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EX-99.2 - EXHIBIT 99.2 - Federal Home Loan Bank of Topekaex12312019992.htm
EX-32 - EXHIBIT 32 - Federal Home Loan Bank of Topekaex1231201932.htm
EX-31.2 - EXHIBIT 31.2 - Federal Home Loan Bank of Topekaex12312019312.htm
EX-31.1 - EXHIBIT 31.1 - Federal Home Loan Bank of Topekaex12312019311.htm
EX-24.1 - EXHIBIT 24.1 - Federal Home Loan Bank of Topekaex12312019241.htm
EX-4.2 - EXHIBIT 4.2 - Federal Home Loan Bank of Topekaex1231201942.htm
EX-4.1 - EXHIBIT 4.1 - Federal Home Loan Bank of Topekaex1231201941.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, 2019
 
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:
Title of each class
Trading Symbol(s)
Name of each exchange
on which registered
None
N/A
N/A

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 every Interactive Data File required to be submitted 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 such files).  x  Yes  ¨  No
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an 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 ¨
Non-accelerated filer x                    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

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 28, 2019, the aggregate par value of stock held by current and former members of the registrant was $1,601,254,400, and 16,012,544 total shares were outstanding.
 
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, 2020
Class A Stock, par value $100 per share
4,524,494
Class B Stock, par value $100 per share
13,099,122

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 “FHLBank,” “FHLBank Topeka,” “we,” “us” and “our” mean Federal Home Loan Bank of Topeka, and “FHLBanks” mean all Federal Home Loan Banks, including 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 FHLBank, and in some cases, 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 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. 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:
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;
Governmental actions, including legislative, regulatory, judicial or other developments that affect FHLBank; its members, counterparties or investors; housing government-sponsored enterprises (GSE); or the FHLBank System in general;
Effects of derivative accounting treatment and other accounting rule requirements, or changes in such requirements;
Competitive forces, including competition for loan demand, purchases of mortgage loans and access to funding;
The ability of FHLBank to introduce new products and services to meet market demand and to manage successfully the risks associated with all products and services;
Changes in demand for FHLBank products and services or consolidated obligations of the FHLBank System;
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;
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;
Soundness of other financial institutions, including FHLBank members, non-member borrowers, counterparties, and the other FHLBanks;
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 FHLBank has joint and several liability;
The volume and quality of eligible mortgage loans originated and sold by participating members to FHLBank through its various mortgage finance products (Mortgage Partnership Finance® (MPF®) Program). “Mortgage Partnership Finance,” “MPF,” “MPF Xtra,” and “MPF Direct” are registered trademarks of FHLBank Chicago.
Changes in the fair value and economic value of, impairments of, and risks associated with, FHLBank’s investments in mortgage loans and mortgage-backed securities (MBS) or other assets and related credit enhancement protections;
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;
Volatility of market prices, changes in interest rates and indices and the timing and volume of market activity;
Gains/losses on derivatives or on trading investments and the ability to enter into effective derivative instruments on acceptable terms;
The effects of amortization/accretion;
The upcoming discontinuance of the London Interbank Offered Rate (LIBOR) and the related effect on FHLBank's LIBOR-based financial products, investments, and contracts;
Changes in FHLBank’s capital structure;
Our ability to declare dividends or to pay dividends at rates consistent with past practices; and
The ability of 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 FHLBank’s business;

Readers of this annual report should not rely solely on the forward-looking statements and should consider all risks and uncertainties addressed throughout this annual 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 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 annual report.


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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, purchasing mortgages, 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. Section 1433 of the Bank Act provides that we and the other FHLBanks 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, non-federally insured credit union, 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. (See Table 43 under Item 7 – "Management’s Discussion and Analysis of Financial Condition and Results of Operations – Liquidity and Capital Resources" for counts and balances by member type.) 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 2019, this specified amount was $1.2 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 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 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 84 and 85 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 achievement 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. The Primary Mission Asset ratio, as defined by the FHFA, is calculated as average advances and average mortgage loans to average consolidated obligations less average U.S. Treasury securities classified as trading or available for sale with maturities of ten years or less utilizing par balances. As of December 31, 2019, our Primary Mission Asset ratio was 75 percent. We generally intend to maintain the Primary Mission Asset ratio within the range of 70 to 80 percent, which exceeds the FHFA's recommended minimum ratio of 70 percent. 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 and the implication of its support for the FHLBank System as GSEs. 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.

Advances
We make advances to members and housing associates based on the value of the security of their residential mortgages and other eligible collateral. Advances are required by FHFA regulation to be priced no lower than the cost of raising matching term and maturity funds in the marketplace plus the administrative and operating expenses associated with making such advances. 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 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 62 and 63 under Item 7A – “Quantitative and Qualitative Disclosures About Market Risk.”


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We also offer a variety of specialized advance products to address housing and community development needs. 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 their 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 10 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 26 and 27 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, 2019 and 2018 and the accrued interest income associated with the five borrowers providing the highest amount of interest income for the years ended December 31, 2019 and 2018.


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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 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 Chicago, respectively, for securitization, collectively provide our members an opportunity to further their cooperative partnership with us. We also offer the MPF Direct product, which provides the PFI the opportunity to sell to Redwood Trust (an entity that is not affiliated with us) for securitization mortgage loans exceeding the FHFA conforming loan limit under the MPF Program structure. These products are intended to further assist our members and their mortgage product needs while enhancing our ability to manage mortgage volumes and receive a counterparty fee from FHLBank Chicago based on mortgage volumes sold by our PFIs. We have the authority to offer participation interests in risk sharing MPF loan pools to member institutions, which we believe may further enhance our ability to manage the size of our mortgage loan portfolio in the future.

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, MPF Direct, and government-guaranteed loan products). In order to share the credit risk with our PFIs, we use a third-party model to determine the amount of credit enhancement obligation (CE obligation), needed to achieve credit quality that is permissible under the AMA regulation and consistent with our risk appetite. PFIs are required to have a CE obligation in an amount that provides FHLBank a high degree of confidence that the CE obligation will absorb losses in excess of the First Loss Account (FLA), even under reasonably likely adverse changes to expected economic conditions. The amount of the CE obligation is based on a documented analysis, including consideration of applicable insurance, credit enhancements, and other sources for repayment on the asset or pool . Effective January 1, 2020, all new and amended master commitments will have a set minimum CE obligation, which will be lower for products that offer performance-based credit enhancement fees (CE fees) (see Table 1).

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 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 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 Chicago for securitization into Ginnie Mae MBS. MPF Direct is a sale of jumbo loans to Redwood Trust for securitization. We receive a counterparty fee from our PFIs for facilitating their participation in the MPF Xtra, MPF Government MBS, and MPF Direct products.


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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, MPF Xtra, and MPF Direct products do not have a first loss and/or credit enhancement structure.

Table 10 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 28 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.
 
MPF Provider: FHLBank 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, MPF Government MBS loans, and MPF Direct 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 applicable 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. 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 quarterly fixed service cost and a transaction services fee, which is based upon the unpaid principal balances (UPB) before any charge-offs of MPF loans.

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.


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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.


10


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, 2019 or currently offered as a loan sale from the PFI to FHLBank Chicago:

Table 1
Product Name
Size of
FHLBank’s FLA
PFI CE Obligation Description
CE Fee
Paid to PFI
CE Fee Offset1
Servicing Fee
to PFI2
MPF Original
4 basis points (bps) per year against unpaid balance, accrued monthly
Greater of aggregate sum of the loan level credit enhancements (LLCEs) or one percent of gross fundings
10 bps per year, paid monthly based on remaining UPB; guaranteed3
No
25 bps per year, paid monthly
MPF 1004
100 bps fixed based on gross fundings
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
Greater of aggregate sum of the LLCEs less FLA or 25 bps
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 Plus5
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/A6
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
MPF Direct
N/A
N/A
N/A
N/A
Servicing released only
                   
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 PFI has the option of retaining or selling the servicing on all MPF products except MPF Direct. If the servicing is sold (servicing released), the PFI will receive an upfront servicing released premium as opposed to receiving servicing fees over time.
3 
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.     
4 
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).
5 
Due to higher costs associated with the acquisition of supplemental insurance policies, the MPF Plus product is currently not active.
6 
Two government master commitments have been grandfathered and paid 2 bps per year. All other government master commitments are not paid a CE fee.


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Table 2 presents an illustration of the FLA and CE obligation calculation for each conventional MPF product type listed as of December 31, 2019:

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 was determined based on a sample $100 million loan pool. The final premium determination was made during the 13th month of the master commitment agreement, at which time any premium adjustment was 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).

Under FHFA regulations, we are prohibited from investing in certain types of securities including:
Instruments, such as common stock, that represent 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 a Nationally Recognized Statistical Rating Organization (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. As of December 31, 2019, the amortized cost of our MBS/CMO portfolio represented 262 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 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, 2019 and 2018 (in millions):

Table 3
 
12/31/2019
12/31/2018
Par value of consolidated obligations of FHLBank Topeka
$
59,481

$
44,623

 
 
 
Par value of consolidated obligations of all FHLBanks
$
1,025,895

$
1,031,617


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 our 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, 2019 and 2018 (dollar amounts in thousands):

Table 4
 
12/31/2019
12/31/2018
Total non-pledged assets
$
63,017,801

$
47,568,214

Total carrying value of consolidated obligations
$
59,461,225

$
44,574,726

Ratio of non-pledged assets to consolidated obligations
1.06

1.07



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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, Secured Overnight Financing Rate (SOFR), 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 sold at a discount and mature at par.

Derivatives
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.

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. Generally, we designate derivatives as a fair value hedge of an underlying financial instrument or firm commitment. 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 asset/liability management.

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 terms 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.


14


We 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 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 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” 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 remaining 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.


15


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., Federal funds) 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.


16


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 includes detailed calculations of five components:
Market risk, which is calculated using the percentage change method at a 99 percent confidence level for an 120-business day period (consistent with the market component of our regulatory risk‐based capital value-at-risk requirement). For periods prior to March 31, 2019, market risk was calculated using a Monte Carlo simulation where the 99 percent confidence level result over a 90-day simulation horizon represented 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;
Operations risk, which is calculated using a combination of: (1) the Basel II basic indicator approach; and (2) the Basel II standardized approach. For periods prior to September 30, 2019, operations risk was 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 at the average overnight Federal funds rate on average stock for the most recent calendar quarter. For periods prior to December 31, 2019, the dividend payment risk subcomponent was 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 2019 and 2018 (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)
12/31/2019
09/30/2019
06/30/2019
03/31/2019
Market Risk
$
108,053

$
107,575

$
155,131

$
142,109

Credit Risk
50,732

64,756

50,933

55,035

Pre-settlement Risk
30,000

30,000

30,000

30,000

Operations Risk
44,296

44,296

34,003

31,230

Net Income Volatility
68,525

120,208

150,598

124,285

Total Retained Earnings Threshold
301,606

366,835

420,665

382,659

Actual Retained Earnings as of End of Quarter
999,809

972,948

950,276

942,840

Overage
$
698,203

$
606,113

$
529,611

$
560,181


Table 6
 
 
 
 
 
Retained Earnings Component (based upon prior quarter end)
12/31/2018
09/30/2018
06/30/2018
03/31/2018
Market Risk
$
123,960

$
134,678

$
135,894

$
82,048

Credit Risk
60,928

62,329

78,556

60,963

Pre-settlement Risk
30,000

30,000

30,000

30,000

Operations Risk
31,219

30,817

30,791

27,544

Net Income Volatility
123,440

131,568

144,184

127,517

Total Retained Earnings Threshold
369,547

389,392

419,425

328,072

Actual Retained Earnings as of End of Quarter
914,022

894,016

875,790

854,241

Overage
$
544,475

$
504,624

$
456,365

$
526,169



17


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.

