. Detailed discussion relating to the fluctuations in net gains (losses) on derivatives and hedging activities, net gains (losses) on trading securities, net interest income, and operating expenses can be found under this Item 7 – “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Results of Operations.”

Total assets increased $2.9 billion, or 6.3 percent from December 31, 2016 to December 31, 2017, resulting primarily from continued strong demand for advances and growth in our mortgage loan portfolio, which allowed for additional growth in our investments. The average balance of advances increased by $2.1 billion, or 7.1 percent, during 2017 compared to 2016 (see Table 12 under this Item 7 – “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Results of Operations”). We have been increasing dividends incrementally since 2014; the weighted average dividend rate increased to 5.77 percent in 2017, compared to 2.42 percent in 2013. The increase in dividends lowers the effective borrowing cost of advances, which has contributed to increased utilization of advances, especially the line of credit product, which increased $2.0 billion between December 31, 2016 and December 31, 2017. Our mortgage loan portfolio increased $0.6 billion, or 9.7 percent, from December 31, 2016 to December 31, 2017, to $7.3 billion, with recent growth attributed to the addition of high-production PFIs and program enhancements that provide PFIs with additional funding opportunities. The average balance of mortgage loans increased $0.4 billion from December 31, 2016 to December 31, 2017. We strive to maintain a ratio of average advances and average mortgage loans to average consolidated obligations (CMA ratio), based on par balances, of 70 to 80 percent, so increases in the average balance of both advances and mortgages allows for growth in non-mission assets while maintaining our desired CMA ratio. Although our investments represent non-mission assets, they are utilized to provide liquidity and primary and secondary market support for the U.S. housing securities market.

Total liabilities increased $2.3 billion, or 5.4 percent, from December 31, 2016 to December 31, 2017. This increase was attributable to a $3.8 billion increase in consolidated obligation bonds, partially offset by a $1.4 billion decrease in discount notes. Our funding mix generally is driven by asset composition, but we may also shift our debt composition as a result of market conditions that impact the cost of consolidated obligations swapped or indexed to LIBOR. Short-term advances, including line of credit advances, represent the majority of the assets funded by term discount notes. We also use term discount notes to fund overnight investments to maintain liquidity sufficient to meet the advance needs of members. During the last half of 2016, the spread to LIBOR began to improve and as a result, we began increasing our allocation of floating rate consolidated obligation bonds and decreased our allocation of discount notes. During the last half of 2017, we increased our allocation of floating rate consolidated obligation bonds to increase liquidity in response to uncertainty surrounding the pending Congressional budget resolution and debt ceiling deadline. For additional information, see Item 7 – “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Financial Condition.”

Return on average equity (ROE) increased to 8.18 percent for the year ended December 31, 2017 compared to 7.45 percent for the prior year period. The increase in net income resulted in an increase in ROE for the year ended December 31, 2017 despite the increase in average capital caused by the increase in advances.

Dividends paid to members totaled $92.0 million for the year ended December 31, 2017 compared to $78.4 million for the prior year. The dividend rate for Class A Common Stock increased to 1.25 percent from 1.00 percent for the last two quarters of 2017, and the dividend rate for Class B Common Stock increased to 6.50 percent from 6.00 percent for all of 2017. Differences in the weighted average dividend rates between the last five years are due to the difference in the mix of outstanding Class A Common Stock and Class B Common Stock between those periods and the increases in the dividend rates. Other factors impacting the outstanding stock class mix and, therefore, the average dividend rates, include weekly exchanges of excess Class B Common Stock to Class A Common Stock and periodic repurchases of excess Class A Common Stock (see “Liquidity and Capital Resources - Capital” under this Item 7 and Item 5 – “Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities”).


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Our strategic business plan is structured in such a way that our business activities are intended to achieve our mission consistent with the FHFA’s CMA guidance. Our CMA ratio was 77 percent for 2017. We intend to manage our balance sheet with an emphasis towards maintaining a CMA ratio within the range of 70 to 80 percent during 2018. However, this ratio is dependent on several variables such as member demand for our advance and mortgage loan products, so it is possible that we will be unable to maintain this level indefinitely.

Financial Market Trends
The primary external factors that affect net interest income are market interest rates and the general state of the economy.

General discussion of the level of market interest rates:
Table 9 presents selected market interest rates as of the dates or for the periods shown.

Table 9
Market Instrument
Average Rate for
Average Rate for
12/31/2017
12/31/2016
2017
2016
Ending Rate
Ending Rate
Federal funds effective rate1
1.00
%
0.39
%
1.33
%
0.55
%
Federal Reserve interest rate on excess reserves1
1.10

0.51

1.50

0.75

3-month U.S. Treasury bill1
0.94

0.31

1.38

0.50

3-month LIBOR1
1.26

0.74

1.69

1.00

2-year U.S. Treasury note1
1.39

0.83

1.89

1.20

5-year U.S. Treasury note1
1.91

1.33

2.21

1.94

10-year U.S. Treasury note1
2.33

1.84

2.41

2.45

30-year residential mortgage note rate2
4.22

3.87

4.22

4.39

                   
1 
Source is Bloomberg.
2 
Mortgage Bankers Association weekly 30-year fixed rate mortgage contract rate obtained from Bloomberg.

During 2017, the cost of FHLBank consolidated obligations as measured by the spread to comparative U.S. Treasury rates remained relatively stable; however, the Congressional budget agreement reached in early 2018 includes an increase in spending which will be financed primarily by debt, which could increase the cost of issuing consolidated obligations. Funding spreads relative to LIBOR have been deteriorating on the short end of the curve since the beginning of 2017, while spreads on longer tenors have improved. The Federal Open Market Committee (FOMC) raised the target rate for overnight Federal funds in March, June and December of 2017, amid positive economic indicators. Many market participants are assigning a high probability of additional increases in 2018 amidst a backdrop of accelerated economic conditions. During the January 2018 meeting, the FOMC reaffirmed its plan to reinvest reduced amounts of principal payments from its holdings of GSE debt, GSE MBS, and U.S. Treasury securities. We issue debt at a spread above U.S. Treasury securities; as a result, higher interest rates increase the cost of issuing FHLBank consolidated obligations and increase the cost of advances to our members and housing associates. For further discussion, see this Item 7 – “Financial Condition – Consolidated Obligations.”

Other factors impacting FHLBank consolidated obligations:
Investors continue to view FHLBank consolidated obligations as carrying a relatively strong credit profile. Historically, our strong credit profile has resulted in steady investor demand for FHLBank discount notes and short-term bonds. Recent regulatory changes to money market funds has intensified demand for our debt. Several market events continue to have the potential to impact the demand for our consolidated obligations including geopolitical events and/or disruptions; potential policy changes under the current administration; pending regulatory changes in liquidity requirements; changes in interest rates and the shape of the yield curve as the FOMC contemplates additional increases in short-term interest rates; the replacement of LIBOR with another index; and a decline in dealer demand due to regulatory changes related to capital.


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Critical Accounting Policies and Estimates
The preparation of our financial statements in accordance with GAAP requires management to make a number of judgments and assumptions that affect our reported results and disclosures. Several of our accounting policies are inherently subject to valuation assumptions and other subjective assessments and are more critical than others in terms of their importance to results. These assumptions and assessments include the following:
Accounting related to derivatives and hedging activities;
Fair value determinations;
Accounting for deferred premium/discount associated with MBS; and
Determining the adequacy of the allowance for credit losses.

Changes in any of the estimates and assumptions underlying critical accounting policies could have a material effect on our financial statements.

The accounting policies that management believes are the most critical to an understanding of our financial condition and results of operations and require complex management judgment are described below.
 
Accounting for Derivatives and Hedging Activities: Derivative instruments are carried at fair value on the Statements of Condition. Any change in the fair value of a derivative is recorded each period in current period earnings or other comprehensive income (OCI), depending upon whether the derivative is designated as part of a hedging relationship and, if it is, the type of hedging relationship. A majority of our derivatives are structured to offset some or all of the risk exposure inherent in our lending, mortgage purchase, investment, and funding activities. We are required to recognize unrealized gains or losses on derivative positions, regardless of whether offsetting gains or losses on the hedged assets or liabilities are recognized simultaneously. Therefore, the accounting framework introduces the potential for considerable income variability from period to period. Specifically, a mismatch can exist between the timing of income and expense recognition from assets or liabilities and the income effects of derivative instruments positioned to mitigate market risk and cash flow variability. Therefore, during periods of significant changes in interest rates and other market factors, reported earnings may exhibit considerable variability. We seek to utilize hedging techniques that are effective under the hedge accounting requirements; however, in some cases, we have elected to enter into derivatives that are economically effective at reducing risk but do not meet hedge accounting requirements, either because it was more cost effective to use a derivative hedge compared to a non-derivative hedging alternative, or because a non-derivative hedging alternative was not available. As required by FHFA regulation and our RMP, derivative instruments that do not qualify as hedging instruments may be used only if we document a non-speculative purpose at the inception of the derivative transaction.
 
A hedging relationship is created from the designation of a derivative financial instrument as either hedging our exposure to changes in the fair value of a financial instrument or changes in future cash flows attributable to a balance sheet financial instrument or anticipated transaction. Fair value hedge accounting allows for the offsetting fair value of the hedged risk in the hedged item to also be recorded in current period earnings. Highly effective hedges that use interest rate swaps as the hedging instrument and that meet certain stringent criteria can qualify for “shortcut” fair value hedge accounting. Shortcut hedge accounting allows for the assumption of no ineffectiveness, which means that the change in fair value of the hedged item can be assumed to be equal to the change in fair value of the derivative. If the hedge is not designated for shortcut hedge accounting, it is treated as a “long haul” fair value hedge, where the change in fair value of the hedged item must be measured separately from the derivative, and for which effectiveness testing must be performed regularly with results falling within established tolerances. If the hedge fails effectiveness testing, the hedge no longer qualifies for hedge accounting and the derivative is marked to estimated fair value through current period earnings without any offsetting change in estimated fair value related to the hedged item. We had previously discontinued using shortcut hedge accounting for derivative transactions entered into on or after July 1, 2008 but resumed using shortcut hedge accounting during the fourth quarter of 2017.

For derivative transactions that potentially qualify for long haul fair value hedge accounting treatment, management must assess how effective the derivatives have been, and are expected to be, in hedging offsetting changes in the estimated fair values attributable to the risks being hedged in the hedged items. Hedge effectiveness testing is performed at the inception of the hedging relationship and on an ongoing basis for long haul fair value hedges. We perform testing at hedge inception based on regression analysis of the hypothetical performance of the hedging relationship using historical market data. We then perform regression testing on an ongoing basis using accumulated actual values in conjunction with hypothetical values. Specifically, each month we use a consistently applied statistical methodology that employs a sample of 30 historical interest rate environments and includes an R-squared test (commonly used statistic to measure correlation of the data), a slope test, and an F-statistic test (commonly used statistic to measure how well the regression model describes the collection of data). These tests measure the degree of correlation of movements in estimated fair values between the derivative and the related hedged item. For the hedging relationship to be considered effective, results must fall within established tolerances.
 

33


Given that a derivative qualifies for long haul fair value hedge accounting treatment, the most important element of effectiveness testing is the price sensitivity of the derivative and the hedged item in response to changes in interest rates and volatility as expressed by their effective durations. The effective duration will be influenced mostly by the final maturity and any option characteristics. In general, the shorter the effective duration, the more likely it is that effectiveness testing would fail because of the impact of the short-term LIBOR side of the interest rate swap. In this circumstance, the slope criterion is the more likely factor to cause the effectiveness test to fail.
 