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.

Tax Status
Section 1433 of the Bank Act provides that we and the other FHLBanks 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 subject to assessment to be contributed to the following year's 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.

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 2.8 percent, 3.0 percent and 3.5 percent of total advances outstanding as of December 31, 2019, 2018, and 2017, respectively. Programs offered during 2019 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, small farms, small agri-business, 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 Native American Area, Federally Declared Disaster Area, or United States Department of Agriculture Drought 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.


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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 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.

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, structure of the debt, liquidity of the instrument, 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 Federal Housing Finance Oversight 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 will 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.


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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 March 13, 2020, we had 233 employees. Our employees are not represented by a collective bargaining unit, and we have a good relationship with our employees.

Where to Find Additional Information
We file our annual, quarterly, and current reports and related information with the SEC. You can 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 free of charge 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) 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.

Legislative and Regulatory Developments
FHFA Advisory Bulletin 2020-01 - Acquired Member Assets Risk Management. On January 31, 2020, the FHFA issued an Advisory Bulletin on risk management of AMA (the AMA AB). The guidance communicates the FHFA’s expectations with respect to an FHLBank’s funding of its members through the purchase of eligible mortgage loans and includes expectations that an FHLBank will have board-established limits on AMA portfolios and management-established thresholds to serve as monitoring tools to manage AMA-related risk exposure. The AMA AB provides that the board of an FHLBank should ensure that the FHLBank serves as a liquidity source for members, and an FHLBank should ensure that its portfolio limits do not result in the FHLBank’s acquisition of mortgages from smaller members being “crowded out” by the acquisition of mortgages from larger members. The AMA AB contains the expectation that the board of an FHLBank should set limits on the size and growth of portfolios and on acquisitions from a single PFI. In addition, the guidance sets forth that the board of an FHLBank should consider concentration risk in the geographic area, high-balance loans, and third-party loan originations. The FHLBanks are expected to demonstrate their progress toward adherence to the AMA AB by September 30, 2020 and should have final limits in place by December 31, 2020.

We continue to evaluate the potential impact of the AMA AB on our financial condition and results of operations.

FHLBank Membership Request for Input. On February 24, 2020, the FHFA issued a Request for Input on FHLBank membership (the Membership RFI). The Membership RFI, as part of a holistic review of FHLBank membership, seeks public input on whether the FHFA's existing regulation on FHLBank membership, located at 12 CFR part 1263, remains adequate to ensure: (1) the FHLBank System remains safe and sound and able to provide liquidity to members in a variety of conditions; and (2) the advancement of the FHLBank's housing finance and community development mission. The FHFA is seeking input on several broad questions relating to FHLBank membership requirements, as well as on certain more specific questions related to the implementation of the current membership regulation. Responses are due no later than June 23, 2020.

Any rulemaking actions taken by the FHFA as a result of the Membership RFI to update the current FHLBank membership regulation may impact FHLBank membership eligibility or requirements, and ultimately our business, business opportunities, and results of operations.


20


FHFA Proposed Amendments to Stress Test Rule. On December 16, 2019, the FHFA published a proposed rule amending its stress testing rule, consistent with section 401 of the Economic Growth, Regulatory Relief, and Consumer Protection Act of 2018, to: (1) raise the minimum threshold to conduct periodic stress tests for entities regulated by the FHFA from those with consolidated assets of more than $10 billion to those with consolidated assets of more than $250 billion; (2) remove the requirements for FHLBanks to conduct stress tests; and (3) remove the adverse scenario from the list of required scenarios. The proposed rule maintains the FHFA’s discretion to require that an FHLBank with total consolidated assets below the $250 billion threshold conduct stress testing. The proposed amendments align the FHFA’s stress testing rules with rules adopted by other financial institution regulators that implement the Dodd-Frank Act stress testing requirements, as amended by the Economic Growth, Regulatory Relief, and Consumer Protection Act of 2018.

The results of our most recent annual severely adverse economic conditions stress test were published to our public website on November 15, 2019. If the proposed rule is adopted as proposed, it will eliminate these stress testing requirements for FHLBanks. We do not expect this rule, if adopted as proposed, to materially impact our financial condition or results of operations.

FDIC Brokered Deposits Restrictions. On December 12, 2019, the Federal Deposit Insurance Corporation (FDIC) issued a proposed rule to amend its brokered deposits restrictions that apply to less than well-capitalized insured depository institutions. The FDIC states that the proposed amendments are intended to modernize its brokered deposit regulations and would establish a new framework for analyzing whether deposits placed through deposit placement arrangements qualify as brokered deposits. These deposit placement arrangements include those between insured depository institutions and third parties, such as financial technology companies, for a variety of business purposes, including access to deposits. By creating a new framework for analyzing certain provisions of the “deposit broker” definition, including shortening the list of activities considered “facilitating” and expanding the scope of the “primary purpose” exception, the proposed rule would narrow the definition of “deposit broker” and exclude more deposits from treatment as “brokered deposits.” The proposed rule would also establish an application and reporting process with respect to the primary purpose exception.

If this rule is adopted as proposed, it may have an effect on member demand for advances, but we cannot predict the extent of the impact. We do not expect this rule, if adopted as proposed, to materially affect our financial condition or results of operations.

FHFA Supervisory Letter on Planning for LIBOR Phase-Out. On September 27, 2019, the FHFA issued a supervisory letter (the Supervisory Letter) to the FHLBanks that the FHFA stated is designed to ensure the FHLBanks will be able to identify and prudently manage the risks associated with the termination of LIBOR in a safe and sound manner. The Supervisory Letter provides that the FHLBanks should cease entering into new LIBOR referenced financial assets, liabilities, and derivatives with maturities beyond December 31, 2021 for all product types except investments. On March 16, 2020, in light of market volatility, the FHFA extended from March 31, 2020 to June 30, 2020 the FHLBanks’ ability to enter into instruments referencing LIBOR that mature after December 31, 2021, except for investments and option embedded products. With respect to investments, the FHLBanks should, by December 31, 2019, stop purchasing investments that reference LIBOR and mature after December 31, 2021. These phase-out dates do not apply to collateral accepted by the FHLBanks. The Supervisory Letter also directs the FHLBanks to update their pledged collateral certification reporting requirements by March 31, 2020 in an effort to encourage members to distinguish LIBOR-linked collateral maturing after December 31, 2021. The FHLBanks are expected to cease entering into LIBOR-indexed financial instruments maturing after December 31, 2021 by the deadlines specified in the Supervisory Letter, subject to limited exceptions granted by the FHFA under the Supervisory Letter for LIBOR-linked products serving compelling mission, risk mitigating, and/or hedging purposes that do not currently have readily available alternatives.

As a result of the Supervisory Letter and the extension, beginning July 1, 2020, we expect to suspend transactions in advances with terms directly linked to LIBOR that mature after December 31, 2021. In addition, beginning July 1, 2020, we expect to no longer enter into consolidated obligation bonds and derivatives with swaps, caps, or floors indexed to LIBOR that terminate after December 31, 2021. We have ceased purchasing investments that reference LIBOR and mature after December 31, 2021.

We continue to evaluate the potential impact of the Supervisory Letter on our financial condition and results of operations and LIBOR transition planning, but we may experience increased basis risk from our inability to fund LIBOR-indexed assets with LIBOR-indexed debt, reduced investment opportunities, and lower overall demand or increased costs for advances, which in turn may negatively impact the future composition of our balance sheet, capital stock levels, primary mission assets ratio, and net income.

For additional information on our LIBOR transition efforts and LIBOR exposure, see “Risk Management – Interest Rate Risk Management” under Item 7.

FHFA Advisory Bulletin 2019-03 - Capital Stock Management. On August 14, 2019, the FHFA issued an Advisory Bulletin (the Capital Stock Management AB) providing for each FHLBank to maintain a ratio of at least two percent of capital stock to total assets in order to help preserve the cooperative structure incentives that encourage members to remain fully engaged in the oversight of their investment in the FHLBank. In February 2020, the FHFA began to consider the proportion of capital stock to assets, measured on a daily average basis at month end, when assessing each FHLBank’s capital management practices.


21


We do not expect the Capital Stock Management AB to have a material impact on our capital management practices, financial condition, or results of operations.

SEC Final Rule on Auditor Independence with Respect to Certain Loans or Debtor-Creditor Relationships. On July 5, 2019, the SEC published a final rule, which became effective on October 3, 2019 (Final Rule), that adopts amendments to its auditor independence rules to modify the analysis that must be conducted to determine whether an auditor is independent when the auditor has a lending relationship with certain shareholders of an audit client at any time during an audit or professional engagement period. The Final Rule, among other things, focuses the analysis on beneficial ownership rather than on both record and beneficial ownership; replaces the existing ten percent bright-line shareholder ownership test with a “significant influence” test; and adds a “known through reasonable inquiry” standard with respect to identifying beneficial owners of the audit client’s equity securities.

Under the prior loan rule on debtor-creditor relationships, the independence of an accounting firm generally could be called into question if it or a covered person in the accounting firm received a loan from a lender that is a “record or beneficial owner of more than ten percent of the audit client’s equity securities.” A covered person in the firm includes personnel on the audit engagement team, personnel in the chain of command, partners and managers who provide ten or more hours of non-audit services to the audit client, and partners in the office where the lead engagement partner practices in connection with the client. The Final Rule replaced the existing ten percent bright-line test with a significant influence test similar to that referenced in other SEC rules and based on concepts applied in Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) Topic 323.

Under the Final Rule, which is now in effect, with certain exceptions, the receipt of loans from the beneficial owners of an audit client’s equity securities where such beneficial owner has significant influence over the audit client would impair the independence of the auditor. The analysis under the Final Rule would be based on the facts and circumstances and would focus on whether the beneficial owners of an audit client’s equity securities have the ability to exercise significant influence over the operating and financial policies of an audit client.

There were no members with the ability to exercise significant influence over the operating and financial policies of FHLBank at December 31, 2019.