The estimated fair values of the derivatives and hedged items do not have any cumulative economic effect if the derivative and the hedged item are held to maturity, or contain mutual optional termination provisions at par. Since these fair values fluctuate throughout the hedge period and eventually return to zero (derivative) or par value (hedged item) on the maturity or option exercise date, the earnings impact of fair value changes is only a timing issue for hedging relationships that remain outstanding to maturity or the call termination date.
 
For derivative instruments and hedged items that meet the requirements as described above, we do not anticipate any significant impact on our financial condition or operating performance. For derivative instruments where no identified hedged item qualifies for hedge accounting, changes in the market value of the derivative are reflected in income. As of December 31, 2017 and 2016, we held a portfolio of derivatives that are marked to market with no offsetting qualifying hedged item. This portfolio of economic derivatives consisted primarily of: (1) interest rate swaps hedging fixed rate MBS and non-MBS trading investments; (2) interest rate caps hedging adjustable rate MBS with embedded caps; and (3) interest rate swaps hedging variable rate consolidated obligation bonds. While the fair value of these derivative instruments, with no offsetting qualifying hedged item, will fluctuate with changes in interest rates and the impact on our earnings can be material, the change in fair value of trading securities being hedged by economic hedges is expected to partially offset that impact. The change in fair value of the derivatives classified as economic hedges is only partially offset by the change in the fair value of trading securities being hedged by economic hedges because the amount of economic hedges exceeds the amount of swapped trading securities and because of the relationship between mortgage rates relative to the interest rate swap curve for the swapped MBS trading securities. See Tables 61 and 62 under Item 7A – "Quantitative and Qualitative Disclosures About Market Risk," which present the notional amount and fair value amount (fair value includes net accrued interest receivable or payable on the derivative) for derivative instruments by hedged item, hedging instrument, hedging objective and accounting designation. The total par value of non-MBS and MBS classified as trading securities related to economic hedges was $0.4 billion and $0.9 billion, respectively, as of December 31, 2017, which matches the notional amount of interest rate swaps hedging the GSE debentures and MBS in trading securities on that date. For asset/liability management purposes, our fixed rate GSE debentures and MBS currently classified as trading are matched to interest rate swaps that effectively convert the securities from fixed rate investments to variable rate instruments. See Tables 14 through 16 under this Item 7, which show the relationship of gains/losses on economic hedges and gains/losses on the trading securities being hedged by economic derivatives. Our projections of changes in fair value of the derivatives have been consistent with actual results.
 
Fair Value: As of December 31, 2017 and 2016, certain assets and liabilities, including investments classified as trading or available-for-sale, and all derivatives, were presented in the Statements of Condition at fair value. Under GAAP, fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Fair values play an important role in the valuation of certain assets, liabilities and derivative transactions. The fair values we generate directly impact the Statements of Condition, Statements of Income, Statements of Comprehensive Income, Statements of Capital, and Statements of Cash Flows as well as risk-based capital, duration of equity (DOE), and market value of equity (MVE) disclosures. Management also estimates the fair value of collateral that borrowers pledge against advance borrowings and other credit obligations to confirm that we have sufficient collateral to meet regulatory requirements and to protect ourselves from a credit loss.
 
Fair value measurement under GAAP uses a three-level fair value hierarchy to reflect the level of judgment involved in estimating fair value. Fair values are based on market prices when they are available (generally considered a Level 1 or Level 2 valuation under GAAP). If market quotes are not available, fair values are based on discounted cash flows using market estimates of interest rates and volatility, or on prices of similar instruments (generally considered a Level 3 valuation under GAAP). Pricing models and their underlying assumptions are based on our best estimates for discount rates, prepayment speeds, market volatility and other factors. We validate our financial models at least annually and the models are calibrated to values from outside sources on a monthly basis. We validate modeled values to outside valuation services routinely to determine if the values generated from discounted cash flows are reasonable. Additionally, due diligence procedures are completed for third-party pricing vendors. The assumptions used by third-party pricing vendors or within our models may have a significant effect on the reported fair values of assets and liabilities, including derivatives, and the related income and expense. See Note 16 of the Notes to Financial Statements under Item 8 – “Financial Statements and Supplementary Data” for a detailed discussion of the assumptions used to calculate fair values and the due diligence procedures completed. The use of different assumptions as well as changes in market conditions could result in materially different net income and retained earnings.


34


As of December 31, 2017, we had no fair values that were classified as level 3 valuations for financial instruments that are measured on a recurring basis at fair value. However, we have impaired mortgage loans and REO, which were written down to their fair values and considered level 3 valuations as of year-end. Based on the validation of our inputs and assumptions with other market participant data, we have concluded that the pricing derived should be considered level 3 valuations. We record private-label MBS at fair value at the time any are determined to have other-than-temporary impairment (OTTI). Due to a general lack of trades in the market for these securities, we have concluded that the pricing derived should be considered level 3 valuations.
 