FHFA Advisory Bulletin 2019-01 Business Resiliency Management. On May 7, 2019, the FHFA issued an advisory bulletin on Business Resiliency Management for FHLBanks and other entities regulated by the FHFA (the Business Resiliency AB) that communicates the FHFA’s expectations with respect to minimizing the impact of disruptions in service from uncontrolled events and the maintenance of business operations at predefined levels. The Business Resiliency AB rescinds the FHFA’s 2002 disaster recovery guidance. The new guidance states that a business resiliency program should guide the regulated entity to respond appropriately to disruptions affecting business operations, personnel, equipment, facilities, information technology systems, and information assets. The Business Resiliency AB provides guidance on the elements of a safe and sound business resiliency program, which include governance, risk assessment and business impact analysis, risk mitigation and plan development, testing and analysis, and risk monitoring and program sustainability.

We do not expect the Business Resiliency AB to have a material effect on our financial condition or results of operations.

Final Rule on FHLBank Capital Requirements. On February 20, 2019, the FHFA published a final rule, effective January 1, 2020, that adopted, with amendments, the regulations of the Federal Housing Finance Board (FHFB, predecessor to the FHFA) pertaining to the capital requirements for the FHLBanks. This final rule carries over most of the prior FHFB regulations without material change but substantively revises the credit risk component of the risk-based capital requirement, as well as the limitations on extensions of unsecured credit. The main revisions remove requirements that we calculate credit risk capital charges and unsecured credit limits based on ratings issued by an NRSRO, and instead require that we establish and use our own internal rating methodology (which may include, but not solely rely on, NRSRO ratings). The rule imposes a new credit risk capital charge for cleared derivatives. This final rule also revises the percentages used in the regulation’s tables to calculate credit risk capital charges for advances and for non-mortgage assets. This final rule also rescinds certain contingency liquidity requirements that were part of the FHFB regulations, as these requirements are now addressed in an Advisory Bulletin on FHLBank Liquidity Guidance issued by the FHFA in 2018.

We do not expect this rule to materially affect our financial condition or results of operations.


22


FDIC Final Rule on Reciprocal Deposits. On February 4, 2019, the FDIC published a final rule, effective March 6, 2019, related to the treatment of “reciprocal deposits,” which implements Section 202 of the Economic Growth, Regulatory Relief, and Consumer Protection Act of 2018. This final rule exempts, for certain insured depository institutions (depositories), certain reciprocal deposits (deposits acquired by a depository from a network of participating depositories that enables depositors to receive FDIC insurance coverage for the entire amount of their deposits) from being subject to FDIC restrictions on brokered deposits. Under the rule, well-capitalized and well-rated depositories are not required to treat reciprocal deposits as brokered deposits up to the lesser of twenty percent of their total liabilities or $5 billion. Reciprocal deposits held by depositories that are not well-capitalized and well-rated may also be excluded from brokered deposit treatment in certain circumstances.

We do not expect the rule to materially affect our financial condition or results of operations. The rule could, however, enhance depositories’ liquidity by increasing the attractiveness of deposits that exceed FDIC insurance limits. This could affect the demand for certain advance products.

Developments applicable to interest rate swaps:

Uncertainty Regarding Brexit. In June 2016, the United Kingdom (the UK) voted in favor of leaving the European Union (the EU), and in March 2017, Article 50 of the Lisbon Treaty was invoked, commencing a period of negotiations between the UK and the European Council for the UK’s withdrawal from the EU, which was subsequently extended by the European Council members in agreement with the UK. On January 31, 2020, the UK withdrew from the EU, with a transition period to last until December 31, 2020, which period may be extended for an additional two years. During this transition period, the UK and the EU will negotiate the details of their future relationship, including what conditions will apply to EU-based entities that want to do business with the UK, and vice versa, after the transition period.

We do not have material exposure to non-cleared swap counterparties based in the UK or the EU.

CFTC No-action Relief for LIBOR Amendments. On December 17, 2019, three divisions of the Commodity Futures Trading Commission (CFTC) issued no-action letters to provide relief with respect to the transition away from LIBOR and other interbank offered rates (IBORs). Among other forms of relief, the letters, subject to certain limitations:
permit registered swap dealers, major swap participants, security-based swap participants, and major security-based swap participants (covered swap entities) to amend an uncleared swap entered into before the compliance date of the CFTC’s uncleared swap margin requirements (such swap, a legacy swap, and such requirements, the CFTC margin rules) to include LIBOR or other IBOR fallbacks without the legacy swap becoming subject to the CFTC margin rules; and
provide time-limited relief, until December 31, 2021, for: (1) swaps that are not subject to the central clearing requirement because they were executed prior to the relevant compliance date; and (2) swaps that are subject to the trade execution requirement to be amended to include LIBOR or other IBOR fallbacks without becoming subject to such clearing or trade execution requirements.

We do not expect these no-action letters to have a material effect on our financial condition or results of operations.

Margin and Capital Requirements for Agency Covered Swap Entities. On November 7, 2019, the Office of the Comptroller of the Currency, the Federal Reserve Board, the FDIC, the Farm Credit Administration and the FHFA (collectively, the Agencies) jointly published a proposed rule that would amend the Agencies’ regulations that established minimum margin and capital requirements for uncleared swaps (the prudential margin rules) for covered swap entities under the jurisdiction of one of the Agencies (Agency covered swap entities). In addition to other changes, the proposed amendments would permit those uncleared swaps entered into by Agency covered swap entities before the compliance date of the prudential margin rules (Agency legacy swaps) to retain their legacy status and not become subject to the prudential margin rules in the event that they are amended to replace LIBOR or another rate that is reasonably expected to be discontinued or is reasonably determined to have lost its relevance as a reliable benchmark due to a significant impairment. Among other things, the proposed rule would also amend the prudential margin rules to: (1) extend the phase-in compliance date for initial margin requirements from September 1, 2020 to September 1, 2021 for Agency covered swap entity counterparties with an average daily aggregate notional amount of non-cleared swaps from $8 billion to $50 billion; (2) clarify that an Agency covered swap entity does not have to execute initial margin trading documentation with a counterparty prior to the time that the counterparty is required to collect or post initial margin; and (3) permit Agency legacy swaps to retain their legacy status and not become subject to the prudential margin rules in the event that they are amended due to certain life-cycle activities, such as reductions of notional amounts or portfolio compression exercises.

We do not expect this rule, if adopted as proposed, to have a material effect on our financial condition or results of operations.


23


CFTC Advisory on Initial Margin Documentation Requirements. On July 9, 2019, the CFTC issued an advisory (the Advisory) on the CFTC margin rules to clarify that documentation governing the posting, collection, and custody of initial margin is not required to be completed until such time as the aggregate unmargined exposure to a counterparty (and its margin affiliates) exceeds a threshold of $50 million. The CFTC margin rules provide that CFTC covered swap entities are required to post and collect initial margin with counterparties that are swap dealers or financial end users with material swaps exposure, as defined under the rule. The CFTC margin rules, however, contain an initial margin threshold amount of $50 million between a covered swap entity (and its margin affiliates) on the one hand, and its counterparty (and its margin affiliates) on the other. The Advisory clarifies that no initial margin documentation is required until the amount of initial margin exchangeable between a covered swap entity (and its margin affiliates) and its counterparty (and its margin affiliates) exceeds the initial margin threshold amount of $50 million. The Advisory, however, does instruct CFTC covered swap entities to closely monitor initial margin amounts if they are approaching the $50 million initial margin threshold with a counterparty and to take appropriate steps to ensure that the required documentation is in place at such time as the threshold is reached.

We are monitoring the initial margin thresholds and do not currently expect our documentation requirements to change based on the clarification to the CFTC margin rules provided by the Advisory.

Item 1A: Risk Factors

Business Risk - General
Changes in economic conditions, or federal fiscal and monetary policy could impact our business. Our net income is sensitive to changes in market conditions that can impact the interest we earn and pay and introduce volatility in other income (loss). These conditions include, but are not limited to, the following: (1) changes in interest rates; (2) fluctuations in both debt and equity capital markets; (3) conditions in the financial, credit, mortgage, and housing markets; (4) the willingness and ability of financial institutions to expand lending; and (5) and the strength of the U.S. economy and the local economies in which we conduct business. Our financial condition, results of operations, and ability to pay dividends could be negatively affected by changes in one or more of these conditions. Additionally, our business and results of operations may be affected by the fiscal and monetary policies of the federal government and its agencies, including the Federal Reserve, which regulates the supply of money and credit in the U.S. The Federal Reserve’s policies directly and indirectly influence the yield on interest-earning assets and the cost of interest-bearing liabilities, which could adversely affect our financial condition, results of operations, and ability to pay dividends.

An economic downturn, natural disaster, or pandemic in the FHLBank’s region could adversely affect our profitability and financial condition. Economic recession over a prolonged period or other unfavorable economic conditions in our region (including on a state or local level) could have an adverse effect on our business, including the demand for our products and services, and the value of the collateral securing advances, investments, and mortgage loans held in portfolio. Portions of our region also are subject to risks from tornadoes, floods, or other natural disasters, and all are subject to pandemic risk. These natural disasters, including those resulting from significant climate changes, could damage or dislocate the facilities of our members, may damage or destroy collateral that members have pledged to secure advances or mortgages, or the livelihood of borrowers of members, or otherwise could cause significant economic dislocation in the affected areas of our region.

Additionally, the impact of widespread health emergencies may adversely impact our financial condition and results of operations, such as the potential impact from the recent outbreak of the coronavirus, which was first detected in Wuhan, Hubei Province, China but has now spread to other countries, including the United States. If our members are adversely affected, or if the virus leads to a widespread health emergency that impacts our employees or vendors, or the borrowers of our members, or economic growth generally, our financial condition and results of operations could be adversely affected.

Business Risk - Legislative and Regulatory
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 significant legislation. 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.


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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, which serves as the federal regulator of the FHLBanks and the Office of Finance, Fannie Mae, and Freddie Mac. 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 because of the significant difference in their business models compared to ours. 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 FHLBank or the FHLBank System. We are, or may also become, subject to further regulations promulgated by the SEC, CFTC, Federal Reserve Bank, Financial Crimes Enforcement Network, or other regulatory agencies. 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.
 
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.

Business Risk - Strategic
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.


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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 concentration of advances (see Table 26) 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.

Changes in our credit ratings may adversely affect our business operations. As of March 13, 2020, 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.

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, 2020, 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.


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Credit Risk
Declines in U.S. home prices or in activity in the U.S. housing market or rising delinquency or default rates on mortgage loans could result in credit losses and adversely impact our business operations and/or financial condition. A deterioration of the U.S. housing market and national decline in home prices could adversely impact the financial condition of a number of our borrowers, particularly those whose businesses are concentrated in the mortgage industry. One or more of our borrowers may default on their obligations to us for a number of reasons, such as changes in financial condition, a reduction in liquidity, operational failures, or insolvency. In addition, the value of residential mortgage loans pledged to us as collateral may decrease. If a borrower defaults, and we are unable to obtain additional collateral to make up for the reduced value of such residential mortgage loan collateral, we could incur losses. A default by a borrower lacking sufficient collateral to cover its obligations to us could result in significant financial losses, which would adversely impact 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.