Deferred Premium/Discount Associated with MBS: When we purchase MBS, we often pay an amount that is different than the UPB. The difference between the purchase price and the contractual note amount is a premium if the purchase price is higher and a discount if the purchase price is lower. Accounting guidance permits us to amortize (or accrete) the premiums (or discounts) in a manner such that the yield recognized on the underlying asset is constant over the asset’s estimated life. We typically pay more than the UPBs when the interest rates on the MBS are greater than prevailing market rates for similar MBS on the transaction date. The net purchase premiums paid are then amortized using the level-yield method over the expected lives of the MBS as a reduction in yield (decreases interest income). Similarly, if we pay less than the UPB because interest rates on the MBS are lower than prevailing market rates on similar MBS on the transaction date, the net discounts are accreted in the same manner as the premiums, resulting in an increase in yield (increases interest income). The level-yield amortization method is applied using expected cash flows that incorporate prepayment projections that are based on mathematical models which describe the likely rate of consumer mortgage loan refinancing activity in response to incentives created (or removed) by changes in interest rates. Changes in interest rates have the greatest effect on the extent to which mortgage loans may prepay, although, during times of disruption in the financial markets, tight credit, and declining home prices, consumer mortgage refinancing behavior can also be significantly affected by the borrower’s credit score and the value of the home in relation to the outstanding loan value. Generally, however, when interest rates decline, mortgage loan prepayment speeds are likely to increase, which accelerates the amortization of premiums and the accretion of discounts. The opposite occurs when interest rates rise. We use a third-party data service that provides estimates of cash flows, from which we determine expected asset lives for the MBS. The level-yield method uses actual prepayments received and projected future mortgage prepayment speeds, as well as scheduled principal payments, to determine the amount of premium/discount that must be recognized and will result in a constant monthly yield until maturity. Amortization of MBS premiums could accelerate in falling interest-rate environments or decelerate in rising interest-rate environments. Exact trends will depend on the relationship between market interest rates and coupon rates on outstanding MBS, the historical evolution of mortgage interest rates, the age of the underlying mortgage loans, demographic and population trends, and other market factors such as increased foreclosure activity, falling home prices, tightening credit standards by mortgage lenders and the other housing GSEs, and other repercussions from the financial market conditions.
 
Allowance for Credit Losses: We have established an allowance methodology for each of our portfolio segments to estimate the allowance for credit losses, if necessary, to provide for probable losses inherent in our portfolio segments.

Mortgage Loans - We estimate the allowance for loan loss on homogeneous pools of mortgage loans or on an individual mortgage loan basis to assess the credit losses that are inherent in our conventional mortgage loan portfolio but have not been realized.
Collectively Evaluated Mortgage Loans - The assessment of loan loss for the pools of loans entails segmenting the loan pool into strata based on each of the current classifications of each loan (i.e., current, delinquent, non-performing, referred to foreclosure). We perform a migration analysis to determine the probability of default for each stratum of loans based on a short- and mid-term horizon utilizing historical statistics. In addition, we determine the pool’s historical loss statistics based on a short- and mid-term horizon to determine the loss severity. Loan balances, probability of default, and loss severity are then utilized to determine the expected loan loss for the pool.
Individually Evaluated Mortgage Loans - We calculate an allowance for loan loss on individual loans if events or circumstances make it probable that we will not be able to collect all amounts due according to the contractual terms for a subset of the mortgage loans. We have determined that all mortgage loans held in our mortgage loan portfolio are considered collateral dependent and have elected to measure individual loan impairment based on collateral value less estimated cost to sell. Collateral value is based on appraisals, if available, or estimated property values using an automated valuation model or housing pricing index. If the collateral value less cost to sell is less than the recorded investment in the loan, the loan is considered impaired. Beginning in January 2015, the excess of the recorded investment in the loan over the loan’s collateral value less cost to sell is charged off if the loan is over 180 days delinquent or in bankruptcy. If a loan has been individually evaluated for impairment, it is excluded from the loan population for which a collective allowance is estimated.

Once the collectively evaluated and individually evaluated assessments are completed, the total estimates of loan losses are accumulated to the master commitment level to determine if, and by how much, the estimated loan losses exceed the FLA. The estimated loan losses in excess of the FLA by master commitment may be covered up to the PFI’s CE obligation amount (provided directly by the PFI or through the PFI’s purchase of SMI). We are responsible for any estimated loan losses in excess of the PFI’s CE obligation for each master commitment. For additional information on the loss allocation rules for each traditional MPF product, see Item 1 – “Business – Mortgage Loans.” The estimated losses that will be allocated to us (i.e., excluding estimated losses covered by CE obligations) are recorded as the balance in the allowance for loan loss with the resulting offset being presented as the provision for credit losses on mortgage loans.

35



Credit products - We have never experienced a credit loss on an advance. Based upon the collateral held as security, our credit extension and collateral policies, credit analysis and repayment history, we currently do not anticipate any credit losses on advances and have not recorded an allowance for losses on advances. We are required by statute to obtain and maintain security interests in sufficient collateral on advances to protect against losses, and to accept as collateral on such advances only certain qualified types of collateral, which are primarily U.S. government, U.S. obligation or GSE securities, certain residential mortgage loans, deposits in the FHLBank, and other real estate related assets. See Item 1 – “Business – Advances” for a more detailed discussion of collateral.

Direct financing lease receivable - We have a recorded investment in a direct financing lease receivable with a member for a building complex and property. Under the office complex agreement, we have all rights and remedies under the lease agreement as well as all rights and remedies available under the member's Advance, Pledge and Security Agreement. Consequently, we can apply any excess collateral securing credit products to any shortfall in the leasing arrangement.

Term Federal Funds Sold and Term Securities Purchased Under Agreements to Resell - There were no investments in term Federal funds sold or in term securities purchased under agreements to resell outstanding at any time during the years ended December 31, 2017 and 2016.

The process of determining the allowance for credit losses requires a high degree of judgment. It is possible that others, given the same information, may at any point in time reach different reasonable conclusions. Because of variability in the data underlying the assumptions made in the process of determining the allowance for credit losses, estimates of the portfolio’s inherent risks will change as warranted by changes in the economy. The degree to which any particular change would affect the allowance for credit losses would depend on the severity of the change.
 
For additional information regarding allowances for credit losses, see Note 7 of the Notes to Financial Statements under Item 8 – “Financial Statements and Supplementary Data.”

Results of Operations
Earnings Analysis: Table 10 presents changes in the major components of our net income (dollar amounts in thousands):

Table 10
 
Increase (Decrease) in Earnings Components
 
2017 vs. 2016
2016 vs. 2015
 
Dollar Change
Percentage Change
Dollar Change
Percentage Change
Total interest income
$
251,541

43.3
 %
$
115,007

24.7
%
Total interest expense
238,717

73.8

97,503

43.2

Net interest income
12,824

5.0

17,504

7.3

(Reversal) provision for credit losses on mortgage loans
(77
)
(70.6
)
1,800

94.3

Net interest income after mortgage loan loss provision
12,901

5.0

15,704

6.5

Net gains (losses) on trading securities
20,623

150.4

34,282

71.4

Net gains (losses) on derivatives and hedging activities
10,382

89.3

31,216

72.9

Other non-interest income
(1,188
)
(10.3
)
761

7.1

Total other income (loss)
29,817

215.6

66,259

82.7

Operating expenses
2,296

4.3

5,378

11.1

Other non-interest expenses
1,034

10.5

566

6.1

Total other expenses
3,330

5.2

5,944

10.3

AHP assessments
3,950

22.0

7,606

73.3

NET INCOME
$
35,438

21.9
 %
$
68,413

73.3
%


36


Table 11 presents the amounts contributed by our principal sources of interest income (dollar amounts in thousands):

Table 11
 
Year Ended December 31,
 
2017
2016
2015
 
Interest Income
Percent of Total
Interest Income
Percent of Total
Interest Income
Percent of Total
Investments1
$
214,239

25.7
%
$
145,358

25.0
%
$
113,578

24.4
%
Advances
402,071

48.3

229,904

39.6

145,689

31.3

Mortgage loans held for portfolio
214,388

25.8

203,916

35.1

204,778

44.0

Other
1,280

0.2

1,259

0.3

1,385

0.3

TOTAL INTEREST INCOME
$
831,978

100.0
%
$
580,437

100.0
%
$
465,430

100.0
%
                   
1 
Includes trading securities, available-for-sale securities, held-to-maturity securities, interest-bearing deposits, securities purchased under agreements to resell and Federal funds sold.

Net income for the year ended December 31, 2017 was $197.2 million compared to $161.8 million for the year ended December 31, 2016. The $35.4 million increase in net income was driven primarily by fair value fluctuations on derivatives and hedging activities and trading securities, which resulted in a net increase of $31.0 million. The increase in the LIBOR swap curve between periods had a positive impact on the net interest settlements on interest rate swaps, which accounted for a large part of the positive fair value fluctuations for the year ended December 31, 2017 when compared to the prior year. The positive fair value fluctuations on trading securities were generally due to changes in the relative level of interest rates. Net interest income increased $12.8 million for the year ended December 31, 2017 as a result of continued growth in advances and mortgage loans, along with the corresponding increase in investments. Further, the replacement of matured and called consolidated obligations at a lower cost during the last half of 2016 partially offset the increase in the cost of debt resulting from the increase in market interest rates in 2017. Despite the increase in net interest income, net interest margin decreased slightly for the year ended December 31, 2017 compared to the prior year due to increases in the average rate on borrowings between periods, which was largely offset by increases in the average yield on interest-earning assets between periods. Increases to net income were partially offset by increases in compensation and benefits, software expenses, and an increased allocation of funds available to members for affordable housing. ROE was 8.18 percent and 7.45 percent for the years ended December 31, 2017 and 2016, respectively. The increase in net income resulted in an increase in ROE for the year ended December 31, 2017 despite the increase in average capital caused by the increase in advances. Dividends paid to members totaled $92.0 million for the year ended December 31, 2017 compared to $78.4 million for the prior year.

Net income for the year ended December 31, 2016 was $161.8 million compared to $93.4 million for the year ended December 31, 2015. The $68.4 million increase in net income was driven by fair value fluctuations on derivatives and hedging activities and trading securities, which resulted in a net increase of $65.5 million. The positive fair value fluctuations were due largely to a tightening of the spread between mortgage rates relative to the interest rate swap curve during 2016, compared to significant widening of the same spread in the latter half of 2015. The tightening of the spread positively impacted the values of both our economic interest rate swaps and the hedged multi-family GSE MBS. Net interest income increased $17.5 million for the year ended December 31, 2016 largely as a result of advance growth, primarily in our lower-yielding line of credit advances, and increases in higher-yielding investments, partially offset by an increase in average funding cost driven by increases in short-term interest rates. ROE was 7.45 percent and 4.78 percent for the years ended December 31, 2016 and 2015, respectively. Dividends paid to members totaled $78.4 million for the year ended December 31, 2016 compared to $68.7 million for the prior year.
 
Net Interest Income: Net interest income, which includes interest earned on advances, mortgage loans, and investments less interest paid on consolidated obligations, deposits, and other borrowings is the primary source of our earnings. The $12.8 million increase in net interest income for the year ended December 31, 2017 compared to the year ended December 31, 2016 was a result of a result of continued growth in advances, mortgage loans, and investments, combined with a reduction in long-term debt costs resulting from the refinancing of debt during the decline in rates in the last half of 2016 which partially offset the increase in the cost of debt resulting from the increase in market interest rates in 2017 (see Table 12). The increase in net interest income for the year ended December 31, 2016 compared to the year ended December 31, 2015 was a result of growth in our short-term advances and increases in short-term interest rates, and increases in the average balances and yields of investments, partially offset by an increase in average funding cost driven by increases in short-term interest rates.