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 could: (1) 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.
 

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Market Risk
Our profitability may be adversely affected if we are not successful in managing our interest rate risk. Like most financial institutions, our results of operations are significantly affected by our ability to manage interest rate risk. We use a number of tools to monitor and manage interest rate risk, including income simulations and duration/market value sensitivity analyses. Given the unpredictability of the financial markets, capturing all potential outcomes in these analyses is extremely difficult. Key assumptions used in our market value sensitivity analyses include interest rate volatility, mortgage prepayment projections and the future direction of interest rates, among other factors. Key assumptions used in our income simulations include projections of advances volumes and pricing, MPF volumes and pricing, market conditions for our debt, prepayment speeds and cash flows on mortgage-related assets, the level of short-term interest rates, and other factors. These assumptions are inherently uncertain and, as a result, the measures cannot precisely estimate net interest income or the market value of our equity nor can they precisely predict the effect of higher or lower interest rates or changes in other market factors on net interest income or the market value of our equity. Actual results will most likely differ from simulated results due to the timing, magnitude, and frequency of interest rate changes and changes in market conditions and management strategies, among other factors. Our ability to maintain a positive spread between the interest earned on our earning assets and the interest paid on our interest-bearing liabilities may be affected by the unpredictability of changes in interest rates.

There is substantial uncertainty regarding the replacement of the LIBOR benchmark interest rate, which could adversely affect our business, results of operations, and financial condition. In July 2017, the United Kingdom's Financial Conduct Authority (FCA) announced that it plans to phase out the regulatory oversight of LIBOR interest rate indices by 2021. The FCA and the submitting LIBOR banks have indicated they will support the LIBOR indices through 2021 to allow for an orderly transition to an alternative reference rate. While we currently expect LIBOR to be viable benchmark until the end of 2021, it is possible that LIBOR will become unavailable prior to the end of 2021. We are unable to predict when LIBOR will cease to be available and market participants have not agreed on a cessation trigger. The Alternative Reference Rates Committee (ARRC) in the United States has identified SOFR as the rate that represents best practice for use in new US Dollar (USD) derivatives and other financial contracts as its recommended alternative to USD LIBOR in the United States. SOFR is intended to be a broad measure of the average cost of borrowing cash overnight collateralized by Treasury securities. The Federal Reserve Bank of New York began publishing SOFR rates in April 2018. As noted throughout this annual report, many of our assets and liabilities, including derivative assets and derivative liabilities, are indexed to USD LIBOR. A portion of these assets and liabilities and related collateral have maturity dates that extend beyond 2021.

We are evaluating the potential impact of the replacement of the LIBOR benchmark interest rate, including the likelihood of SOFR prevailing as the most widely adopted replacement reference rate. The market transition away from LIBOR is expected to be gradual and complicated, including the development of term and credit adjustments to accommodate differences between LIBOR, an unsecured rate, and SOFR, a secured rate. Introduction of an alternative reference rate also may introduce additional basis risk for market participants as an alternative index is utilized along with LIBOR. There can be no guarantee that SOFR will become widely used and that other alternative reference rates may or may not be developed with additional complications. We are not able to predict whether LIBOR will cease to be available after 2021, whether SOFR will become a widely accepted reference rate in place of LIBOR, or what the precise impact of a possible transition to SOFR or another alternate replacement reference rate will have on our business, financial condition, or results of operations. The upcoming discontinuance of LIBOR and transition to SOFR or an alternative reference rate could adversely impact existing financial assets and liabilities indexed to LIBOR, including the effectiveness of existing hedging transactions, which could have an adverse impact on our business, financial condition, and results of operations.

For additional information on our LIBOR transition efforts and LIBOR exposure, see “Risk Management – Interest Rate Risk Management” under Item 7.

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.

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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 accounting guidance 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.

Liquidity and Capital Risk
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, we are subject to various regulatory liquidity requirements, including a contingency funding 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 funding plan and the related costs, 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.

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 Bank Act requires each FHLBank to contribute to its AHP the greater of: (1) 10 percent of that 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 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. A decline in dividend rates may diminish members’ interest in holding FHLBank capital stock and could decrease demand for advances.

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.
 

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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.
 
Operational Risk
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 and 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.

For additional information on information system and security threats, see “Risk Management – Operations Risk Management” under Item 7.


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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.

For additional information on internal controls, see “Risk Management – Operations Risk Management” under Item 7.

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 Chicago as MPF Provider could have a negative impact on our business if FHLBank Chicago were to default on its contractual obligations owed to us. As part of our business, we participate in the MPF Program with FHLBank Chicago. In its role as MPF Provider, FHLBank 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 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 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.

Item 1B: Unresolved Staff Comments
 
Not applicable.
 
Item 2: Properties
 
We own our primary facility located at 500 SW Wanamaker Road, Topeka, Kansas.
 
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. However, 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.
 

31


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, 2020, we had 706 stockholders of record and 4,524,494 shares of Class A Common Stock and 13,099,122 shares of Class B Common Stock outstanding, including 15,214 shares of Class A Common Stock and 8,500 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) of the Exchange Act 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.
 
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.

Due to the decline in interest rates in recent periods, stock dividends on Class A Common Stock and Class B Common Stock will likely be lower in 2020 than what was paid in 2019. Historically, dividend levels have been influenced by several factors, including the following objectives: (1) moving dividend rates gradually over time; (2) having dividends reflective of the level of current short‑term interest rates; and (3) 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.

Item 6: Selected Financial Data

Table 7 presents Selected Financial Data for the periods indicated (dollar amounts in thousands):

32



Table 7
 
12/31/2019
12/31/2018
12/31/2017
12/31/2016
12/31/2015
Statement of Condition (as of period end):
 
 
 
 
 
Total assets
$
63,276,654

$
47,715,256

$
48,076,605

$
45,216,749

$
44,426,133

Investments1
20,086,473

10,305,382

13,998,599

13,609,653

13,606,080

Advances
30,241,315

28,730,113

26,295,849

23,985,835

23,580,371

Mortgage loans, net2
10,633,009

8,410,462

7,286,397

6,640,725

6,390,708

Total liabilities
60,485,603

45,261,004

45,570,502

43,254,301

42,584,381

Deposits
790,640

473,820

461,769

598,931

759,366

Consolidated obligation discount notes, net3
27,447,911

20,608,332

20,420,651

21,775,341

21,813,446

Consolidated obligation bonds, net3
32,013,314

23,966,394

24,514,468

20,722,335

19,866,034

Total consolidated obligations, net3
59,461,225

44,574,726

44,935,119

42,497,676

41,679,480

Mandatorily redeemable capital stock
2,415

3,597

5,312

2,670

2,739

Total capital
2,791,051

2,454,252

2,506,103

1,962,448

1,841,752

Capital stock
1,766,456

1,524,537

1,640,039

1,226,675

1,208,947

Total retained earnings
999,809

914,022

840,406

735,196

651,782

Accumulated other comprehensive income (loss) (AOCI)
24,786

15,693

25,658

577

(18,977
)
Statement of Income (for the year ended):
 
 
 
 
 
Net interest income
256,064

271,197

270,008

257,184

239,680

Provision (reversal) for credit losses on mortgage loans
387

27

(186
)
(109
)
(1,909
)
Other income (loss)
22,973

(12,847
)
15,987

(13,830
)
(80,089
)
Other expenses
72,816

69,108

67,036

63,706

57,762

Income before assessments
205,834

189,215

219,145

179,757

103,738

AHP
20,597

18,944

21,934

17,984

10,378

Net income
185,237

170,271

197,211

161,773

93,360

Selected Financial Ratios and Other Financial Data (for the year ended):
 
 
 
 
 
Dividends paid in cash4
281

399

267

291

296

Dividends paid in stock4
99,169

96,256

91,734

78,068

68,415

Weighted average dividend rate5
6.46
%
6.13
%
5.77
%
5.29
%
5.26
%
Dividend payout ratio6
53.69
%
56.77
%
46.65
%
48.44
%
73.60
%
Return on average equity
7.32
%
6.82
%
8.18
%
7.45
%
4.78
%
Return on average assets
0.33
%
0.31
%
0.37
%
0.33
%
0.21
%
Average equity to average assets
4.45
%
4.62
%
4.55
%
4.47
%
4.45
%
Net interest margin7
0.45
%
0.50
%
0.51
%
0.53
%
0.55
%
Total capital ratio8
4.41
%
5.14
%
5.21
%
4.34
%
4.14
%
Regulatory capital ratio9
4.38
%
5.12
%
5.17
%
4.34
%
4.19
%
                   
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 $985,000, $812,000, $1,208,000, $1,674,000, and $1,972,000 as of December 31, 2019, 2018, 2017, 2016, and 2015, 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 $139,000, $229,000, $195,000, $79,000, and $39,000 for the years ended December 31, 2019, 2018, 2017, 2016, and 2015, 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.


33


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 report. 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.

Additionally, refer to Item 7 – "Management’s Discussion and Analysis of Financial Condition and Results of Operations" in our 2018 Annual Report on Form 10-K for our MD&A for the fiscal year 2018 compared to fiscal year 2017.

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 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 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 our Capital 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 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 resulting from 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.

Net income for the year ended December 31, 2019 was $185.2 million compared to $170.3 million for the year ended December 31, 2018. The $14.9 million, or 8.8 percent, increase in net income for the year ended December 31, 2019 compared to the prior year was due largely to a $37.7 million increase in unrealized net gains on economic derivatives and trading securities resulting from declines in longer-term market interest rates since December 31, 2018. The unrealized net gains on trading securities were due to decreases in mortgage and U.S. Treasury interest rates and were partially offset by negative fair value fluctuations on some interest rate swaps caused by a decrease in LIBOR between periods. Detailed discussion relating to the fluctuations in net gains (losses) on derivatives and hedging activities and net gains (losses) on trading securities can be found in "Results of Operations" under this MD&A.

34



For the year ended December 31, 2019, net interest income was $256.1 million compared to $271.2 million for the same period in the prior year. The volume of interest-earning assets increased for the year ended December 31, 2019 compared to the prior year, but an increase in premium amortization and tightening spreads caused a $15.1 million, or 5.6 percent, decline in net interest income. Premium amortization on mortgage-related assets increased due to the decline in long-term market interest rates during 2019. This decline resulted in an increase in prepayment speeds on mortgage-related assets which accelerates premium amortization, thereby reducing net interest income. However, this decrease in long-term market interest rates also allowed us to replace some callable debt at a lower cost, which will provide a greater benefit in future periods. The accelerated amortization of concessions (i.e., broker fees) on the called debt further reduced net interest income for the year ended December 31, 2019. Changes in regulatory liquidity requirements effective March 31, 2019 changed the level and composition of assets held for liquidity purposes and the structure of the related funding, which has resulted in spread compression.

The change in net interest income for the year ended December 31, 2019 was also impacted by the adoption of a new hedge accounting standard on January 1, 2019 that requires fair value fluctuations on designated fair value hedges to be presented in the income statement line item related to the hedged item, which is interest income/expense for us. The guidance was adopted prospectively, so the fair value fluctuations on fair value hedges in the prior year are presented in other income, which creates a lack of comparability between periods. Fair value fluctuations on designated fair value hedges decreased net interest income by $2.4 million for the year ended December 31, 2019.

Total assets increased $15.6 billion, or 32.6 percent, from December 31, 2018 to December 31, 2019. Although we experienced growth in mortgage loans and advances, the majority of the increase was in short- and long-term investments in response to changes to regulatory liquidity requirements that became effective March 31, 2019, including the purchase of $5.7 billion in U.S. Treasury obligations since the third quarter of 2018. We believe the MPF Program continues to meet the needs of members by providing a reliable option for mortgage sales, as indicated by mortgage deliveries of over $1.0 billion for each of the last two quarters of 2019.

Total liabilities increased $15.2 billion, or 33.6 percent, from December 31, 2018 to December 31, 2019, which corresponded with the increase in assets, but the funding mix remained consistent between periods. 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, SOFR, Prime, Treasury bills, or the overnight index swap (OIS) rate. For additional information on market trends impacting the cost of issuing debt, including discussion of the transition from LIBOR to an alternate reference rate, see "Market Trends" and "Financial Condition" under this MD&A.

Total capital increased $336.8 million, or 13.7 percent, between periods primarily due to an increase in capital stock held in excess of activity requirements, capital stock related to advance utilization, and growth in retained earnings.

An increase in average assets and average equity combined with the increase in net income resulted in a return on average equity (ROE) of 7.32 percent for the year ended December 31, 2019 compared to 6.82 percent for the prior year. Dividends paid to members totaled $99.5 million for the year ended December 31, 2019 compared to $96.7 million for the prior year. From December 31, 2018 to December 31, 2019, the dividend rate for Class A Common Stock increased to 2.50 percent from 2.00 percent and the dividend rate for Class B Common Stock increased to 7.50 percent from 7.25 percent. The weighted average dividend rate for the year ended December 31, 2019 was 6.46 percent, which represented a dividend payout ratio of 53.7 percent, compared to a weighted average dividend rate of 6.13 percent and a payout ratio of 56.8 percent for the same period in 2018. Differences in the weighted average dividend rates between periods 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 during 2019 and, therefore, the average dividend rates, include regular 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).

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 core mission achievement guidance. The Primary Mission Asset ratio is calculated as average advances and average mortgage loans to average consolidated obligations less average U.S. Treasury securities classified as trading or available-for-sale with maturities of ten years or less, utilizing par balances. Our Primary Mission Asset ratio was 75 percent for 2019. We intend to manage our balance sheet with the goal of maintaining a Primary Mission Asset ratio within a range of 70 to 80 percent. 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.


35


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 8 presents selected market interest rates as of the dates or for the periods shown.

Table 8
Market Instrument
Average Rate
Average Rate
12/31/2019
12/31/2018
2019
2018
Ending Rate
Ending Rate
Secured Overnight Financing Rate1,2
2.21
%
N/A

1.55
%
3.00
%
Federal funds effective rate1
2.16

1.83
%
1.55

2.40

Federal Reserve interest rate on excess reserves1
2.13

1.88

1.55

2.40

3-month U.S. Treasury bill1
2.09

1.96

1.55

2.36

3-month LIBOR1
2.33

2.31

1.91

2.81

2-year U.S. Treasury note1
1.97

2.53

1.57

2.51

5-year U.S. Treasury note1
1.95

2.75

1.69

2.53

10-year U.S. Treasury note1
2.14

2.91

1.92

2.70

30-year residential mortgage note rate1,3
4.22

4.80

3.95

4.84

                   
1 
Source is Bloomberg.
2 
SOFR was first published on April 3, 2018.
3 
Mortgage Bankers Association weekly 30-year fixed rate mortgage contract rate.

During 2019, the cost of FHLBank consolidated obligations as measured by the spread to comparative U.S. Treasury rates remained relatively stable, although the yield curve flattened, which made shorter-term debt more expensive relative to longer-term structures. However, in March 2020, the Federal Open Market Committee (FOMC) announced two emergency decreases to the Federal funds rate, bringing the target range to zero to 0.25 percent due to the anticipated negative impact of coronavirus on the U.S. economy. The FOMC expects to maintain this target range until it is confident that the economy has recovered from the downturn related to the coronavirus outbreak and is on track to achieve its maximum employment and price stability goals. The FOMC also announced an increase in bond purchases as part of quantitative easing. We issue debt at a spread above U.S. Treasury securities; as a result, the level of interest rates impacts the cost of issuing FHLBank consolidated obligations and the cost of advances to our members and housing associates. For further discussion, see this Item 7 – “Financial Condition – Consolidated Obligations.”

In July 2017, the FCA announced that it planned to phase out the regulatory oversight of LIBOR interest rate indices by 2021. The FCA and the submitting LIBOR banks have indicated they will support the LIBOR indices through 2021 to allow for an orderly transition to an alternative reference rate. The ARRC in the United States has proposed SOFR as its recommended alternative to USD LIBOR in the United States. SOFR is intended to be a broad measure of the cost of borrowing cash overnight collateralized by Treasury securities. The Federal Reserve Bank of New York began publishing SOFR rates in April 2018. As noted throughout this annual report, many of our assets and liabilities, including derivative assets and derivative liabilities, are indexed to USD LIBOR. A portion of these assets and liabilities and related collateral have maturity dates that extend beyond 2021. For additional information on our LIBOR transition efforts and LIBOR exposure, see “Risk Management – Interest Rate Risk Management” under this Item 7.

Other factors impacting FHLBank consolidated obligations:
We believe 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. We believe 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; recent regulatory changes in liquidity requirements; changes in interest rates and the shape of the yield curve as the FOMC contemplates changes to monetary policy; and the replacement of LIBOR with another index as previously discussed.

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: (1) the accounting related to derivatives and hedging activities; and (2) fair value determinations.


36


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 hedging our exposure to changes in the fair value of a financial instrument. 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 quantitative effectiveness testing must be performed regularly with results falling within established tolerances. If the hedge fails effectiveness testing, the hedge no longer qualifies for hedge accounting and the derivative is marked to estimated fair value through current period earnings without any offsetting change in estimated fair value related to the hedged item.

For derivative transactions that potentially qualify for long haul fair value hedge accounting treatment, management must assess how effective the derivatives have been, and are expected to be, in hedging offsetting changes in the estimated fair values attributable to the risks being hedged in the hedged items. Quantitative 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 the most recent 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.
 
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 index 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.
 

37


For derivative instruments and hedged items that meet the requirements as described above and are designated as fair value hedges, we do not anticipate any significant impact on our financial condition or operating performance. For derivative instruments not qualifying for hedge accounting or with no identified hedged item, changes in the market value of the derivative are reflected in income without any offset. As of December 31, 2019 and 2018, 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 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 62 and 63 under Item 7A – "Quantitative and Qualitative Disclosures About Market Risk," which present the notional amount and fair value amount 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 $1.9 billion and $0.8 billion, respectively, as of December 31, 2019, 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 15 through 18 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, 2019 and 2018, 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 Part II, 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.

As of December 31, 2019, 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.


38


Results of Operations
Earnings Analysis: Table 9 presents changes in the major components of our net income (dollar amounts in thousands):

Table 9
 
Increase (Decrease) in Earnings Components
 
2019 vs. 2018
 
Dollar Change
Percentage Change
Total interest income
$
231,743

18.4
 %
Total interest expense
246,876

25.0

Net interest income
(15,133
)
(5.6
)
Provision (reversal) for credit losses on mortgage loans
360

1,333.3

Net interest income after mortgage loan loss provision
(15,493
)
(5.7
)
Net gains (losses) on trading securities
92,171

420.7

Net gains (losses) on derivatives and hedging activities
(54,432
)
(1,705.8
)
Other non-interest income
(1,919
)
(15.7
)
Total other income (loss)
35,820

278.8

Operating expenses
965

1.7

Other non-interest expenses
2,743

21.6

Total other expenses
3,708

5.4

AHP assessments
1,653

8.7

NET INCOME
$
14,966

8.8
 %

Table 10 presents the amounts contributed by our principal sources of interest income (dollar amounts in thousands):

Table 10
 
Year Ended December 31,
 
2019
2018
2017
 
Interest Income
Percent of Total
Interest Income
Percent of Total
Interest Income
Percent of Total
Investments1
$
466,531

31.3
%
$
361,563

28.8
%
$
214,239

25.7
%
Advances
716,199

48.1

637,203

50.7

402,071

48.3

Mortgage loans held for portfolio
304,582

20.5

256,698

20.4

214,388

25.8

Other
1,440

0.1

1,545

0.1

1,280

0.2

TOTAL INTEREST INCOME
$
1,488,752

100.0
%
$
1,257,009

100.0
%
$
831,978

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.


39


Net income for the year ended December 31, 2019 was $185.2 million compared to $170.3 million for the year ended December 31, 2018. The $14.9 million, or 8.8 percent, increase in net income for the year ended December 31, 2019 compared to the prior year was due largely to a $37.7 million increase in net unrealized gains on trading securities and derivatives. The net unrealized gains on trading securities were due mostly to decreases in mortgage and U.S. Treasury interest rates during 2019, which were partially offset by the negative fair value fluctuations on some interest rate swaps caused by the decrease in LIBOR between periods. Detailed discussion relating to the fluctuations in net gains (losses) on derivatives and hedging activities and net gains (losses) on trading securities can be found in this section under the heading "Net Gains (Losses) on Derivatives and Hedging Activities" and "Net Gains (Losses) On Trading Securities." Net interest income decreased by $15.1 million for the year ended December 31, 2019 compared to the same period in the prior year due primarily to increased premium amortization, discussed in greater detail below. Other expenses increased by $3.7 million from December 31, 2018 to December 31, 2019 primarily due to an increase in mortgage loan transaction fees due to the growth in the mortgage loan portfolio and FHLBank System-related expenses. An increase in average assets and average equity combined with the increase in net income resulted in an ROE of 7.32 percent for the year ended December 31, 2019 compared to 6.82 percent for the prior year. Dividends paid to members totaled $99.5 million for the year ended December 31, 2019 compared to $96.7 million for the prior year.

Net Interest Income: Net interest income was $256.1 million for the year ended December 31,2019 compared to $271.2 million for the same period in the prior year. The volume of interest-earning assets increased for the year ended December 31, 2019 compared to the prior year, but an increase in premium amortization and tightening spreads caused a $15.1 million, or 5.6 percent, decline in net interest income. Premium amortization on mortgage-related assets increased due to the decline in long-term market interest rates during 2019. This decline resulted in an increase in prepayment speeds on mortgage-related assets which accelerates premium amortization, thereby reducing net interest income. However, this decrease in long-term market interest rates also allowed us to replace some callable debt at a lower cost, which will provide a greater benefit in future periods. The accelerated amortization of concessions (i.e., broker fees) on the called debt further reduced net interest income.