37


The average yield on total investments, which consist of interest-bearing deposits, Federal funds sold, reverse repurchase agreements, and investment securities, increased from 1.17 percent for the year ended December 31, 2016 to 1.50 percent for the year ended December 31, 2017. The majority of the 33 basis point increase was due to increases in short-term interest rates paid on interest-bearing deposits, Federal funds sold, and reverse repurchase agreements. The increase in long-term interest rates and indices related to variable rate instruments increased yields as variable rate securities repriced upwards and we purchased long-term securities with yields reflecting higher market interest rates. The average yield on total investments increased from 1.00 percent for the year ended December 31, 2015 to 1.17 percent for the year ended December 31, 2016, also due primarily to increases in yields earned on Federal funds sold and reverse repurchase agreements and increases in the indices related to variable rate investment securities, combined with purchases of securities with yields higher than that of the existing portfolio.

The average yield on advances increased 49 basis points, from 0.78 percent for the year ended December 31, 2016 to 1.27 percent for the year ended December 31, 2017 due to continued increases in market interest rates across all maturities. The average yield on advances increased 22 basis points, from 0.56 percent for the year ended December 31, 2015 to 0.78 percent for the year ended December 31, 2016 due to an increase in short-term interest rates.

The average yield on mortgage loans decreased three basis points, from 3.14 percent for the year ended December 31, 2016 to 3.11 percent for the year ended December 31, 2017. The average yield on mortgage loans decreased 10 basis points for the year ended December 31, 2015 to December 31, 2016. The decrease in yield for both annual periods is due to accelerated premium amortization, as prepayments on higher coupon loans increased (yields on interest earning assets decline as premiums are amortized; amortization accelerates as prepayments increase) and reinvestment is typically at a rate lower than the prepaid asset. Average mortgage rates declined between 2015 and 2016, but increased between 2016 and 2017, but even in rising rate environments, yields could still decline depending on the rate and premium of the prepaid assets. We purchased newly originated mortgage loans at market rates during the periods. Premium amortization is likely to remain near or slightly lower than current levels, as prepayments tend to slow during periods of relatively stable or rising rates.

The average cost of total consolidated obligations (bonds and discount notes) increased 41 basis points, from 0.71 percent for the year ended December 31, 2016 to 1.12 percent for the year ended December 31, 2017. During the last half of 2016, we were able to replace some maturing consolidated obligation bonds and called unswapped consolidated obligation bonds at a lower cost, which partially offset the increase in the cost of debt resulting from the increase in market interest rates. The average cost of total consolidated obligations (bonds and discount notes) increased 16 basis points, from 0.55 percent for the year ended December 31, 2015 to 0.71 percent for the year ended December 31, 2016 as a result of the increase in short-term interest rates between periods and the widening of spreads that occurred at the end of 2015 and persisted throughout the first half of 2016. During the last half of 2016 and into 2017, the spread to LIBOR improved so we increased our allocation of floating rate consolidated obligation bonds and decreased our allocation of discount notes. For further discussion of how we use bonds and discount notes, see Item 7 – “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Financial Condition – Consolidated Obligations.”

Our net interest spread is impacted by derivative and hedging activities, as the assets and liabilities hedged with derivative instruments designated under fair value hedging relationships are adjusted for changes in fair values, while other assets and liabilities are carried at historical cost. Further, net interest payments or receipts on interest rate swaps designated as fair value hedges and the amortization/accretion of hedging activities are recognized as adjustments to the interest income or expense of the hedged asset or liability. However, net interest payments or receipts on derivatives that do not qualify for hedge accounting (economic hedges) flow through net gains (losses) on derivatives and hedging activities instead of net interest income (net interest received/paid on economic derivatives is identified in Tables 14 through 16 under this Item 7), which distorts yields, especially for fixed rate trading investments that are swapped to a variable rate.


38


Table 12 presents average balances and yields of major earning asset categories and the sources funding those earning assets (dollar amounts in thousands):

Table 12
 
2017
2016
2015
 
Average
Balance
Interest
Income/
Expense
Yield
Average
Balance
Interest
Income/
Expense
Yield
Average
Balance
Interest
Income/Expense
Yield
Interest-earning assets:
 

 

 

 

 

 

 
 
 
Interest-bearing deposits
$
417,175

$
4,204

1.01
%
$
482,592

$
1,873

0.39
%
$
229,611

$
241

0.10
%
Securities purchased under agreements to resell
2,323,216

23,937

1.03

2,501,676

11,975

0.48

2,271,557

4,371

0.19

Federal funds sold
2,716,688

27,994

1.03

1,414,453

5,743

0.41

1,656,091

2,131

0.13

Investment securities1,2
8,864,480

158,104

1.78

8,011,744

125,767

1.57

7,217,004

106,835

1.48

Advances2,3
31,605,448

402,071

1.27

29,497,498

229,904

0.78

26,108,222

145,689

0.56

Mortgage loans2,4,5
6,891,057

214,388

3.11

6,491,021

203,916

3.14

6,314,880

204,778

3.24

Other interest-earning assets
29,530

1,280

4.33

23,075

1,259

5.46

22,796

1,385

6.07

Total earning assets
52,847,594

831,978

1.57

48,422,059

580,437

1.20

43,820,161

465,430

1.06

Other non-interest-earning assets
204,665

 

 

120,888

 

 

28,810

 
 
Total assets
$
53,052,259

 

 

$
48,542,947

 

 

$
43,848,971

 
 
 
 
 
 
 
 
 
 
 
 
Interest-bearing liabilities:
 

 

 

 

 

 

 
 
 
Deposits
$
486,747

3,371

0.69

$
595,593

1,009

0.17

$
681,316

590

0.09

Consolidated obligations2:
 

 

 

 

 

 

 

 

 

Discount Notes
26,811,378

237,019

0.88

27,181,055

93,052

0.34

20,067,007

21,585

0.11

Bonds
23,038,357

320,895

1.39

18,113,580

228,842

1.26

20,741,913

203,283

0.98

Other borrowings
19,257

685

3.56

8,722

350

4.01

13,352

292

2.18

Total interest-bearing liabilities
50,355,739

561,970

1.11

45,898,950

323,253

0.71

41,503,588

225,750

0.54

Capital and other non-interest-bearing funds
2,696,520

 