The change in net interest income for the year ended December 31, 2019 was also impacted by the adoption of a new hedge accounting standard on January 1, 2019 that requires fair value fluctuations on designated fair value hedges to be presented in the income statement line item related to the hedged item, which is interest income/expense for us. The guidance was adopted prospectively, so the fair value fluctuations on fair value hedges in the prior year are presented in other income, which creates a lack of comparability between periods. Fair value fluctuations on designated fair value hedges decreased net interest income by $2.4 million for the year ended December 31, 2019.

Yields: Market interest rates and trends affect yields and net interest margin on earning assets, including advances, mortgage loans, and investments. The average yield on total interest-earning assets for the year ended December 31, 2019 was 2.62 percent compared to 2.34 percent for the year ended December 31, 2018. The average cost of interest-bearing liabilities for the year ended December 31, 2019 was 2.28 percent, compared to 1.92 percent for the year ended December 31, 2018. Net interest margin declined by 5 basis points to 45 basis points for the year ended December 31, 2019 compared to 50 basis points in the prior year due largely to an increase in average funding cost driven largely by the changes in short-term interest rates and the accelerated amortization of concessions. These same factors also caused net interest spread to decline by 8 basis points for the same period, to 34 basis points for the year ended December 31, 2019 compared to 42 basis points for the same period in the prior year (see Table 13). Recent changes in regulatory liquidity requirements changed the level and composition of assets held for liquidity purposes and the structure of the related funding. The change in liquidity requirements has resulted in margin and spread compression, specifically as it relates to overnight assets funded with term debt, as the average cost of discount notes increased 39 basis points during 2019 compared to 2018 and the average yield on short-term investments increased 35 basis points over the same period. The increase in premium amortization on mortgage loans and the accelerated concession amortization on consolidated obligations decreased net interest spread by four basis points and decreased net interest margin by four basis points. 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.

Average Balances: The average balance of interest-earning assets increased $3.0 billion, or 5.5 percent, for the year ended December 31, 2019 compared to the same period in the prior year. This increase was due to a $3.0 billion, or 19.1 percent, increase in the average balance of investments, which consist of interest-bearing deposits, Federal funds sold, reverse repurchase agreements, and investment securities, largely in response to changes in regulatory liquidity requirements. The average balance of advances decreased $1.6 billion, or 5.3 percent, during 2019 compared to 2018, almost entirely as a result of a decrease in the average balance of line of credit advances. A portion of the growth in average advances over the past few years has resulted from our members’ ability to invest advances in excess reserves at the Federal Reserve and receive a profitable risk adjusted return largely because of the dividend paid on the capital stock supporting the advances. During 2018 and 2019, the short-term advance rates became less attractive relative to the yield on excess reserves at the Federal Reserve. The average balance of mortgage loans increased $1.5 billion, or 19.3 percent, despite prepayment activity associated with the decline in mortgage interest rates during 2019. The increase in mortgage loans was attributed in large part to continued production from our top five PFIs and utilization of recent program enhancements that provide PFIs with additional funding opportunities.


40


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. 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 15 and 16 under this Item 7), which does not reflect the full economic impact of the swaps on yields, especially for trading investments that are swapped to a variable rate. For 2019, net interest income is also impacted by unrealized gains (losses) on hedged items and derivatives in qualifying hedge relationships as a result of new hedge accounting guidance adopted January 1, 2019. Tables 11 and 12 present the impact of derivatives and hedging activities recorded in net interest income (in thousands):

Table 11
 
2019
 
Advances
Investments
Mortgage Loans
Consolidated Obligation Discount Notes
Consolidated Obligation Bonds
Total
Unrealized gains (losses) due to fair value changes
$
47

$
(2,274
)
$

$
193

$
(363
)
$
(2,397
)
Net amortization/accretion of hedging activities
(1,356
)

(2,029
)


(3,385
)
Net interest received (paid)
19,860

1,281


20

(5,312
)
15,849

TOTAL
$
18,551

$
(993
)
$
(2,029
)
$
213

$
(5,675
)
$
10,067


Table 12
 
2018
 
Advances
Investments
Mortgage Loans
Consolidated Obligation Discount Notes
Consolidated Obligation Bonds
Total
Net amortization/accretion of hedging activities
$
(3,881
)
$

$
(403
)
$

$

$
(4,284
)
Net interest received (paid)
9,653

474


12

(5,178
)
4,961

TOTAL
$
5,772

$
474

$
(403
)
$
12

$
(5,178
)
$
677



41


Table 13 presents average balances and yields of major earning asset categories and the sources funding those earning assets (dollar amounts in thousands):

Table 13
 
2019
2018
2017
 
Average
Balance
Interest
Income/
Expense
Yield
Average
Balance
Interest
Income/
Expense
Yield
Average
Balance
Interest
Income/Expense
Yield
Interest-earning assets:
 

 

 

 

 

 

 
 
 
Interest-bearing deposits
$
888,890

$
19,801

2.23
%
$
762,346

$
14,957

1.96
%
$
417,175

$
4,204

1.01
%
Securities purchased under agreements to resell
4,521,312

104,397

2.31

3,571,355

71,298

2.00

2,323,216

23,937

1.03

Federal funds sold
1,476,595

32,834

2.22

2,229,989

40,306

1.81

2,716,688

27,994

1.03

Investment securities1,2
12,121,452

309,499

2.55

9,401,909

235,002

2.50

8,864,480

158,104

1.78

Advances2,3
28,322,033

716,199

2.53

29,899,634

637,203

2.13

31,605,448

402,071

1.27

Mortgage loans4,5
9,326,732

304,582

3.27

7,816,191

256,698

3.28

6,891,057

214,388

3.11

Other interest-earning assets
47,752

1,440

3.02

46,113

1,545

3.35

29,530

1,280

4.33

Total earning assets
56,704,766

1,488,752

2.62

53,727,537

1,257,009

2.34

52,847,594

831,978

1.57

Other non-interest-earning assets
241,586

 

 

357,122

 

 

204,665

 
 
Total assets
$
56,946,352

 

 

$
54,084,659

 

 

$
53,052,259

 
 
 












 
 
 
Interest-bearing liabilities:
 

 

 

 

 

 

 
 
 
Deposits
$
544,001

9,820

1.81

$
560,819

8,912

1.59

$
486,747

3,371

0.69

Consolidated obligations2:
 

 

 

 

 

 

 

 

 

Discount Notes
23,972,736

532,155

2.22

24,713,789

451,380

1.83

26,811,378

237,019

0.88

Bonds
29,441,519

689,275

2.34

25,988,893

524,255

2.02

23,038,357

320,895

1.39

Other borrowings
51,854

1,438

2.78

44,565

1,265

2.84

19,257

685

3.56

Total interest-bearing liabilities
54,010,110

1,232,688

2.28

51,308,066

985,812

1.92

50,355,739

561,970

1.11

Capital and other non-interest-bearing funds
2,936,242

 

 

2,776,593

 

 

2,696,520

 
 
Total funding
$
56,946,352

 

 

$
54,084,659

 

 

$
53,052,259

 
 
 












 
 
 
Net interest income and net interest spread6
 

$
256,064

0.34
%
 

$
271,197

0.42
%
 
$
270,008

0.46
%
 












 
 
 
Net interest margin7
 

 

0.45
%
 

 

0.50
%
 
 
0.51
%
                   
1 
The non-credit portion of the other-than-temporary (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. For 2019, interest amounts reported for advances, investment securities, consolidated obligation discount notes, and consolidated obligation bonds include realized and unrealized gains (losses) on hedged items and derivatives in qualifying hedge relationships. Prior period interest amounts do not conform to new hedge accounting guidance adopted January 1, 2019.
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 $6.9 million, $6.1 million and $5.7 million for the years ended December 31, 2019, 2018, and 2017, 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 defined as net interest income as a percentage of average interest-earning assets.


42


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 14 summarizes changes in interest income and interest expense (in thousands):

Table 14
 
2019 vs. 2018
2018 vs. 2017
 
Increase (Decrease) Due to
Increase (Decrease) Due to
 
Volume1,2
Rate1,2
Total
Volume1,2
Rate1,2
Total
Interest Income3:
 

 

 

 
 
 
Interest-bearing deposits
$
2,668

$
2,176

$
4,844

$
5,014

$
5,739

$
10,753

Securities purchased under agreements to resell
20,834

12,265

33,099

17,253

30,108

47,361

Federal funds sold
(15,481
)
8,009

(7,472
)
(5,741
)
18,053

12,312

Investment securities
69,338

5,159

74,497

10,090

66,808

76,898

Advances
(35,004
)
114,000

78,996

(22,785
)
257,917

235,132

Mortgage loans
49,338

(1,454
)
47,884

29,914

12,396

42,310

Other assets
51

(156
)
(105
)
602

(337
)
265

Total earning assets
91,744

139,999

231,743

34,347

390,684

425,031

Interest Expense3:
 

 

 

 
 
 
Deposits
(274
)
1,182

908

583

4,958

5,541

Consolidated obligations:
 

 

 

 

 

 

Discount notes
(13,891
)
94,666

80,775

(19,895
)
234,256

214,361

Bonds
74,711

90,309

165,020

45,191

158,169

203,360

Other borrowings
202

(29
)
173

743

(163
)
580

Total interest-bearing liabilities
60,748

186,128

246,876

26,622

397,220

423,842

Change in net interest income
$
30,996

$
(46,129
)
$
(15,133
)
$
7,725

$
(6,536
)
$
1,189

                   
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.
3 
Interest income/expense and average rates include the effect of associated derivatives that qualify for hedge accounting treatment. For 2019, interest amounts reported for advances, investment securities, consolidated obligation discount notes, and consolidated obligation bonds include realized and unrealized gains (losses) on hedged items and derivatives in qualifying hedge relationships. Prior period interest amounts do not conform to new hedge accounting guidance adopted January 1, 2019.

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).

As reflected in Tables 15 and 16, the majority of the net unrealized gains and losses on derivatives are related to changes in the fair values of economic derivatives, which do not qualify for hedge accounting treatment under GAAP. Net interest payments or receipts on these economic derivatives 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. For periods prior to January 1, 2019, ineffectiveness on fair value hedges contributed to unrealized gains and losses on derivatives, but to a lesser degree. Beginning January 1, 2019, fair value fluctuations on fair value hedges are recorded in the financial statement line item related to the hedged item (i.e., interest income or expense) in accordance with the prospective adoption of new hedge accounting guidance. 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. Net unrealized gains or losses on derivatives will continue to be a function of the general level of swap rates but also a function of the spreads in relationship to the relevant index rate. Tables 15 and 16 present the earnings impact of derivatives and hedging activities by financial instrument as recorded in other non-interest income (in thousands):


43


Table 15
 
2019
 
Advances
Investments
Mortgage Loans
Consolidated Obligation Discount Notes
Consolidated Obligation Bonds
Total
Derivatives not designated as hedging instruments:
 

 

 

 
 

 

Economic hedges – unrealized gains (losses) due to fair value changes
$
(1,379
)
$
(71,468
)
$

$
(1
)
$
14,960

$
(57,888
)
Mortgage delivery commitments


4,309



4,309

Discount note commitments



(70
)

(70
)
Economic hedges – net interest received (paid)
(21
)
(2,263
)

(3
)
(1,687
)
(3,974
)
Net gains (losses) on derivatives and hedging activities
(1,400
)
(73,731
)
4,309

(74
)
13,273

(57,623
)
Net gains (losses) on trading securities hedged on an economic basis with derivatives

70,950




70,950

TOTAL
$
(1,400
)
$
(2,781
)
$
4,309

$
(74
)
$
13,273

$
13,327


Table 16
 
2018
 
Advances
Investments
Mortgage Loans
Consolidated
Obligation Discount Notes
Consolidated
Obligation Bonds
Other
Total
Net gains (losses) on derivatives and hedging activities:
 

 

 

 
 

 

 

Fair value hedges - unrealized gains (losses) due to fair value changes
$
(4,450
)
$
(2,091
)
$

$

$
251

$

$
(6,290
)
Economic hedges – unrealized gains (losses) due to fair value changes
(333
)
15,880



(4,061
)

11,486

Mortgage delivery commitments


(1,642
)



(1,642
)
Discount note commitments



70



70

Economic hedges – net interest received (paid)
(2
)
(4,172
)


(1,302
)

(5,476
)
Price alignment amount on derivatives for which variation margin is daily settled





(1,339
)
(1,339
)
Net gains (losses) on derivatives and hedging activities
(4,785
)
9,617

(1,642
)
70

(5,112
)
(1,339
)
(3,191
)
Net gains (losses) on trading securities hedged on an economic basis with derivatives

(20,082
)




(20,082
)
TOTAL
$
(4,785
)
$
(10,465
)
$
(1,642
)
$
70

$
(5,112
)
$
(1,339
)
$
(23,273
)


44


For the years ended December 31, 2019 and 2018, net unrealized losses on derivatives decreased net income by $57.6 million and $3.2 million, respectively. For 2019, the majority of the losses were economic interest rate swaps associated with trading securities, and declines in LIBOR and OIS (the index rates on these swaps) between 2018 and 2019 resulted in fair value losses that were largely offset by fair value gains on the trading securities (see Table 17). We experienced unrealized fair value gains on basis swaps economically hedging consolidated obligations primarily caused by the decline in one-month LIBOR. We experienced unrealized fair value losses on interest rate swaps indexed to OIS and hedging U.S. Treasury obligations held in our trading portfolio as OIS declined towards the end of the year relative to the rates at inception. These fluctuations were offset by unrealized gains for the year ended December 31, 2019 attributable to the swapped U.S. Treasury obligations, which are recorded in net gains (losses) on trading securities. Unrealized losses on our interest rate swaps matched to GSE debentures for the year ended December 31, 2019 were a result of the passage of time, as several derivatives approached maturity (reducing the overall loss position of the derivatives), changes in interest rates for their respective maturities (pay fixed rate swap), and decreases in three-month LIBOR (receive variable rate swap). These fluctuations were offset by unrealized gains for the years ended December 31, 2019 attributable to the swapped GSE debentures, which are recorded in net gains (losses) on trading securities.

For 2018, the majority of economic interest rate swaps associated with trading securities were in an unrealized gain position due to increases in LIBOR from the prior period, but we experienced unrealized fair value losses on basis swaps economically hedging consolidated obligations caused by widening between one- and three-month LIBOR in early 2018. We experienced unrealized fair value losses on the interest rate swaps indexed to OIS and hedging U.S. Treasury obligations held in our trading portfolio, as OIS declined towards the end of the year relative to the rates at inception. These fluctuations were offset by unrealized gains for the year ended December 31, 2018 attributable to the swapped U.S. Treasury obligations, which are recorded in net gains (losses) on trading securities. The unrealized gains on our interest rate swaps matched to GSE debentures were a result of the passage of time, changes in interest rates for their respective maturities (pay fixed rate swap), and increases in three-month LIBOR (receive variable rate swap). These fluctuations were offset by unrealized losses for the years ended December 31, 2018 attributable to the swapped GSE debentures, which are recorded in net gains (losses) on trading securities. Changes in the LIBOR swap curve over the respective periods resulted in positive fair value fluctuations on interest rate swaps hedging multi-family GSE MBS recorded as trading securities. We experienced unrealized losses on our fixed rate multi-family GSE MBS investments for the year ended December 31, 2018 compared to unrealized gains in the prior year due to an increase in mortgage-related interest rates between 2017 and 2018. 

Table 17 presents the relationship between the swapped trading securities and the associated interest rate swaps that do not qualify for hedge accounting treatment, by investment type (in thousands):

Table 17
 
2019
2018
 
Gains (Losses) on Derivatives
Gains (Losses) on Trading Securities
Net
Gains (Losses) on Derivatives
Gains (Losses) on Trading Securities
Net
U.S. Treasury obligations
$
(18,745
)
$
18,766

$
21

$
(4,552
)
$
4,408

$
(144
)
GSE debentures
(14,951
)
16,026

1,075

6,718

(7,356
)
(638
)
GSE MBS
(37,421
)
36,158

(1,263
)
13,681

(17,134
)
(3,453
)
TOTAL
$
(71,117
)
$
70,950

$
(167
)
$
15,847

$
(20,082
)
$
(4,235
)

For additional detail regarding gains and losses on trading securities, see Table 18 and related discussion under this Item 7 – “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Results of Operations.”

See Tables 62 and 63 under Item 7A – “Quantitative and Qualitative Disclosures About Market Risk” for additional detail regarding notional and fair value amounts of derivative instruments.


45


Net Gains (Losses) on Trading Securities: All unrealized gains and losses related to trading securities are recorded in other income (loss) as net gains (losses) on trading securities; however, only gains and losses relating to trading securities that are related to economic hedges are included in Tables 15 and 16. Unrealized gains (losses) fluctuate as the fair value of our trading portfolio fluctuates. There are a number of factors that can impact the fair value of a trading security including the movement in interest rates, changes in credit spreads, the passage of time, and changes in price volatility. Table 18 presents the major components of the net gains (losses) on trading securities (in thousands):

Table 18
 
2019
2018
Trading securities not hedged:
 
 
GSE debentures
$
(496
)
$
(1,731
)
U.S. obligation MBS and GSE MBS
(193
)
(113
)
Short-term securities

16

Total trading securities not hedged
(689
)
(1,828
)
Trading securities hedged on an economic basis with derivatives:
 
 
U.S. Treasury obligations
18,766

4,408

GSE debentures
16,026

(7,356
)
GSE MBS
36,158

(17,134
)
Total trading securities hedged on an economic basis with derivatives
70,950

(20,082
)
TOTAL
$
70,261

$
(21,910
)

Our trading portfolio is comprised primarily of fixed rate U.S. Treasury obligations, GSE debentures, and multi-family GSE MBS, with smaller percentages of variable rate GSE debentures and GSE MBS. Periodically, we also invest in short-term securities classified as trading for liquidity purposes. In general, the fixed rate securities are related to economic hedges in the form of interest rate swaps that convert fixed rates to variable rates (see Table 17 for the association between the gains (losses) on the fixed rate securities and the related economic hedges). The fair values of the fixed rate GSE debentures are affected by changes in intermediate interest rates and credit spreads, and are swapped on an economic basis to three-month LIBOR. The fair values of the fixed rate multi-family GSE MBS are affected by changes in mortgage rates and credit spreads, and these securities are swapped on an economic basis to one-month LIBOR. The fair values of the U.S. Treasury obligations are affected by changes in intermediate Treasury rates and swapped on an economic basis to OIS. We experienced unrealized gains on our fixed rate multi-family GSE MBS investments for the year ended December 31, 2019 compared to unrealized losses for the year ended December 31, 2018 due to a decrease in mortgage-related interest rates between periods. The decrease in intermediate interest rates between periods resulted in unrealized gains on the fixed rate GSE debentures and U.S. Treasury obligations for the year ended December 31, 2019. In addition to interest rates and credit spreads, the value of these securities is affected by time decay. The fixed rate GSE debentures possess coupons that are well above current market rates for similar securities and, therefore, are currently valued at substantial premiums. As these securities approach maturity, their prices will converge to par resulting in a decrease in their current premium price (i.e., time decay). Given that the variable rate GSE debentures re-price monthly, they generally account for a small portion of the net gains (losses) on trading securities unless current market spreads on these variable rate securities diverge from the spreads at the time of our acquisition of the securities.

See Tables 62 and 63 under Item 7A – “Quantitative and Qualitative Disclosures About Market Risk” for additional detail regarding notional and fair value amounts of derivative instruments.

Operating Expenses: Operating expenses include compensation and benefits and other operating expenses as presented in the Statements of Income included under Item 8 – “Financial Statements and Supplementary Data.” Approximately two-thirds of our operating expenses consist of compensation and benefits expense. Compensation and benefits expense remained relatively flat for 2019 compared to 2018 despite an increase in salary expense as a result of higher goal achievement as it relates to incentive compensation, hiring for new positions, and increases in market salaries in the industry. These increases were offset by a decrease in employee benefit expense resulting from favorable investment returns on our pension fund investment; thus, no additional contributions were required in 2019. We expect modest increases in compensation and benefits expense for 2020 in anticipation of hiring for new positions. We expect to remain at or near current levels of other operating expenses for 2020.

Other Expenses: We pay FHLBank Chicago for administering the MPF Program and maintaining the infrastructure through which we fund or purchase MPF loans from our PFIs. The increase in other expenses for the year ended December 31, 2019 compared to the prior year was due primarily to an increase in mortgage loan transaction fees due to the growth in the mortgage loan portfolio.


46


We, together with the other FHLBanks, are charged for the cost of operating the FHFA and the Office of Finance. The FHFA’s operating costs are also shared by Fannie Mae and Freddie Mac, and the Recovery Act prohibits assessments on the FHLBanks for operating costs in excess of the costs and expenses related to the FHLBanks. These expenses increased during 2019 and are expected to increase in 2020.

Non-GAAP Measures: We fulfill our mission by: (1) providing liquidity to our members through the offering of advances to finance housing, economic development and community lending; (2) supporting residential mortgage lending through the MPF Program and purchases of MBS; and (3) providing regional affordable housing programs that create housing opportunities for very low-, low- and moderate-income families. In order to effectively accomplish our mission, we must obtain adequate funding amounts at acceptable interest rate levels. We use derivatives as tools to reduce our funding costs and manage interest rate risk and prepayment risk. We also acquire and classify certain investments as trading securities for liquidity and asset-liability management purposes. Although we strive to manage interest rate risk and prepayment risk utilizing these transactions for asset-liability tools, we do not manage the fluctuations in the fair value of our derivatives or trading securities. We are essentially a “hold-to-maturity” investor and transact derivatives only for hedging purposes, even though some derivative hedging relationships do not qualify for hedge accounting under GAAP (referred to as economic hedges) and therefore can add significant volatility to our GAAP net income.