 

2,643,997

 

 

2,345,383

 
 
Total funding
$
53,052,259

 

 

$
48,542,947

 

 

$
43,848,971

 
 
 
 
 
 
 
 
 
 
 
 
Net interest income and net interest spread6
 

$
270,008

0.46
%
 

$
257,184

0.49
%
 
$
239,680

0.52
%
 
 
 
 
 
 
 
 
 
 
Net interest margin7
 

 

0.51
%
 

 

0.53
%
 
 
0.55
%
                   
1 
The non-credit portion of the OTTI discount on held-to-maturity securities and the fair value adjustment on available-for-sale securities are excluded from the average balance for calculations of yield since the changes are adjustments to equity.
2 
Interest income/expense and average rates include the effect of associated derivatives that qualify for hedge accounting treatment.
3 
Advance income includes prepayment fees on terminated advances.
4 
CE fee payments are netted against interest earnings on the mortgage loans. The expense related to CE fee payments to PFIs was $5.7 million, $5.3 million and $5.1 million for the years ended December 31, 2017, 2016, and 2015, respectively.
5 
Mortgage loans average balance includes outstanding principal for non-performing conventional loans. However, these loans no longer accrue interest.
6 
Net interest spread is the difference between the yield on interest-earning assets and the cost of interest-bearing liabilities.
7 
Net interest margin is net interest income as a percentage of average interest-earning assets.


39


Changes in the volume of interest-earning assets and the level of interest rates influence changes in net interest income, net interest spread and net interest margin. Table 13 summarizes changes in interest income and interest expense (in thousands):

Table 13
 
2017 vs. 2016
2016 vs. 2015
 
Increase (Decrease) Due to
Increase (Decrease) Due to
 
Volume1,2
Rate1,2
Total
Volume1,2
Rate1,2
Total
Interest Income:
 

 

 

 
 
 
Interest-bearing deposits
$
(286
)
$
2,617

$
2,331

$
473

$
1,159

$
1,632

Securities purchased under agreements to resell
(912
)
12,874

11,962

485

7,119

7,604

Federal funds sold
8,333

13,918

22,251

(354
)
3,966

3,612

Investment securities
14,185

18,152

32,337

12,225

6,707

18,932

Advances
17,485

154,682

172,167

20,762

63,453

84,215

Mortgage loans
12,462

(1,990
)
10,472

5,628

(6,490
)
(862
)
Other assets
311

(290
)
21

17

(143
)
(126
)
Total earning assets
51,578

199,963

251,541

39,236

75,771

115,007

Interest Expense:
 

 

 

 
 
 
Deposits
(216
)
2,578

2,362

(82
)
501

419

Consolidated obligations:
 

 

 

 

 

 

Discount notes
(1,283
)
145,250

143,967

9,986

61,481

71,467

Bonds
66,850

25,203

92,053

(28,028
)
53,587

25,559

Other borrowings
379

(44
)
335

(126
)
184

58

Total interest-bearing liabilities
65,730

172,987

238,717

(18,250
)
115,753

97,503

Change in net interest income
$
(14,152
)
$
26,976

$
12,824

$
57,486

$
(39,982
)
$
17,504

                   
1 
Changes in interest income and interest expense not identifiable as either volume-related or rate-related have been allocated to volume and rate based upon the proportion of the absolute value of the volume and rate changes.
2 
Amounts used to calculate volume and rate changes are based on numbers in dollars. Accordingly, recalculations using the amounts in thousands as disclosed in this report may not produce the same results.

Net Gains (Losses) on Derivatives and Hedging Activities: The volatility in other income (loss) is driven predominantly by net gains (losses) on derivative and hedging transactions, which generally include interest rate swaps, caps and floors. Net gains (losses) from derivatives and hedging activities are sensitive to several factors, including: (1) the general level of interest rates; (2) the shape of the term structure of interest rates; and (3) implied volatilities of interest rates. The fair value of options, particularly interest rate caps and floors, are also impacted by the time value decay that occurs as the options approach maturity, but this factor represents the normal amortization of the cost of these options and flows through income irrespective of any changes in the other factors impacting the fair value of the options (level of rates, shape of curve, and implied volatility).


40


Table 14
 
2017
 
Advances
Investments
Mortgage Loans
Consolidated Obligation Discount Notes
Consolidated Obligation Bonds
Other
Total
Impact of derivatives and hedging activities in net interest income:
 
 
 
 
 
 
 
Net amortization/accretion of hedging activities
$
(5,381
)
$

$
(1,577
)
$

$

$

$
(6,958
)
Net interest received (paid)
(43,547
)
(9,271
)

(15
)
14,514


(38,319
)
Subtotal
(48,928
)
(9,271
)
(1,577
)
(15
)
14,514


(45,277
)
Net gains (losses) on derivatives and hedging activities:
 

 

 

 
 

 

 

Fair value hedges:
 
 
 
 
 
 
 
Interest rate swaps
(486
)
(2,589
)

(36
)
(741
)

(3,852
)
Economic hedges – unrealized gains (losses) due to fair value changes:
 
 
 
 
 
 
 
Interest rate swaps

15,448



3,965


19,413

Interest rate caps

(3,848
)




(3,848
)
Mortgage delivery commitments


2,207




2,207

Economic hedges – net interest received (paid)

(20,147
)


5,004


(15,143
)
Price alignment amount on derivatives for which variation margin is daily settled





(22
)
(22
)
Subtotal
(486
)
(11,136
)
2,207

(36
)
8,228

(22
)
(1,245
)
Net impact of derivatives and hedging activities
(49,414
)
(20,407
)
630