We believe that certain non-GAAP financial measures are helpful in understanding our operating results and provide meaningful period-to-period comparison of our long-term economic value in contrast to GAAP results, which can be impacted by fair value changes driven by market volatility, gains/losses on instrument sales, or transactions that are considered unpredictable or not routine. Our business model is primarily one of holding assets and liabilities to maturity. However, we utilize some assets and liabilities for liquidity purposes, which may involve periodic instrument sales. We report the following non-GAAP financial measures that we believe are useful to stakeholders as key measures of our operating performance: (1) adjusted income, (2) adjusted net interest margin, and (3) adjusted ROE. Reconciliations of these non-GAAP financial measures to the most comparable GAAP measure are included below. Although we calculate our non-GAAP financial measures consistently from period to period using appropriate GAAP components, non-GAAP financial measures are not required to be uniformly applied and are not audited. Another material limitation associated with the use of non-GAAP financial measures is that they have no standardized measurement prescribed by GAAP and may not be comparable to similar non-GAAP financial measures used by other companies. While we believe the non-GAAP measures contained in this annual report are frequently used by our stakeholders in the evaluation of our performance, such non-GAAP measures have limitations as analytical tools and should not be considered in isolation or as a substitute for analyses of financial information prepared in accordance with GAAP.

As part of evaluating our financial performance, we adjust net income reported in accordance with GAAP for the impact of: (1) AHP assessments (equivalent to an effective minimum income tax rate of 10 percent); (2) fair value changes on derivatives and hedging activities (excludes net interest settlements); and (3) other items excluded because they are not considered a part of our routine operations or ongoing business model, such as prepayment fees, gains/losses on retirement of debt, gains/losses on mortgage loans held for sale, and gains/losses on securities. The result is referred to as “adjusted income,” which is a non-GAAP measure of income. Adjusted income is used to compute an adjusted ROE that is then compared to the average overnight Federal funds effective rate, with the difference referred to as adjusted ROE spread. Components of adjusted income and adjusted ROE spread are used: (1) to measure performance under our incentive compensation plans; (2) as a measure in determining the level of quarterly dividends; and (3) in strategic planning. While we utilize adjusted income as a key measure in determining the level of dividends, we consider GAAP net income volatility caused by gains (losses) on derivatives and hedging activities and trading securities in determining the adequacy of our retained earnings as determined under GAAP. Because the adequacy of GAAP retained earnings is considered in setting the level of our quarterly dividends, gains (losses) on derivatives and hedging activities and trading securities can come into consideration when setting the level of our quarterly dividends. Because we are primarily a “hold-to-maturity” investor and do not trade derivatives, we believe that adjusted income, adjusted ROE and adjusted ROE spread are helpful in understanding our operating results and provide a meaningful period-to-period comparison. In contrast, GAAP net income, ROE based on GAAP net income and ROE spread based on GAAP net income can vary significantly from period to period because of fair value changes on derivatives and certain other items that management excludes when evaluating operational performance. Management believes such volatility hinders a consistent measurement analysis.

Derivative and hedge accounting affects the timing of income or expense from derivatives. However, when the derivatives are held to maturity or call dates, there is no economic income or expense impact from these derivatives. For example, interest rate caps are purchased with an upfront fixed cost to provide protection against the risk of rising interest rates. Under derivative accounting guidance, these instruments are then marked to fair value each month, which can result in having to recognize significant fair value gains and losses from year to year, producing volatility in our GAAP net income. However, if held to maturity, the sum of such gains and losses over the term of a derivative will equal its original purchase price.


47


In addition to impacting the timing of income and expense from derivatives, derivative accounting also impacts the presentation of net interest settlements on derivatives and hedging activities. This presentation differs under GAAP for economic hedges when compared to hedges that qualify for hedge accounting. Net interest settlements on economic hedges are included with the economic derivative fair value changes and are recorded in net gains (losses) on derivatives and hedging activities while the net interest settlements on qualifying fair value hedges are included in net interest margin. Therefore, only the economic derivative fair value changes and the ineffectiveness for qualifying hedges included in the net gains (losses) on derivatives and hedging activities are removed to arrive at adjusted income (i.e., net interest settlements, which represent actual cash inflows or outflows and do not create fair value volatility, are not removed).

Table 19 presents a reconciliation of GAAP net income to adjusted income (in thousands):

Table 19
 
2019
2018
Net income, as reported under GAAP
$
185,237

$
170,271

AHP assessments
20,597

18,944

Income before AHP assessments
205,834

189,215

Derivative (gains) losses1
56,046

(2,285
)
Trading (gains) losses
(70,261
)
21,910

Prepayment fees on terminated advances
(763
)
(277
)
Net (gains) losses on sale of held-to-maturity securities
46

(1,591
)
Total excluded items
(14,932
)
17,757

Adjusted income (a non-GAAP measure)
$
190,902

$
206,972

                   
1 
Consists of fair value changes on all derivatives and hedging activities excluding net interest settlements (see next table) on economic hedges.

Adjusted income decreased $16.1 million for the year ended December 31, 2019 compared to the prior year as a result of a $11.7 million decrease in adjusted net interest income and a $3.7 million increase in other expenses. The decrease in adjusted net interest income for the year was a result of accelerated amortization of concessions on called bonds and accelerated amortization of premiums on mortgage-related assets (see Table 20). The increase in other expenses for the year ended December 31, 2019 was due primarily to an increase in mortgage loan transaction fees due to the growth in the mortgage loan portfolio and FHLBank System-related expenses.

Table 20 presents a reconciliation of GAAP net interest income to adjusted net interest income (in thousands):

Table 20
 
2019
2018
Net interest income, as reported under GAAP
$
256,064

$
271,197

(Gains) losses on derivatives qualifying for hedge accounting recorded in net interest income1
2,397


Net interest settlements on derivatives not qualifying for hedge accounting
(3,974
)
(5,476
)
Prepayment fees on terminated advances
(763
)
(277
)
Adjusted net interest income (a non-GAAP measure)
$
253,724

$
265,444

 
 
 
Net interest margin, as calculated under GAAP
0.45
%
0.50
%
Adjusted net interest margin (a non-GAAP measure)
0.45
%
0.49
%
_________                   
1 
Beginning January 1, 2019, fair value gains and losses on fair value hedges are required to be presented in the income statement line item related to the hedged item, which impacts net interest income prospectively.


48


Management uses adjusted income to evaluate the quality of our earnings. FHLBank management believes that the presentation of adjusted income as measured for management purposes enhances the understanding of our performance by highlighting its underlying results and profitability. Management uses adjusted net interest income to evaluate the earnings impact of economic hedges. Under GAAP, the net interest amount that converts economically swapped fixed rate investments or liabilities to a variable rate is recorded as part of net gains (losses) on derivatives and hedging activities rather than net interest income. Presenting fixed rate investments with the corresponding net interest amount in adjusted net interest income reflects the widening of the spread between the variable rate assets created by the economic hedge and the variable rate liabilities funding them as a result of the change in average LIBOR, SOFR, or OIS between periods. Further, beginning January 1, 2019, fair value gains and losses on fair value hedges are required to be presented in the income statement line item related to the hedged item, which impacts net interest income. These fluctuations are excluded from the calculation of adjusted net income and adjusted net interest income.

Table 21 presents a comparison of adjusted ROE (a non-GAAP financial measure) to the average overnight Federal funds rate, which we use as a key measure of effective utilization and management of members’ capital. The decrease in adjusted ROE for the year ended December 31, 2019 compared to the prior year reflects the decrease in adjusted net income and the increase in average capital; however, the increase in average assets and average capital positively impacted ROE and partially offset the decrease in adjusted net income. Adjusted ROE spread is calculated as follows (dollar amounts in thousands):

Table 21
 
2019
2018
Average GAAP total capital
$
2,531,504

$
2,496,609

ROE, based upon GAAP net income
7.32
%
6.82
%
Adjusted ROE, based upon adjusted income
7.54
%
8.29
%
Average overnight Federal funds effective rate
2.16
%
1.83
%
Adjusted ROE as a spread to average overnight Federal funds effective rate
5.38
%
6.46
%

Financial Condition
Overall: Total assets increased $15.6 billion, or 32.6 percent, from December 31, 2018 to December 31, 2019 Although we experienced growth in mortgage loans and advances, the majority of the increase was in short- and long-term investments in response to changes to regulatory liquidity requirements that became effective March 31, 2019, including the purchase of $5.7 billion in U.S. Treasury obligations since the third quarter of 2018. The MPF Program continues to meet the needs of members by providing a reliable option for mortgage sales, as indicated by mortgage deliveries of over $1.0 billion for each of the last two quarters of 2019. Total capital increased $336.8 million, or 13.7 percent, between periods primarily due to an increase in capital stock held in excess of activity requirements, capital stock related to advance utilization, and growth in retained earnings.

Total liabilities increased $15.2 billion, or 33.6 percent, from December 31, 2018 to December 31, 2019. This increase was primarily due to an $8.0 billion increase in consolidated obligation bonds and a $6.8 billion increase in consolidated obligation discount notes, which corresponded with the increase in assets, but the funding mix remained consistent between periods. 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, SOFR, Prime, Treasury bills, or OIS. We replaced some discount note funding with bonds indexed to SOFR during 2019 in part to reduce our exposure to LIBOR as the market prepares to transition away from LIBOR as a reference rate. For additional information on our LIBOR transition efforts and LIBOR exposure, see “Risk Management – Interest Rate Risk Management” under this Item 7.

Dividends paid to members totaled $99.5 million for the year ended December 31, 2019 compared to $96.7 million for the same period in the prior year. The weighted average dividend rate for the year ended December 31, 2019 was 6.46 percent, which represented a dividend payout ratio of 53.7 percent, compared to a weighted average dividend rate of 6.13 percent and a payout ratio of 56.8 percent for the same period in 2018.


49


Short-term money market investments and investment securities increased notably as a percentage of assets at December 31, 2019 compared to December 31, 2018. The increase in money market investments was driven by attractive yields and spreads on reverse repurchase agreements while maintaining targeted leverage. The increase in investment securities was largely due to purchases of U.S. Treasury obligations in response to regulatory liquidity requirements that became effective March 31, 2019. We continue to fund our short-term advances and overnight investments with term and overnight discount notes, but we also began to fund overnight investments with floating rate bonds to achieve certain liquidity targets. The decrease in the percentage of advances and mortgage loans to total assets was a direct result of the increase in short-term investments and investment securities at December 31, 2019 compared to December 31, 2018. Table 22&