(51
)
22,742

(22
)
(46,522
)
Net gains (losses) on trading securities hedged on an economic basis with derivatives

5,863





5,863

TOTAL
$
(49,414
)
$
(14,544
)
$
630

$
(51
)
$
22,742

$
(22
)
$
(40,659
)

41


Table 15
 
2016
 
Advances
Investments
Mortgage Loans
Consolidated
Obligation Discount Notes
Consolidated
Obligation Bonds
Total
Impact of derivatives and hedging activities in net interest income:
 

 

 

 
 

 

Net amortization/accretion of hedging activities
$
(5,867
)
$

$
(2,189
)
$

$

$
(8,056
)
Net interest received (paid)
(85,793
)
(11,878
)

(67
)
31,559

(66,179
)
Subtotal
(91,660
)
(11,878
)
(2,189
)
(67
)
31,559

(74,235
)
Net gains (losses) on derivatives and hedging activities:
 

 

 

 
 

 

Fair value hedges:
 

 

 

 
 

 

Interest rate swaps
6,858

(340
)

(270
)
(521
)
5,727

Economic hedges – unrealized gains (losses) due to fair value changes:
 

 

 

 

 

 
Interest rate swaps

37,734


(4
)
(14,099
)
23,631

Interest rate caps

(956
)



(956
)
Mortgage delivery commitments


(952
)


(952
)
Economic hedges – net interest received (paid)

(43,803
)

4

4,722

(39,077
)
Subtotal
6,858

(7,365
)
(952
)
(270
)
(9,898
)
(11,627
)
Net impact of derivatives and hedging activities
(84,802
)
(19,243
)
(3,141
)
(337
)
21,661

(85,862
)
Net gains (losses) on trading securities hedged on an economic basis with derivatives

(14,862
)



(14,862
)
TOTAL
$
(84,802
)
$
(34,105
)
$
(3,141
)
$
(337
)
$
21,661

$
(100,724
)


42


Table 16
 
2015
 
Advances
Investments
Mortgage Loans
Consolidated
Obligation Discount Notes
Consolidated
Obligation Bonds
Total
Impact of derivatives and hedging activities in net interest income:
 
 
 
 
 
 
Net amortization/accretion of hedging activities
$
(8,267
)
$

$
(2,128
)
$

$
(9
)
$
(10,404
)
Net interest received (paid)
(117,079
)
(1,657
)

215

69,222

(49,299
)
Subtotal
(125,346
)
(1,657
)
(2,128
)
215

69,213

(59,703
)
Net gains (losses) on derivatives and hedging activities:
 
 
 
 
 
 
Fair value hedges:
 
 
 
 
 


Interest rate swaps
(779
)
636


306

(3,041
)
(2,878
)
Economic hedges – unrealized gains (losses) due to fair value changes:
 
 
 
 
 
 
Interest rate swaps

12,239


4

(1,446
)
10,797

Interest rate caps

(4,159
)



(4,159
)
Mortgage delivery commitments


1,067



1,067

Economic hedges – net interest received (paid)

(56,455
)

44

8,741

(47,670
)
Subtotal
(779
)
(47,739
)
1,067

354

4,254

(42,843
)
Net impact of derivatives and hedging activities
(126,125
)
(49,396
)
(1,061
)
569

73,467

(102,546
)
Net gains (losses) on trading securities hedged on an economic basis with derivatives

(47,577
)



(47,577
)
TOTAL
$
(126,125
)
$
(96,973
)
$
(1,061
)
$
569

$
73,467

$
(150,123
)

As reflected in Tables 14 through 16, the majority of the derivative net unrealized gains and losses are related to economic hedges, such as interest rate swaps matched to GSE debentures or MBS classified as trading securities and interest rate caps and floors, which do not qualify for hedge accounting treatment under GAAP. Net interest payments or receipts on these economic hedges flow through net gains (losses) on derivatives and hedging activities instead of net interest income, which does not reflect the full economic impact of the swaps on yields, especially for trading investments that are swapped to variable rates. Ineffectiveness on fair value hedges contributes to unrealized gains and losses on derivatives, but to a lesser degree. In the past, we generally recorded net unrealized gains on derivatives when the overall level of interest rates would rise over the period and recorded net unrealized losses when the overall level of interest rates would fall over the period, due to the mix of the economic hedges. However, the mix of our economic hedges changed in mid-2015, as a result the general level of interest rates is no longer expected to be the primary factor impacting the net unrealized gains (losses) on derivatives. Net unrealized gains or losses on derivatives will continue to be a function of the general level of LIBOR swap rates and the spread between the LIBOR swap curve and the GSE interest rate curve (interest rates swaps that are economic hedges of GSE debentures held in trading), but will also be affected by the spread between the LIBOR swap curve and mortgage rates (interest rates swaps that are economic hedges of fixed rate GSE MBS held in trading).


43


For the years ended December 31, 2017 and 2016, net unrealized gains and losses on derivatives and hedging activities decreased net income by $1.2 million and $11.6 million, respectively. Net interest paid of $15.1 million and $39.1 million on economic interest rate swaps for the years ended December 31, 2017 and 2016, respectively, drove the net loss between periods, as changes in the LIBOR swap curve over the respective periods resulted in positive fair value fluctuations on most of our derivatives. The increase in LIBOR between periods resulted in the decrease of $24.0 million in net interest settlements year over year. Changes in the LIBOR swap curve over the respective periods resulted in positive fair value fluctuations on most interest rate swaps during 2016 and 2017, as spreads began to tighten mid-2016 from the significant widening experienced during the latter half of 2015. The increases in swap spreads during the second half of 2015 and into the first half of 2016 caused fair value decreases for many of our derivatives, but especially interest rate swaps economically hedging multi-family GSE MBS recorded as trading securities. These spreads i